Category Archives: Federal Reserve

U.S. Federal Public Debt

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As of September 30, 2020, 64 percent of the outstanding amount of marketable Treasury securities held by the public (about $13.1 trillion) was scheduled to mature in the next 4 years. Current coupon rate is around 2,5 percent

During the past decade, the federal government’s debt increased at a faster rate than at any time since the end of World War II, outstripping economic growth over that period. At the end of 2019, federal debt was higher than at any other time since just after the war.

When the federal government runs an annual budget deficit, the Department of the Treasury borrows money to make up the difference between spending and revenue. Then, if special funds like the Medicare trust fund have surpluses, the “extra” revenue is lent to the rest of the federal government.

The federal debt is the total amount of money that the federal government owes, either to its investors or to itself. Total federal debt rose to $26.9 trillion at the end of fiscal year 2020, equal to about 79 percent of GDP, a higher percentage than at any other time since just after World War II.

To finance the government’s activities, the Treasury issues securities—collectively labeled debt held by the public—that differ in time to maturity, the ways they are sold to investors, and the structure of their interest payments. Marketable securities make up the lion’s share of that debt, and nontradable securities, such as savings bonds, make up the rest.

The Treasury sells securities in the capital markets—often through a primary dealer intermediary­—to various U.S. buyers (such as the Federal Reserve System, mutual funds, financial institutions, and individual people), to private investors overseas, and to the central banks of other countries. Domestic investors currently own about three-fifths of outstanding debt held by the public.

Bank Bailouts

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“Bailouts incentivize and encourage the financial behavior that makes bailouts necessary.” ~ Holman W. Jenkins, Jr.

The fundamental business model of banking is that the bank accepts money from bank depositors and invest almost all of it. A certain amount of depositors’ money, called reserve requirement, must be kept for redeeming customer accounts and customer withdraws. The remaining deposits gets loaned out, often in long-term illiquid loans  and assets.

If customers want to withdraw amounts greater then the reserves, typically refer to as “ run on a bank”, a bank has two options:

  • Raise money by selling investments at a profit or loss
  • Raise enough money to bridge its cash needs by selling equity in the bank itself hurting shareholders.

Going forward, your bank deposits are implicitly safe from bank failures, but your bank deposits aren’t safe from inflation due to lost of purchasing power, writes Holman W.Jenkins in  WSJ Opinion piece. In essence, the investment risks that large sophisticated uninsured depositors take were shifted to bank shareholders and U.S. taxpayers by the federal government.

Effectively, the FDIC $250K bank deposit insurance limit guarantee is now uncapped. By implicitly guaranteeing all bank deposits, the government’s policy will actually incentivized banks to take even more riskier investment bets with depositers’ cash to garner outsize returns. In short, uninsured deposits were a source of market deposits discipline.

Moral hazard refers to the situation that arises when an individual or bank have the chance to take advantage of a financial deal or situation, knowing that all the risks and fallout will land on another party. It means that one party is open to the option – and therefore the temptation – of taking advantage of another party.

Moral Hazard

In this case, the secondary party, the tax payers, are the ones that suffers all the consequences of any financial risks taken in a moral hazard situation, leaving the first party free to do as they please, without fear of responsibility. They are able to ignore all moral implications and act in a way that is most beneficial to them.

The government’s actions to implicitly guarantee bank deposits does not actually eliminate the risks of additional bank runs or failures, it only transfers the risk and subsequent obligations to the FDIC and ultimately the U.S. taxpayers. It also encourages financial moral hazard, the taking of extraordinary investment risk with bank assets, by bank chief executives.

Source: Holman W. Jenkins, Jr., “Joe Biden’s $19 Trillion Monday”, The Wall Street Journal, March 15, 2023

Types of Bonds

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Bonds can play a vital role in your investment or retirement portfolio. Bonds yield income, are often considered less risky than stocks and can help diversify your portfolio.  ~ BlackRock

Bonds – also known as fixed income instruments – are used by governments or companies to raise capital by borrowing from investors. Bonds are typically issued to raise funds for specific projects. In return, the bond issuer promises to pay back the investment, with interest, over a certain period of time.

Certain types of bonds – corporate and government bonds – are rated by credit agencies to help determine the quality of those bonds. These ratings are used to help assess the likelihood that investors will be repaid. Typically, bond ratings are grouped into two major categories: investment grade (higher rated) and high yield (lower rated).

