In June, U.S. employers added 157,000 jobs, dropping the unemployment rate to 3.9% (generally considered full employment), continuing a trend seen in prior months. It’s been almost 20 years since the last time the unemployment rate fell below 4%!
- Last month, it was reported that the U.S. economy grew 4.1% in the second quarter, the strongest in 4 years;
- Average hourly wages ticked up 2.7% year over year, in line with expectations given somewhat stagnant wage growth post-Recession;
- The Federal Open Market Committee (FOMC) convened and met Wall Street expectations for no rate hike, which means if the Fed holds true to its prior statements, we’ll have two more rate hikes this year in September and December;
- In reaction, the yield on the U.S. 10-year treasury note rose above 3% yield on August 1 for the first time since the end of May (see our prior commentary regarding the importance of a 3% yield).
With confidence high and an economy performing well, why is there a measure of market chatter about inflationary pressures, growing deficits, and even the potential of a recession in the next few years?
One answer: The federal budget deficit has almost always narrowed during times such as these — or even posted a surplus, as it did from 1998 to 2001 at the end of the dot-com boom. But instead of improving the country’s finances, Washington is adding to the credit card bill.
Recently, the Congressional Budget Office (CBO) noted the U.S. budget deficit is expected to reach $1 trillion by next year, or about 5% of the U.S. GDP (find the report here). Running large budget deficits is hardly a new phenomenon, but it is unusual for a country to increase its deficit during an economic boom.
Since World War II, the U.S. has posted a deficit greater than 5% of GDP in just two periods – 1983 and each year from 2009 to 2012 – both occurring around periods of significant economic decline or gnation, including when unemployment hovered around 10%.
Why should anyone care about a growing U.S. deficit?
The short answer is that it’s not sound fiscal policy. Deficits may rise and fall, but they can’t keep rising forever, including for the U.S., the largest economy in the world. If spending continues at this pace (and there is every indication that it will), the growing deficit will probably lead to higher interest rates, raise borrowing costs for the private sector, lower investor confidence, and slow the economy, compounding the problem and leaving state and local governments with potential trickle-down effects. Conventional economics also suggests that the U.S. will have much less flexibility to pump up the economy during a downturn. Put another way: you may be able to carry your credit card balance fine today, but you could have a problem getting that car loan tomorrow.
Indeed, the U.S. government hasn’t tested this level of debt – where debt held by the public equals or exceeds the entire U.S. economy – in the modern era. It’s why many economists (including the CBO director) have been warning Congress and the White House to rein in spending and/or boost revenues now.
According to the CBO’s report, if the deficit is allowed to reach 7.1% of GDP as projected in 2028 and continue thereafter due to a lack of fiscal restraint, the U.S.’s debt-to-GDP ratio would reach 150%, putting it in line with countries such as Italy, Greece, and Portugal. Needless to say, investors would likely demand higher yields to buy U.S. debt under that scenario, increasing borrowing costs and reducing the amount of discretionary funds available.
Because financial markets look ahead, the real (inflation-adjusted) interest rate on long-term US bonds is already rising. Ten-year U.S. Treasury inflation protected securities (TIPS) have increased in yield from about 0.00% in August 2016, to 0.46% a year ago, to 0.83% as of August 3 (see chart above). Given that inflation is presently about 2%, the nominal yield on ten-year Treasury notes recently increased to 3% last week for the first time since May, although declining slightly this week. Looking ahead, the combination of the rising debt ratio, higher short-term interest rates, and inflationary pressures may push the nominal yield on ten-year bonds significantly higher in the near future.
That being said, a rising deficit obviously doesn’t mean the economy or stock market will crash in the near future. The U.S. can run such high deficits because the U.S. Treasury sells U.S. debt to investors around the world, and right now, a lot of people want to buy U.S. government bonds for any number of reasons. However, no one knows when people might say enough is enough and stop buying U.S. debt or demand much higher rates of return. At the bare minimum, most economists would agree that large deficits are a drag on the economy. Investors choose to buy government debt instead of making the type of private investments necessary to create jobs or raise wages.
In the long run, a day of reckoning is likely to come– meaning, the U.S. will have to raise taxes or cut spending— or some combination of both – all of which is very politically unpalatable. The CBO forecast suggests future interest payments alone would dwarf discretionary spending on all non-military items combined – meaning, cutting discretionary spending wouldn’t be enough to “right the ship.”
None of this should come as a surprise for many state and local governments. Municipalities have been dealing with how to balance their budgets for years! However, it means that Americans under the age of 50 are likely to foot the bill, particularly those under the age of 35, while getting much less back than prior generations. Moreover, spending on everything from programs such as Medicare and Medicaid to infrastructure and school funding could all potentially decline in an effort to avoid a fiscal crisis, potentially leaving states and local governments to pick up the slack.
