Higher Interest Rates Could Crush U.S. Economy
Top investment fund managers have been sounding the alarm on interest rates in recent months, and astute investors should take heed. The Who’s Who on Wall Street are striking an increasingly bearish interest rate forecast tone, startling equity investors and interest-sensitive industries everywhere.
We start with Jeffrey Gundlach, who oversees $100.0 billion at DoubleLine Capital. He recently gave his interest rate prediction for 2017, and it was mostly bearish for prices (bullish on yields), especially on medium-term forecasts.
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Gundlach predicted that the yield on the 10-year note could rise to six percent within four or five years, owing to increasing economic activity at home and higher inflation. “If nominal GDP pushes toward 4%, 5%, or even 6%, there is no way you are going to get bond yields to stay below 2%,” said Gundlach. (Source: “Gundlach: Bond Yields to Hit 6 Percent in 5 Years as Inflation Will Roar,” NewsMax, November 13, 2016).
The “Warren Buffett” of investment fund managers, Ray Dalio, who oversees $160.0 billion as founder of Bridgewater Associates, LP, sees the same thing. In mid-November 2016, he too became bearish on bonds, indicating that the Donald Trump era likely signaled a shift to higher domestic growth and inflation.”We think that there’s a significant likelihood that we have made the 30-year top in bond prices,” said Dalio. (Source: “Ray Dalio Is Bullish on Trump Presidency, Bearish on Bonds,” Bloomberg, November 15, 2016.)
Dalio continued, “We probably have made both the secular low in inflation and the secular low in bond yields relative to inflation.”
Keeping with the “higher inflation is bearish for bond prices” meme, uber-successful Hayman Capital Management, LP overseer Kyle Bass recently weighed in on inflation expectations for 2017. In fact, his central investment thesis for his thrice-launched Asia-focused fund centers around a core macro bet on higher worldwide inflation. (Source: “Kyle Bass: Global markets are at the beginning of a tectonic shift,” Yahoo! Finance, January 4, 2017.)
“Unlike establishment prognosticators, we hold a nuanced view of the world that contemplates higher global inflation, tepid real economic growth, and severe imbalances in select Asian financial systems and currency markets,” said Bass, adding that “global markets are at the beginning of a tectonic shift from deflationary expectations to reflationary expectations.” (Source: “Kyle Bass Has Found A ‘Breathtaking’ Opportunity With The “Greatest Risk-Reward Profile Ever Encountered,” Zero Hedge, January 5, 2017.)
So why are these U.S. interest rate predictions arousing so much alarm among equity investors and CEOs alike? Because, should the rate hikes come to pass, both the stock market and middle-class America could get crushed underneath a monster truck.
And this is somewhat counterintuitive because, in many business cycles, higher growth portends to higher wages, which leads to higher consumer and capital expenditure (CAPEX) spending. This has immediate downstream effects on the stock market, where rising corporate profits precede higher stock market prices. However, this isn’t a normal business cycle.
The big fly in the ointment this time is debt. While consumer debt has decreased around 17% from the peak of the U.S. housing crisis in 2008, it still remains stubbornly high. Retail sales continue to slouch along while two-thirds of Americans would struggle to come up with $1,000 to pay for an emergency. The U.S. household debt-servicing ratio is at its lowest level since 1980, indicating trouble serving payments. The glacial pace of wage increases is a bad sign, considering we are at the top of the business cycle.
Don’t count on rising wages to materialize this time around, either. Despite the Bureau of Labor Statistics (BLS) claim of full employment (less than five percent unemployment), the facts show otherwise. Currently, the labor participation rate is at 38-year-lows, at 62.6%, with nearly 95 million Americans out of work.
Compounding the problem, “industry 4.0” is on the cusp of replacing millions of jobs in the United States. Most employees still don’t realize how close they are to meeting their robotic counterparts. It already started long ago, with robots in car factories and automatic checkout machines in grocery stores, but now it’s graduating to increasingly complex intelligence tasks.