The three major types of bonds are corporate, municipal, and Treasury bonds:

  • Corporate bonds are debt instruments issued by a company to raise capital for initiatives like expansion, research and development. The interest you earn from corporate bonds is taxable. But corporate bonds usually offer higher yields than government or municipal bonds to offset this disadvantage.
  • Municipal bonds are issued by a city, town or state to raise money for public projects such as schools, roads and hospitals. Unlike corporate bonds, the interest you earn from municipal bonds is tax-free. There are two types of municipal bonds: general obligation and revenue.
    • Municipalities use general obligation bonds to fund projects that don’t produce income, such as playgrounds and parks. Because general obligation bonds are backed by the full faith and credit of the issuing municipality, the issuer can take whatever measures necessary to guarantee payments on the bonds, such as raising taxes. 
    • Revenue bonds, on the other hand, pay back investors with the income they’re expected to create. For example, if a state issues revenue bonds to finance a new highway, it would use the funds generated by tolls to pay bondholders. Both general obligation and revenue bonds are exempt from federal taxes, and local municipal bonds are often exempt from state and local taxes as well. Revenue bonds a good way to invest in a community while generating interest.
  • Treasury bonds (also known as T-bonds) are issued by the U.S. government. Since they’re backed by the full faith and credit of the U.S. government, treasury bonds are considered risk-free. But treasury bonds don’t yield interest rates as high as corporate bonds. While treasury bonds are subject to federal tax, they’re exempt from state and local taxes.
  • Bond funds are mutual funds that typically invest in a variety of bonds, such as corporate, municipal, Treasury, or junk bonds. Bond funds usually pay higher interest rates than bank accounts, money market accounts or certificates of deposit. For a low investment minimum ranging from a few hundred to a few thousand dollars, bond funds allow you to invest in a whole range of bonds, managed by professional money managers. When investing in bond funds, keep in mind:Bond funds usually include higher management fees and commissions
  • Junk bonds are a type of high-yield corporate bond that are rated below investment grade. While these bonds offer higher yields, junk bonds are named because of their higher default risk compared to investment grade bonds. Investors with a lower tolerance for risk may want to avoid investing in junk bonds.

Bonds are an investment approach focused on preservation of capital and the generation of income. It typically includes investments like government and corporate bonds. Fixed income can, such as bonds, offer a steady stream of income with less risk than stocks.

References:

  1. https://www.blackrock.com/us/individual/education/how-to-invest-in-bonds

Duration Risk…What Does It Mean

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Duration is a measure of the sensitivity of the price of a bond to a change in interest rates.  Interest rate changes can affect the value of a bank or financial institution’s fixed income (bond) holdings. How a bond or bond portfolio’s value is likely to be impacted by rising or falling interest rates is best measured by duration.  ~ PIMCO

Duration is a measurement of a bond’s interest rate risk that considers a bond’s maturity, yield, coupon and call features. These many factors are calculated into one number that measures how sensitive a bond’s value may be to interest rate changes.

Interest rates may change after you invest in a bond and interest rate changes have a significant impact on bond values. Say you invest in a bond at 5% interest. If interest rates increase by 1%, additional investors in the same bond will now demand a 6% rate of return. Because the bond interest payments are fixed each year, the market price of the bond will decrease to increase the rate of return from 5% to 6%.

The key point to understanding how interest rates and bond prices are related.  It’s important to remember that interest rates and bond prices move in opposite directions. When interest rates rise, prices of traditional bonds fall, and vice versa. So if you own a bond that is paying a 3% interest rate (in other words, yielding 3%) and rates rise, that 3% yield doesn’t look as attractive. It’s lost some appeal (and value) in the marketplace.

Duration is measured in years. Generally, the higher the duration of a bond or a bond fund (meaning the longer you need to wait for the payment of coupons and return of principal), the more its price will drop as interest rates rise.

Duration risk, also known as interest rate risk, is the possibility that changes in borrowing rates (i.e. interest rates) or the Federal Reserve fund rate may reduce or increase the market value of a fixed-income investment.

Generally, the higher a bond’s duration, the more its value will fall as interest rates rise, because when rates go up, bond values fall and vice versa.

If an investor expects interest rates to fall during the course of the time the bond is held, a bond with a longer duration would be appealing because the bond’s value would increase more than comparable bonds with shorter durations.

As you might conclude, the shorter a bond’s duration, the less volatile it is likely to be. For example, a bond with a one-year duration would only lose 1% in value if rates were to rise by 1%. In contrast, a bond with a duration of 10 years would lose 10% if rates were to rise by that same 1%. Conversely, if rates fell by 1%, bonds with a longer duration would gain more while those with a shorter duration would gain less.

% Change in bond prices if rates spike 1%
Hypothetical illustration of the effects of duration, exclusively on bond prices

In summary, bond duration measures the interest rate risk. It is a measure of the change in bond prices due to a change in interest rate. Duration is measured in years. The higher the duration of the bond, the more will be the price drop as interest rates increase. This is because one needs to wait longer to get their coupon payments and principal amount back.

Bond duration is important as it helps in measuring the sensitivity of a bond’s price to interest rates. If the interest rates were to fall by 1% and bond duration is three years, then the price will increase by 3%. This knowledge will help you understand the effect on interest rate changes on the portfolio returns.