Muni Yields Increase Slightly
In previous editions of this Commentary, we have discussed the fact that yields on municipal bonds have remained remarkably stable for many months. For example, since February 1 the yield on a AAA-rated 10-year bond, as measured by Bloomberg Valuation, has varied by only 0.15%, from 2.41% to 2.56%. We can all remember times when bond yields rose or dropped by over .15% in a single day. Over the past several weeks, however, yields have increased by .05% to .12%, as shown in the table below, rising toward the higher end of the recent range. This is certainly related to the rise in Treasury yields mentioned earlier.
Despite the recent increases in yields, demand for munis remains strong, and we have seen excellent results on recent bond sales. If you are considering issuing debt in the near future, contact your Ehlers municipal advisors to discuss your plans.
Investment Trends – Ehlers Investment Partners
Caution was the word used by Neel Kashkari, President & CEO of the Federal Reserve Bank of Minneapolis in his recently published article, “The Flattening Yield Curve,” on July 18th to describe the flattening yield curve or the narrowing difference between short-term and long-term Treasury interest rates. Kashkari is now another prominent voice in the growing list of voices expressing concern for the flattening yield curve and the potential for the yield curve to completely invert which has historically been linked as a predictive indicator for the dreaded word, recession.
Typically, when the economy is heathy, interest rates on bonds with a longer maturity will be higher than short-term bonds to compensate for the extra risk on a longer-term investment. The economy has been clipping along at a healthy pace with increased consumer spending and the lowest unemployment in over 18 years. But lately longer-term Treasury rates are not increasing at the same speed as short-term rates as the Fed continues to raise short-term rates. Thus, according to Matt Phillips, Markets reporter with the New York Times, “The gap between two-year and 10-year United States Treasury notes is roughly 0.34 percentage points. It was last at these levels in 2007 when the United States economy was heading into what was arguably the worst recession in almost 80 years.”
Well does this flattening of the yield curve really signal trouble ahead? According to Kashkari, “Some say, No. This time is different, and that the flattening yield curve is not a concern. The truth is we don’t know for sure. But we do know the bond market is telling us that inflation expectations appear well-anchored, the economy is not showing signs of overheating and rates are already close to neutral. This suggests that there is little reason to raise rates much further, invert the yield curve, put the brakes on the economy and risk that it does, in fact, trigger a recession.”
Mr. Kashkari, went on to say, “If the Fed continues raising rates, we risk not only inverting the yield curve, but also moving to a contractionary policy stance and putting the brakes on the economy, which the markets are indicating is at this point unnecessary.”
Ehlers Investment Partners has commented several times recently regarding the flattening yield curve. We feel this is an important topic because as short-term interest rates rise to nearly match long term rates it is tempting to abandon long term investments all together. But if the yield curve continues to flatten or possibly invert, local government fixed income investor’s best prescription is caution. John Templeton, the late investor, banker, and fund manager suggested, “The four most dangerous words in investing are “This time it’s different.”
Ehlers Investment Partners, with a combined 50+ years of staff experience, assists all forms of local governments in evaluating current Investments, evaluates banking relationships, and prepares Requests for Proposals as needed. Safety of your investments is most important to Ehlers Investment Partners. With the risks inherent in financial markets, strategies proposed and implemented by EIP take the objectives of Safety, Liquidity and Yield literally. Please speak with an Ehlers Investment Partner advisor today to assist with your investment and banking needs.
The Flattening Yield Curve – Neel Kashkari
What’s the Yield Curve – Matt Phillips
IMPORTANT INFORMATION: PLEASE READ
The information contained herein reflects, as of the date hereof, the view of Ehlers & Associates, Inc. (or its applicable affiliate providing this publication) (“Ehlers”) and sources believed by Ehlers to be reliable. No representation or warranty is made concerning the accuracy of any data compiled herein. In addition, there can be no guarantee that any projection, forecast or opinion in these materials will be realized. Past performance is neither indicative of, nor a guarantee of, future results. The views expressed herein may change at any time subsequent to the date of publication hereof. These materials are provided for informational purposes only, and under no circumstances may any information contained herein be construed as "advice" within the meaning of Section 15B of the Securities and Exchange Act of 1934, or otherwise relied upon by you in determining a course of action in connection with any current or prospective undertakings relative to any municipal financial product or issuance of municipal securities. Ehlers does not provide tax, legal or accounting advice. You should, in considering these materials, discuss your financial circumstances and needs with professionals in those areas before making any decisions. Any information contained herein may not be construed as any sales or marketing materials in respect of, or an offer or solicitation of municipal advisory service provided by Ehlers, or any affiliate or agent thereof. References to specific issuances of municipal securities or municipal financial products are presented solely in the context of industry analysis and are not to be considered recommendations by Ehlers.