For example, Fukoku Mutual Life Insurance Company of Japan, slashed 34 human underwriter positions in January. The artificial intelligence (AI) technology “IBM Watson Explorer” has the ability to scan hospital records to determine precise insurance payouts to claimants (Source: “Japanese insurance firm replaces 34 staff with AI,” BBC, January 5, 2017.)
Competition from automation is acting as an enormous black hole on wage growth; it simply cannot escape the effects.
The bottom line is: although increasing GDP growth may rebound as manufacturing production and related capital expenditures make a comeback on domestic soil, don’t expect consumer spending to rebound similarly.
The inflation to come will probably be input-price-driven, as well as stemming from more restricted trade. This will not be friendly to the lower and middle classes, as they continue to lose financial ground incrementally. Nor will inflation be good for corporate profits, as companies will have to accept lower margins to remain competitive against a tapped-out consumer.
Wherever inflation goes in this next cycle, the interest rates forecast is sure to follow. If Trump follows through on ramming a giant stimulus package through Congress, the mounting public debt will receive further scrutiny from long-term purchasers of debt.
Normalcy bias aside, there is a limit to the amount of debt that the U.S. Federal Reserve can issue without pressuring interest rates too much. The Congressional Budget Office (CBO) already projects that net interest rate costs will grow from $270.0 billion today to $712.0 billion annually in 2026. (Source: “Higher Interest Rates Will Raise Interest Costs On The National Debt,” Peter G. Perterson Foundation, December 14, 2016.)
Interest costs are expected to continue climbing beyond the next 10 years, and are projected to be the third-largest category in the federal budget by 2028 (after Social Security and Medicare), the second-largest category in 2046, and the single-largest category in 2050 (Source:Ibid.)
Unless interest rates can somehow be restrained against the headwinds of rising debt and rising inflation, something has to give.
Mortgage rates look poised to increase over the next few years, as the U.S. Federal Reserve looks to sell part of its Mortgage Backed Securities (MBS) portfolio. The Fed currently owns a third of the market, so any selling will provide a put on the market. (Source: “Everyone is Suddenly Worried About This U.S. Mortgage-Bond Whale,” Bloomberg, February 5, 2017.)
Unwinding quantitative easing (QE) “will be a massive and long-lasting hit” for the mortgage market, said Michael Cloherty, the head of U.S. interest-rate strategy at RBC Capital Markets, LLC.
Moody’s Corporation (NYSE:MCO) expects it could help lift 30-year mortgage rates past six percent within three years. (Source: Ibid.)
Rising rates are already taking a toll. Existing home sales in December 2016 declined, even though full-year sales remain the strongest in a decade. This kind of result is a splendid example of how interest-rate-sensitive the consumer is. We can just imagine how far sales will decline with five-percent or 5.5% rates.
With the jumping rates catching many off guard, homeowners and businesses are left wondering: has the best chance in a lifetime to refinance my property come and gone? Probably. It could well be that the 30-year fixed rate at 3.36% was that number.
Interest Rate Forecast for 2017
There’s almost universal agreement among large bond buyers that the U.S. interest rate forecast is headed higher. Whether it’s through input price inflation due to protectionist policies, or unsustainable debt, which keeps endlessly mounting, the trend is up. The greatest bull market in the history of asset classes looks long in the tooth. Many analysts cite the 10-year breaching three percent as would-be confirmation of this.
Whether the mainstream economy can hold up to higher inflation and rates will depend on the robustness or job growth and wage growth. However, for the reasons mentioned above, I’m not overly optimistic. Unless the government manages to suppress the role of automation in the labor force, it’s hard to see how.
Corporate America is not the job engine of the past, and those days are never coming back. It’s hard to envision robust corporate earnings in such an environment. Corporations have largely streamlined operations to full efficiency after the 2008 housing crisis, the low-hanging fruit long since plucked away.
Prepare accordingly.
