Hoisington: The Case For Lower Long Term Rates

When the herd on Wall Street is moving to one side of the boat, I am inclined to start thinking about moving to the other. Or at the bare minimum, I want to consider getting to the middle.

I make that point as many strategists and Wall Street savants are playing the momentum card and recommending that people overweight equities and underweight bonds because rates are assuredly headed higher.

The vicious sell off in bonds over the last two months on the heels of Fed chair Bernanke’s comments about tapering is clear cut evidence that the savants are right and that rates will continue their move higher, correct?

I think the Fed and others on Wall Street and Washington would like us to believe that underlying strength in the economy — and especially the labor market — is the reason that rates have increased and will continue to do so. I don’t buy it. Neither do the folks at Hoisington Investment Management who recently wrote:

The secular low in bond yields has yet to be recorded. This assessment for a continuing pattern of lower yields in the quarters ahead is clearly a minority view, as the recent selling of all types of bond products attest.

Hoisington highlights 4 reasons supporting their premise of lower long term rates:

a) diminished inflation pressures; b) slowing GDP growth; c) weakening consumer fundamentals; and d) anti-growth monetary and fiscal policies.

Let’s navigate further along each of these paths.

Inflation
The year-over-year change in the core personal consumption expenditures deflator, an indicator to which the Fed pays close attention, stands at a record low for the entire five plus decades of the series.

Additional factors restraining inflation are the appreciation of the dollar and the decline in commodity prices. The dollar is currently up 14% from its 2011 lows. Commodity prices have dropped more than 20% from their peak in 2011.

Slowing GDP Growth
GDP growth, whether if measured in nominal or real terms, is the slowest of any expansion since 1948. From the first quarter of 2012 through the first quarter of 2013, nominal GDP grew at 3.3%. This is below the level of every entry point of economic contraction since 1948.

Real GDP shows a similar pattern. For the past four quarters real economic growth was just 1.6%, which was even less than the 1.8% growth rate in the 2000s and dramatically less than the 3.8% average growth rate in the past 223 years. These results demonstrate chronic long term economic underperformance.
Additionally,

. . . when the bond yield rises more rapidly than the GDP growth rate, monetary conditions are a restraint on economic growth.

The Consumer
Consumers have not yet healed from the great recession. Their income and employment situations have languished. Based on the standard of living, as measured by the real median household income, this entire recovery has bypassed the consumer sector. The standard of living has contracted regularly in recessions, but this is the first time deep into an expansion that it has continued to erode. The current standard of living is unchanged from 1995.

In spite of job gains in the first half of 2013, the downward pressure on the standard of living actually intensified. Approximately three quarters of the increases in jobs were in four of the lowest paying industries.

Part time jobs averaged increases of 93,000 per month in the first half of 2013, while full time jobs averaged increases of only 22,000 per month. Full time employment as a percentage of the adult population is currently 47%, which is near the lows of the last three decades.

The drop in the saving rate in 2013 also serves to explain why the primary drain from higher taxes (can you say Obamacare!!) occurs with a lag after the taxes take effect. Based on various academic studies there is a two or three quarter lag in curtailed spending after the tax increase. Thus, the main drag on growth will fall in the third and fourth quarters of this year, with negative residual influences persisting through the end of 2015.

Monetary and Fiscal Policies
Astronomical sums of money have been expended by both monetary and fiscal authorities since the crisis. With the benefit of hindsight it is clear their efforts have not aided economic growth, but rather the balance of their actions has been counter productive.

The Fed has maintained the Fed Funds rate at near-zero levels, and it has tried to lower longer term rates through a series of quantitative easings.

The effect of each of the quantitative easings was the opposite of the Fed’s intentions. During every period of balance sheet expansion long rates rose, yet when securities purchases were discontinued yields fell.

The Fed cannot control long rates because long rates are affected by inflation expectations, not by supply and demand in the market place.

In terms of government spending, fiscal policy has not, and will not, have a major affect on economic growth. The research on government spending multipliers suggests that the multiplier on spending is very close to zero.

The impact of tax changes is not nearly as harmless. It has been argued that an expired “temporary payroll tax cut” would not effect spending as the initial increase in income was not seen as permanent. The facts seem to counter this opinion. The average monthly year-over-year growth rate of real personal income less transfer payments for 2011 was 3.4%, and in 2012 it was 2.2%. This year, with the payroll tax change in effect, the average is 1.8% through May. The slower income has resulted in a slowdown in spending.

A Final Case for Lower Long Term Rates
In the aftermath of the debt induced panic years of 1873 and 1929 in the U.S. and 1989 in Japan, the long term government bond yield dropped to 2% between 13 and 14 years after the panic. The U.S. Treasury bond yield is tracking those previous experiences.

Thus, the historical record also suggests that the secular low in long term rates is in the future.