References:

  1. https://www.pimco.co.uk/en-gb/resources/education/understanding-duration 
  2. https://scripbox.com/mf/bond-duration/https://scripbox.com/mf/bond-duration/
  3. https://www.blackrock.com/us/individual/education/understanding-duration

Interest Rates, Cost of Capital and Recession

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Interest rates are often called the price of money. They determine how expensive capital is to access for companies, but also for individuals and even governments. ~ Jonathan Schramm

The Federal Reserve controls what is called the federal funds rate, which is the rate banks pay to borrow from other banks. Other interest rates throughout the system are based on that rate.

When an economy is in recession or unemployment is high, the Fed lowers rates. This is meant to encourage investment and spending, pushing more money into the economy.

Inflation is a sign there is too much money in the financial system and economy. One way to reduce the monetary supply is to give people and businesses an incentive to take on less debt. A good way to do that is to raise rates. And this is just what the Federal Reserve is doing.

Interest rates affect stocks in two main ways: the impact companies’ bottom line and impact investor’s behavior.

Many companies “roll over” their debt. This means they never really pay their debt, just pay the interest and renew their old bonds with new ones. In this case, rising rates mean the new bonds will cost the company a lot more in interest expenses going forward.

Some companies are also highly reliant on cheap debt to keep afloat or grow. Others rely on customers spending on credit cards. These companies’ profits might suffer in an environment of rising rates.

This is why a rising rate environment favors skilled stock pickers. A solid balance sheet, low debt, cheap valuation, or high profitability will be very valuable in an environment of rising rates.

Higher interest rates are a disincentive for investors to plow borrowed money into asset markets. That’s one of the main reasons why stocks, cryptocurrencies, and other assets crashed in 2022.

Rising rates for borrowed money tends to cause capital flow out of markets, depressing the values of even quality companies. That hurts investors who bought at the top, especially if they bought at the top with borrowed money. For others it creates a valuable entry point.

Overall, rising interests rates and tightening the money supply are a useful tool to help bring inflation under control. But the recent interest rate increase might not have been enough and there’s probably more to come. If inflation stays high, we would need rates continue to rise to curb inflation.

The positive aspects for US investors:

  • Rising rates support a stronger dollar.
  • A strong dollar makes US imports cheaper.
  • A strong dollar support consumers’ spending by decreasing import costs.
  • Rising rates might help to keep inflation under control.

The negative aspects for US investors:

  • Currency devaluation can hurt overseas investments measured in USD.
    Overindebted companies and consumers might not be able to manage higher rates.
  • Rising rates decrease demand for big-ticket items like homes and vehicles.
  • Rising rates increase the risk of a recession.
  • Rising rates make US exporters less competitive.
  • Rising rates restrict the use of borrowed money by investors, decreasing demand for assets across the board.vehicles.
  • Rising rates increase the risk of a recession.
  • Rising rates make US exporters less competitive.
  • Rising rates restrict the use of borrowed money by investors, decreasing demand for assets across the board.

References:

  1. https://finmasters.com/rising-interest-rates-effects/

Are American Consumers in a Recession?

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Over the past few months, supply-chain headwinds, inflationary pressures, inverted U.S. Treasury bond yield curve, and rising interest rates has added friction to the U.S. economy and to business operations across industries.

Consequently, investors have become extremely pessimistic about the economic outlook and stock market sentiment, which both are expected to witness a downturn in 2023 amid the impending prospects of a recession.

Per JPMorgan Chase, rising interest rates, record decades high inflation, geopolitical pressure and other factors could lead to a recession that will likely wash away the benefits of savings and the massive government aid received during the pandemic. Moreover, the job market is expected to downshift significantly and unemployment is projected to increase next year as the economy weakens.

A growing number of companies are opting to leave jobs vacant when employees leave or announcing hiring freezes. Widespread layoffs so far have been limited to the handful of industries hammered by rising interest rates, such as technology, housing and finance, say Mark Zandi, chief economist of Moody’s Analytics, and Jim McCoy, senior vice president of talent solutions for ManpowerGroup, a staffing firm.

The Federal Reserve, by increasing its benchmark interest rate to counter inflation, has raised the possibility of a downturn next year. Some experts believe that the Federal Reserve’s bid to contain inflation by increasing interest rate and tightening the money supply will likely achieve its target but put pressure on the consumer’s wallet and potentially trigger a recession in 2023.

Fifty-seven percent of the National Association for Business Economics (NABE) economists see more than a 50% chance of recession next year, according to the results of a new survey published by NABE. The survey pointed to the Federal Reserve’s continued raising the federal funds rate and tightening of monetary policy in an effort to tame inflation as the biggest challenge facing the economy.

