Rising interest rates, higher inflation and tighter monetary policy should be bad news for bonds. Yet investors have been buying record volumes of new bonds.
- Highly rated U.S. companies issued $414.5 billion of debt during the first quarter, a record for any quarter.
- Dealogic reported that companies and governments in emerging markets sold $178.5 billion of dollar-denominated debt in the first three months of the year, the best first quarter on record.
- U.S. companies with junk-bond ratings issued debt totaling $79.6 billion, double from a year earlier.
Why are bonds so popular now?
Economic growth remains uncertain. There’s been plenty of good economic news of late.
The unemployment rate fell to 4.5% in March – or 8.9% if you use the U-6 rate, which even Fed Chair Janet Yellen seems to finally agree is more accurate. The labor force participation rate, which was 62.6% on November, has nudged up to 63%. New orders are up, capital expenditures are up and housing starts are up.
Yet there’s still plenty of uncertainty about the economy, which could be affected by actions in the Middle East, Russia, Korea or elsewhere.
Syria’s use of chemical weapons and President Trump’s response, for example, have created geopolitical uncertainties. While former Secretary of State John Kerry said in 2014 that “we got 100 percent of the chemical weapons out” of Syria as a result of an agreement brokered by Russia, that clearly wasn’t the case. It wasn’t the first time that Syria violated its agreement. It was just the first time that the violation was widely reported.
In addition, while deregulation and tax reform are expected to boost the economy, how successful President Trump will be in accomplishing either is still uncertain. The Affordable Care Act, the number one regulatory target on practically every deregulation advocate’s hit list, was given new life when the Freedom Caucus failed to support a proposed substitute.
So bond buying, in part, is a reaction to economic uncertainty.
Interest rates are increasing slowly. With rates now at 0.75% to 1%, there’s still plenty of room before rates reach normal pre-crisis levels. And while the Fed has increased rates twice since December, it’s expected to raise rates only a couple of more times this year.
Rates will remain low, in part, because the natural interest rate is low. They will also remain low if economic growth remains low. But a third important reason they may remain low is that even small increases cause interest payments on federal debt to spike billions of dollars higher. Interest payments totaled $432,649,652,901.12 for fiscal year 2016.
We’ve frequently noted that interest payments on federal debt are a drain on taxpayers. It’s money we pay out for which we receive nothing in return. In spite of record spending, the total was relatively in check during the Obama presidency, thanks to the Fed’s zero interest rate policy. But as interest rates return to normal, it’s going to balloon.
According to Motley Fool, “we can really see the expected impact of higher interest rates on what was a substantial increase in national debt during the Obama administration. Between 2015 and 2020, the percentage of annual federal spending being diverted to cover net interest payments on our national debt is expected to grow from 6.1% to 11.1%. Ouch!”
CBO reported that in March alone net interest payments rose $7 billion or 30% from a year earlier. And higher interest payments isn’t the only added cost of rising rates.
“This not-so-free Fed lunch is starting to end,” The Wall Street Journal noted. “CBO estimates that $160 billion more spending will be required each year over the next decade if interest rates are merely one percentage point higher than in its current projections. As interest rates rise, the Fed will also have to pay banks more to keep excess reserves parked at the central bank. After its latest rate increase in March, the Fed now pays banks 1% on reserve balances or about $20 billion a year, and that will go up.”
So the Fed is likely in no hurry to bring rates back to normal.
Stocks are overpriced. We recently noted that Shiller’s cyclically adjusted price/earnings ratio (CAPE), which since 1870 has averaged 16.7 for all stocks, had rocketed to 27.2, putting stock prices as a ratio to earnings in the 95thpercentile. Since then, has jumped even higher, to 28.91.
With stock prices at that level, investors are recognizing that they are unlikely to go much higher, so they are chasing yield and buying bonds.
Now On Sale: $4.5 Trillion in Bonds
As a postscript to the above, consider that the Fed indicated in minutes from its last meeting that it would like to begin shrinking its balance sheet, which grew from less than $1 trillion to $4.5 trillion because of the Fed’s bond-buying program.
As bonds have matured, the Fed has been replenishing them with new bond purchases. In the process, it has created $90 billion in income in recent years that has helped keep the budget deficit from being even further out of line with what we can afford.
While the Fed wouldn’t think of putting $4.5 trillion in bonds on the market all at once, imagine the impact that it will have as the Fed slims down its bloated bond portfolio. The Fed will likely find it difficult to avoid the bond bubble that so many economists have been anticipating for many years.