Stocks continued to slump Friday even as bond yields recovered a bit. But the yield on the 10-year Treasury is back above 5% early this morning and equity futures are back in the red. Monday is often a big day for merger news. Today’s biggie is Chevron’s# planned $53 billion acquisition of Hess, somewhat replicating the $60 billion purchase of Pioneer Natural Resources by Exxon.
One factor that gets less attention than deserved is the Fed’s goal to reduce its balance sheet by $90 billion per month, a program that has now been in place for over a year. Such action reduces the money supply. Over the past year, the cumulative impact has been to reduce M2, the broadest published measure of money supply, by 3.9%. While most of us think of GDP as the sum of consumption, investment and government spending, a monetarist views GDP as the product of money supply times velocity, the rate at which money turns over.
In a vacuum, it would be logical that a decline in the money supply of as much as 3.9% would create a recession rather quickly. But this time there is an offset, the accumulation of money generated by the extraordinarily expansive monetary and fiscal policy implemented during the pandemic. By some measures the bubble of excess was close to $3 trillion. Thus, it requires an extended period of monetary tightening to deflate it.
When will the process be complete? When will all the excess be drained? There is no precise answer. GDP forecasts for the third quarter expect growth of close to 4%, the fastest pace of growth since early in the pandemic recovery. Forecasts for Q4 are more muted. But Chicken Little has been screaming the sky is falling for so long that few will believe it until they see it. Thus, the Fed continues to contract the money supply and will continue to do so until data suggests that it is time to stop, that all or most of the excess has been soaked up. The most recent employment report showing a monthly increase in jobs of over 337,000 in September suggests the time isn’t now. On the positive front, inflation continues to recede. At 3.7% year-over-year, it is now about half of what it was at its peak, although still well above the Fed’s 2% target.
To continue to cool inflation, the Fed not only is contracting money supply but has also raised short-term interest rates. Those are the Fed’s two primary tools, raising rates and reducing the money supply. Since there is a lag between cause and effect, the Fed rightfully has begun to slow the pace of interest rate increases. Indeed, it may be done. If it isn’t, it is close to done.
While GDP growth remains stubbornly high, Fed actions have increased pressure. With mortgage rates now near 8%, housing activity has now declined to levels last seen in the depths of the Great Recession. The spread between the monthly payment for an average home today, assuming a 20% down payment, and the equivalent rental payment is wider than at any time this century, even wider than when the housing bubble burst close to 20 years ago. While there are still lifestyle reasons to try and buy a home, economically, this is as bad a time as any in recent memory.
If it’s a bad time to buy a home, it’s probably a bad time to buy a car as well. Unlike mortgages that can be refinanced if rates fall, car loan interest rates don’t change when rates decline. High rates also impact demand for money from businesses. Although the Fed Funds rate is 5.25-5.50%, the prime rate that governs many business loans is now 8.5%. Businesses with less than a pristine rating today pay over 10%. The cost of money is a big hurdle to investment when it gets to double-digit levels.
Remember that data is, by definition, backward looking. The impact of 8% mortgage money was only beginning to be felt in September. Credit card interest rates are now well over 20%. That will impact Christmas spending to some degree. When the excesses built up during the pandemic are finally dissipated, activity will slow measurably. Will that mean a soft landing or a recession? It’s still a close call, but the higher borrowing costs go, the odds of a soft landing decrease.
Washington is still out of action until Republicans find a new Speaker of the House. But that isn’t stopping President Biden from asking for more money. A supplemental appropriation to support war efforts exceeds $100 billion. That is money that, if approved, will be spent quickly adding to a bloated deficit. He also wants Congress to pass a $16 billion tax credit for first-time home buyers. Good luck with that request guaranteed to go nowhere.
The deficit for this fiscal year and next is forecasted now to exceed $3.5 trillion. Treasury will have to finance that as well as maturing debt that must be replaced. At the moment, there appears to be a buyer’s strike. Foreign governments are hesitant to add more Treasuries especially in the wake of an unnecessary debt default crisis, a House out of action, and two wars underway that we are backing. Corporations are still generating positive cash flow meaning they need to borrow less. Their idle cash may sit in Treasuries but only with very short maturities. Banks have been net sellers of bonds, by some estimates over $500 billion over the past year. Over the years, when rates rise bank debt security holdings decline in value. That gap shows up in income statements if the bonds, loans or mortgages aren’t intended to be held to maturity. But since the spring failures of Silicon Valley Bank and Signature Bank, investors have focused much more attention on the unrealized losses on loans intended to be held to maturity. Banks have always been in this predicament during periods of rising rates but newer accounting rules spotlight the extent of the unrealized losses. That is forcing banks today to reduce duration in their fixed income portfolios thus reducing overall demand for longer-dated bonds.
The gap is to be filled by individuals. Normally, individuals can absorb a deficit of about 3% of GDP keeping an even balance between supply and demand. But with a deficit approaching 6% or more, the only way to reach a balance is to pay debt holders more. Thus, rates rise not only because the Fed is raising the Fed Funds rate or reducing the size of its balance sheet, but because supply is overwhelming demand. And it is doing so while the money supply is shrinking with the unintended consequence perhaps of adding volatility to the bond market.
How high can rates go? It’s an unanswerable question. Assuming the nation’s credit isn’t in question, as rates rise and inflation falls, the real return from owning bonds to maturity increases. However, in the short-term, bond prices adjust to the changing rates. If you buy a bond yielding 5% to maturity and hold it until then, your return will be 5%. But if you buy a 10-year bond yielding 5% and market rates go to 6%, your short-term unrealized loss will wipe out your 5% return. You won’t actually lose if you don’t sell, but it’s no different than buying a stock that is destined to be a good long-term holding but falls with the market during a short-term correction. Individuals don’t buy bonds expecting paper losses right away. The sudden rise in rates and the attendant drop in bond prices is making investors hesitant at a time when other buyers, such as banks, are reducing their own demand for bonds.
Ultimately, however, valuation will matter. Bonds compete with stocks for investment dollars. If you can lock in a superior return for risk-free bonds during increasingly uncertain economic times, money will shift from stocks to bonds. What is happening now, as rates rise, is that stocks themselves are being revalued as well. The way that happens is to lower the P/E that investors are willing to pay to own stocks. Thus, even as earnings increase for the majority of companies, the price one is willing to pay for those earnings declines. The fall in P/Es, commensurate with the rise in rates, overwhelms the growth in earnings.
Speaking of earnings, this is the biggest week in earnings season. Microsoft# and Alphabet# both report tomorrow after the close. Meta Platforms# and Amazon# follow later this week. Reactions to those results will clearly be impactful. But as long as yields on 10-year bonds move 10 basis points per day, stocks will remain slaves of the bond market, and so will the economy. Lending is the engine of growth. If rates rise too much too quickly, the impact on economic activity will be both quick and noticeable. At the moment, that’s an if. But the sector most tied to interest rates, housing, is a harbinger of what’s to come if rates keep rising at their current pace.
Today, Ryan Reynolds is 47. Weird Al Yankovic is 64. Golfer Chi Chi Rodriguez turns 88.
James M. Meyer, CFA 610-260-2220