Additionally, Gregory Daco, chief economist of EY-Parthenon, expects a recession to hit by the first half of 2023 as hiring slows and layoffs spread across industries, leading to net job losses for the year. He expects the economy to grow just 0.3% for the full year and unemployment to peak at 5.5%.

Many Americans believe that the U.S. economy and the global economy are already in a recession. However, with consistently strong job growth, historically low unemployment and solid growth in consumer spending, that doesn’t sound like a recession most people would remember.

But, a recession is in the eyes of the beholders. Essentially, “It depends on who you ask,” says Capital Group economist Jared Franz. “With food, energy and shelter prices all rising faster than wages, the average American consumer would probably say yes. In my view, we are either on the edge of a recession or we are already tipping into it.”

To put things in perspective, over the past 70 years the average U.S. recession has lasted about 10 months and resulted in a GDP decline of 2.5%. In Franz’s estimation, the next one may be worse than average, if current trends persist, but still less severe than the Great Recession from December 2007 to June 2009.

Key economic indicators point to a potential recession

Sources: Capital Group, Bureau of Economic Analysis, National Bureau of Economic Research, U.S. Department of Commerce.

The official arbiter of U.S. recessions, the National Bureau of Economic Research (NBER) considers many factors beyond GDP, including employment levels, household income and industrial production. Since NBER usually doesn’t reveal its findings until six to nine months after a recession has started, we may not get an official announcement of an economic recession until next year.

“It’s fair to say that most consumers probably don’t care what NBER thinks,” says Capital Group economist Jared Franz. “They see inflation above 9%, sharply higher energy prices and declining home sales. They feel the impact of those data points. The labor market is one of the only data points that isn’t signaling a recession right now.”

References:

  1. https://www.cnbc.com/2022/12/06/recession-walmart-jpmorgan-gm-ceos-talk-about-possible-slowdown.html
  2. https://www.msn.com/en-us/money/markets/is-a-2023-recession-coming-job-growth-likely-to-slow-sharply-companies-brace-for-impact/ar-AA159tMa
  3. https://www.foxbusiness.com/economy/labor-market-may-skirt-us-recession-nabe
  4. https://www.capitalgroup.com/advisor/insights/articles/is-us-already-in-recession.html

Federal Reserve Policy and the Stock Market

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“Don’t Fight the Fed” is an old market cliché that was very applicable during the longest bull market in US history. It is also very applicable currently as the Fed implemented policies to slow the economy by raising interest rates and selling assets from its balance sheet. ~ Chris Vermeulen, Seeking Alpha

In 1977, the US Congress officially gave the Federal Reserve a multi-part mandate to maximize employment, maintain prices near an acceptable inflation target of around 2%, and moderate long-term interest rates. In general terms, Fed policies are supposed to stimulate the economy when it’s weak and cool it when it’s too hot.

The adage highlights the strong correlation between Federal Reserve policy and the direction of the stock market.

“Don’t Fight the Fed” embodied the sentiment that if the Fed was stimulating the economy with accommodative policies, it made little sense to bet against the market’s bullish trend. Effectively, when the Federal Reserve’s monetary policy is loose, markets tend to move higher, volatility is subdued, and investors’ risk is limited, so it makes sense to stay invested and ride the wave. Why “fight the Fed” by selling stocks when it’s on your side?

The Fed held interest rates near zero and instituted a policy called quantitative easing—where it bought mortgage-backed securities and U.S. Treasuries to increase the money supply in hopes of spurring lending and capital investment.

When the Federal Reserve is on a mission to slow the economy down in order to tap down inflation, technology and growth stocks are generally hurt as the cost of capital and borrowing money increases. Thus, the old adage, “Don’t fight the Fed” becomes an important one for investors to abide.

With inflation being persistent in the U.S., Fed officials have taken a new monetary stance that is far less appealing for investors.

The Fed is in Quantitative Tightening mode and has raised interest rates and sold assets from its balance sheet. This calendar year, the Fed has raised interest rates four times and has begun shrinking its balance sheet after years of quantitative easing pushed its holdings to nearly $9 trillion. Its intent is to cool the economy and reduce inflation.

The adage, “Don’t fight the Fed”, is a warning to avoid stocks, or at least to take a more conservative approach to investing.

As a result, investors should take a more cautious approach in this tightening environment and prioritize defensive stocks with pristine balance sheets and steady revenue growth that can survive inflationary pressure.

Inflationary economies tend to punish unprofitable technology and growth companies, despite their potential. Without profits or cash flow, it’s simply too hard to improve quarter over quarter at a time when money becomes more expensive to borrow.

References:

  1. https://www.fortunebuilders.com/best-stocks-to-buy/
  2. https://fortune.com/2022/09/14/dont-fight-the-fed-new-meaning-inflation-economy-dan-niles-satori-fund/amp/
  3. https://seekingalpha.com/article/4544537-dont-fight-the-fed