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Good News: The Taper
The U.S. Federal Reserve announced last week that it will begin to reduce, or ‘taper,’ its purchases of U.S. federal government and other bonds by ten billion dollars a month, in January, 2014, down to $75 billion in that month, and will continue to reduce purchases unless there are unusual and negative events such as deflation or a jump in unemployment. The end to uncertainty about the change in policy injected enthusiasm into the stock markets as well as the bond markets, to some surprise.
While the Fed’s announcement was likely the major cause of investor elation, there are some other developments that may be regarded as positive, even if not on their face.
The Fed considers the U.S. economy as still not in full recovery, let alone expansion, and reiterated that official unemployment needs to get to or below 6.5% (it is now 7.0%) before it will begin to contemplate raising short term interest rates above their current level of 0.15%.
Debt Not Disappearing
On the fiscal side, U.S. federal government spending is still expansionary, with an estimated deficit of roughly 4-5% of GDP, including the small share, thus far, that is interest payments.
Both houses of the U.S. Congress approved a federal budget deal that does not raise taxes and slows down federal spending increases to a slight extent. It does not tackle important issues such as efficiency of government, tax reform, or restructuring entitlement programs to ensure they can continue to provide an acceptable level of benefits. That will have to wait until after the 2016 Presidential and general election.
Energy Costs to Remain Tame
The dramatic reform of Mexico’s energy industry, mainly because of the untenable and deteriorating state of its government owned petroleum monopoly, Pemex, now likely to be constitutionally approved and implemented over the next couple of years, validates the outlook for increasing shale oil and gas production, which Mexico had not been able to exploit indigenously.
This shale revolution seems assured to provide abundant supply of both commodities for many more years, perhaps several decades, assuring low probability of inflation from any sort of oil price spike, one of the overlooked causes of the 2008-9 severe recession (West Texas Intermediate went over $147 per barrel in June of 2008; it is now just around $98). In California, there is cautious initial exploitation of the Monterey shale, another huge formation with much promise of future supply at reasonable cost. In Ukraine, successful shale gas wells were recently drilled. In the U.K., exploration has resumed, with much promise.
Iran Treaty Likely Positive, Mideast Improving
Again related to oil, indirectly, sanctions may soon be eased on Iran if the draft treaty allowing it to continue developing nuclear power under international monitoring is passed in the U.N. and by the U.S. government. The ease of sanctions could mean more Iranian oil output, and exports, putting a lid on any possible increase in the international price of oil.
Meanwhile, not only have peace negotiations resumed between Israeli and Palestinian officials, but Israel’s new offshore gas supplies will soon be made available to hard-pressed neighboring Jordan, along with fresh desalinated water and by-product brine to replenish the Dead Sea. Aside from the disruption and devastation the civil war in Syria has brought to that nation and countries on its borders, the news is improving in the Middle East, in many respects, lowering the political risks from that region.
Foreign Exchange Risks, Bond Issues Remain Immense, Banks Uncertain
On the forex front, the new predictability of U.S. monetary and open market operation policy could be bringing some needed stability to exchange rates, which have been causing some injury in vulnerable nations with balance of payments issues such as India, Turkey, Brazil and South Africa.
With all this good news, there are still many sources of concern. The U.S. Federal Reserve has been a major buyer of bonds, and will, at the current pace, start becoming a net seller as soon as 2015. When bond selling or issuance exceeds normal demand, prices fall, increasing interest rates.
U.S. banks have also increased their reserves to more than regulatory levels. They have been unable or unwilling to lend or otherwise disperse their funds, but commercial and household demand for loans is increasing as the economic recovery continues. The potential increase to the money supply from all the monetization of U.S. government debt the Fed has performed is immense, which could contribute to inflation, which would also cause investors to demand higher inflation and inflation escalation risk premiums, boosting short, medium, and long-term interest rates.
Stock Market and Housing Surges Possibly Unsustainable
In the stock markets, share prices seem to be outpacing corporate profit growth, or even increasing confidence in the durability and solidity of the economic recovery domestically or abroad. There seems to be a bubble, if only a low-grade one.
In the housing sector, prices have recovered dramatically, and there are preliminary signs that a new bubble may be beginning. Some worrying indicators include the new reluctance to sell or close down the secondary mortgage financing agencies Freddie Mac (FMCC) and Fannie Mae (FNMA), which were central to the disaster of 2007-8. Another major red flag has been the re-emergence of the zero-down mortgage, and the apparent willingness of Fannie and Freddie to encourage them, to some extent. Should any domestic or foreign political, military, or economic shock or crisis cause some panic, big weaknesses could reappear, causing rates to rise, with little fiscal or monetary ammunition or credibility available for the Fed or government to employ.
U.S. Political Change May Not Matter
Part of the euphoria that has infected the markets of late may have come, oddly, from the problems of the Patient Protection and Affordable Care Act, or ‘ObamaCare.’ The disastrous website problems, and the policy cancellations, along with rate and deductible rises, with the employer-related problems to come next year, have led some investors to believe that a change in control of the Senate may occur in less than a year’s time. While that could indeed happen, it would not likely bring about any major changes in policy, nor the worrying fiscal trajectory of the United States. President Obama will remain in office until January 20th, 2017, and will veto anything that curtails federal government spending too rapidly.
U.S. federal debt already exceeds 100% of GDP, which is a warning level in any economy. The rate of increase in debt has slowed, and the deficit has dipped substantially, but the influx of 1950’s and 1960’s baby boomers onto the Social Security and Medicare rolls will escalate dramatically later in this decade, according to the non-partisan Congressional Budget Office, and others.
Entitlement Spending Escalation to Balloon Debt
These programs are not truly independently funded; their backing is from the general U.S. government Treasury-issued debt. If their projected increases are not bent downward, debt levels will increase far faster than the economy can grow. Pension benefit-induced insolvency or threat of it has already caused major, painful restructuring in several U.S. states and cities.
Another worry for the Fed, if not for many federal politicians as yet, is that as rates rise, the value of the bonds on the books of the Fed, over $4 trillion, currently, will decline, and then will be sold at a loss, sales that will start after tapering ends. The Fed returns several billions in ‘profit,’ largely from creating money, to the federal government every year. It will be come difficult to do that, in practice, and in political ‘optics,’ when it is taking on losing on disposal of a huge magnitude. It will also crimp its other operations.
Rollover, Yellen, Lew (If Not Beethoven)
Finally, the U.S. Treasury must roll over trillions of dollars of debt over the next several years, some of it issued at much lower rates in the past five years, especially the very short-term debt at under one per cent per annum. The interest bill will start to expand the deficit very soon. While the U.S. savings rate has gone up in recent years, it remains inadequate to finance all government debt. Investors have other places for their funds, too: equity and real estate markets at home and abroad, and foreign currency and bond markets, too. U.S. treasury debt has already been downgraded by some ratings agencies. At some point, investors could start to agree, and, while a true currency crisis is unlikely, due to the size, depth, breadth, diversity, and dynamism of both the U.S. economy and its financial markets, it is far from the ‘only game in town.’
Conclusion: Not Out of the Woods; Danger Persists
Domestic and foreign investors have many other financial choices; it could require much higher interest rates to induce them to keep buying all the bond and note issues Washington generates. While rates have already risen dramatically from their amazing lows in the summer of 2012, roughly 1.5% on the ten and thirty-year bonds, they are still markedly below their long-term averages, or what they theoretically might be predicted to be in current circumstances, with the current and future inflation and fiscal demand outlooks. There is still a lot of room for them to move much higher.