Market averages continue to waffle around recent highs with minor movement for most of this week. If this morning’s futures hold up, major averages will end the week flat. The 10-year Treasury yield is also in a holding pattern, closing near similar levels as two months ago at 1.30%. As we have been espousing, interest rates are key to stock movement over the coming months, but they are hardly indicative of anything “normal” at today’s levels. Our post-Covid world is filled with never-before-seen growth rates, easy year-over-year comparisons and stimulus measures. The Delta variant keeps wreaking havoc on global supply chains, preventing investors from getting a true, long-term picture on growth rates, inflation and wage growth. Today’s data has little impact on what will happen by the end of 2022.
Lately, it appears the market expects that low interest rates are here to stay, and stable, predictable growth stories deserve even higher multiples. Since late March, the Nasdaq has bounced 20% while more traditional value stocks like Industrials, Transportation and Financial companies are only up single digits. With Covid, nothing is as it seems. Interest rates in particular now seem to be heavily influenced by issuance factors related to the debt ceiling.
On August 1st, the debt ceiling became effective. The total amount of money the U.S. is allowed to borrow to meet its obligations is determined by Congress. Once that level is reached, the Government has to live off its checking account. That account is quickly drying up on a daily basis:
Since 1968, we’ve reached this debt ceiling limit 78 times. Each one of them ended with Congress either raising the debt ceiling, suspending or extending it, but not after some haggling on a partisan basis. The next debt limit increase will be #100 since 1939. We should hear a lot more of this over the coming weeks as the Treasury’s general account dwindles down to zero. Democrats will likely attach some bipartisan measure with increased spending to a debt increase bill which Republicans will veto. At the end of the day, the Democrats are in charge and don’t need any Republican votes. However, nothing is easily done in DC as one side will want to blame the other for any and everything.
One other side effect involves interest rates. On August 1st, gross national debt outstanding hit $28.4T and hasn’t moved since. Since then, the Government has not been able to issue any incremental debt. They can only reissue maturities. In fact, Treasury issuance has been decelerating for months before August because of the debt ceiling concerns. What this means is new Treasury supply has been slowing since August, all while the Fed keeps buying bonds hand over fist. Obviously, this has a side effect of suppressing interest rates and causing distortions further out the yield curve. Basically, even more stimulus is in the system than traditionally measured; quantitative easing on steroids, if you will.
This can only last so long. Janet Yellen has already sent letters to elected officials and made comments regarding the seriousness of a dwindling checking account balance. By her count, “cash and extraordinary measures will be exhausted during the month of October.” Further, she also indicated they want to maintain a cash cushion of $750B once the increase is approved, which is double its historical average. Eventually, the debt ceiling will be raised and a massive influx of Treasuries will come to the marketplace all at once. Since a large chunk will be set aside instead of spent, it will act as quantitative tightening.
Most economists also expect tapering to begin in November. Combined, one can’t help but worry that it will create a perfect storm. New issuance over and above normal times, a large buyer slowing down purchases, solid economic data, inflation running hot and a market priced for perfection. If this doesn’t force interest rates higher in the short-term, I’m not sure what will!
The implications are somewhat obvious if rates rise substantially. Quantitative tightening periods are quickly (and briefly) followed by lower stock prices, P/E contraction and volatility. EtherRock NFT’s selling for over a million dollars will dry up. Meme stocks will come back to earth. Crypto pyramid schemes will crush retail investors and sky-high P/E stocks will revert back to normal valuation metrics.
This is the bearish case. However, for much of the past year and a half, traditional economic analysis has not been very helpful. Recent trends could just continue. A tiny form of economic tightening might be just enough to squash inflation, assuming Covid-induced supply chain mishaps self-correct. This would keep rates low and allow P/E’s to stay high.
For now, we preach diversification and adherence to asset allocation guidelines. Stocks are up 20%+ again this year, and bonds have given negative returns. Stock/bond weightings in portfolios may need to be readjusted. Proceed accordingly.
Alibaba founder, Jack Ma, turns 57 years old today.
James Vogt, 610-260-2214