At its most basic, interest rates reflect supply and demand. Supply comes from the amount of money in circulation and demand from the various parties who, for their own reasons, desire to borrow. In a free market the two sides agree upon a given cost for money, called a rate of interest, which can be different for different borrowers depending on their perceived ability to pay back and for the time frame borrowed. Another factor is whether the rate of interest is fixed over the life of the loan or fluctuates based on some related yardstick. Loans that are parceled out in denominations that investors can trade, or hold are called bonds. In the case of bonds, interest paid is usually fixed. Interest rates fluctuate up or down in relation to this supply/demand dynamic. As interest rates rise, the value of existing bonds decline, and vice versa.
What can impact interest rates is the perception of risk and the estimate of the rate of inflation during the time of the loan. As the perception of risk increases, the cost of borrowing increases or the option to borrow may no longer be available. Inflation, which erodes the value of the future interest payments received, acts as a tax on the returns from investing in bonds.
After several years of being afraid of a major economic decline, the Federal Reserve in 2022 decided to hike interest rates to address the rate of inflation at the time. The stated goal then and now is to get inflation back to a rate of 2 percent per annum.
This change in policy has caused at least two banks to fail, eroded the balance sheets of any number of institutions and has created a cottage industry of trying to predict when the Fed will cut rates again. This is not an abstract question. It has been estimated that 40 percent of the profit growth of the S & P 500 in the past 7 years has come from either lower interest rates or corporate tax cuts. At the end of last year there were forecast of as many as 7 interest rate cuts in 2024. That number has shrunk to1or 2. It may wind up being zero.
To understand this stance by the Fed to lower rates begrudgingly, if at all, one must look no further than inflation trends. In general, a strong economy creates price pressures that buttress inflation, while a weak economy is conducive to reducing inflation. Right now, the US economy is arguably the strongest in the world. The reasons for the economic strength include an expanding workforce, higher employment, higher wages, and spending by state and local governments. Immigration, both legal and otherwise, has kept the economy expanding despite a low birth rate by its citizens.
The Federal Government continues to spend more than it takes in, stimulating the economy in the process. The strength of the dollar relative to foreign currencies makes the US a magnet for foreign funds looking to invest in a relatively safe and liquid manner. The trading of US Treasury securities is considered the most liquid and transparent market in the world. Finally, the spending of retirement savings by seniors is a privatized stimulant program. The current level of interest rates is higher than the Fed would like it, but not relative to the rate of inflation which now runs in excess of 3 percent. And while the current equilibrium seems to make everyone happy except for those who want lower interest rates, it is a very precarious financial system. Should foreign investors stop buying US debt, interest rates will rise further still. Should investors feel that inflation will go sharply higher interest rates would need to go up to keep their after-inflation returns positive.
Receiving almost no notice is the potential for the Trump tax cuts, launched in 2017, sunsetting starting in 2025. While additional tax revenues would result presumably shrinking the deficit in the process, corporate after-tax profits would also be affected. The question is how much a decline in aftertax profits would affect stock prices. Congress could extend the cuts, but if they do not the default action is for them to go away.
As for inflation reaching the magical 2 percent level for Federal Reserve reductions: forecasts do not look good. Everything from the price of oil to looming electricity shortages point the way to higher prices. Service sector inflation is running higher than goods inflation. Inflation in housing seems impervious to higher interest rates, save to put fewer buyer in reach of a home for sale at a given price. It has often been suggested that the economy has benefitted Wall Street more than Main Street. For the 50 percent of the public that do not own stocks, there is an element of truth to that. With taxes possibly increasing on corporations, this may be a case that is an exception.
The Economy
Wall Street keeps forecasting an economic slowdown to support the interest rate reduction thesis. It keeps not happening. Job creation continues to be robust. No one seems to know where the workers are coming from, but without them there would be higher inflation, so no one seems to care. Higher oil prices are created by events in the Middle East as well as constraints on domestic production to pacify the environmentalists.
The looming shortage of electrical capacity will prove disruptive when it happens. The combination of electric vehicles, semiconductor chip manufacturing and bitcoin production will put the economy on a trajectory for blackouts when all three require peak power at the same time. While making crypto currency illegal would perhaps help in the short run, the reality is that with the location of electrical generation changing and the grid system in place to deliver the power not changing, there is going to be a real delivery problem. It is exacerbated by the government’s stance against the growth of natural gas fired power. Natural gas plants have low capital cost compared to nuclear and can run whenever there is gas available.
Inflation
While the specifics will change month to month, the trend is pretty obvious. Inflation will not come down any time soon. Short-run reasons range from higher oil prices to wage acceleration. Longer term, a shortage of housing pretty much guarantees the inflation rate will stay where it is, if not go higher. A deficit reduction such as provided by sunsetting the Trump tax cuts will be helpful in two ways. It will reduce the growth of the deficit and reduce demand. It will also reduce economic activity, which will have to be addressed as well. Further deficit reductions being discussed are eliminating the step-up in cost basis to estate benefactors as well as taxing distributions as income, including distributions to charities and trusts.
Interest Rates
As stated above, it is felt that interest rates will not go down and may even go up. In a way, the US is hostage to its own need for debt. Because of the size of the deficits, the US has to sell increasing amounts of its debt to foreign investors. Such buyers are chiefly interested in the safety of the principal, the rate of return and the exchange rate between their own currency and the US Dollar. Of these three factors, the interest rate is the most objective. If interest rates on US debt were to decline, foreign investors could go elsewhere. This would affect the dollar as well as the perception of safety that investing in Treasury securities provides.
The Stock Market
After a bang-up first quarter, the stock market seems to be looking for another catalyst to power it higher. It is having a problem finding one. It is expected that the data on commodities, especially oil, will provide headwinds going forward. Supply chain disruptions from the Red Sea, Baltimore harbor, and the like will result in the trimming of earnings forecasts for 2024. According to the 2025 earnings, estimates will probably be impacted by tax increases on companies. Companies with solid demand and cash flows are most preferred. Crowded trades like crypto and meme stocks may become a lot less crowded as investors bail.
Warren M. Barnett, CFA
April 10, 2024
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