by Franklin J. Parker
- Omicron continues to make headlines, with pandemic measures to be implemented by numerous state and national governments. Investors are worried omicron will dent economic growth, and with inflation running high, there is uncertainty around central bank response. Because inflation has been driven, at least partly, by supply constraints due to Covid, there is debate whether another wave of lockdowns is inflationary, or if it would result in slowing business and consumer spending (disinflationary). Either way, the Fed has repeatedly stated that they would not step in with a change to policy unless the slowdown became clear in the data. In other words, they will not anticipate the effects of another Covid wave, waiting instead for the data to reflect the effects.
- Tensions with Russia over Ukraine have increased. The US is considering sending military equipment to the border to deter a Russian incursion. Of course, Putin has claimed that they have no designs to take Ukrainian land. As we discussed last week, this has been a foreign policy test for the Biden administration, and is, in many ways, a foreshadowing of a potential US-China tussle over Taiwan.
- The Federal Reserve announced, in keeping with the expectations they had telegraphed, that they would slow down their money-printing program with the expectation to be done by mid March. While that was notable, the big shift in Fed policy expectations came as the committee indicated the likelihood of three rate hikes in 2022 rather than the originally-expected two. One day post-meeting, one Fed governor even indicated that the March meeting could be “live” for a rate hike—another adjustment to policy expectations. In all, investors have been struggling to anticipate and adjust during this time of transitionary monetary policy.
- While I do not believe investors should be too concerned, long-term, with the current market dynamics (this is not the end of the economic cycle, so far as I can tell), it could make sense to begin increasing defensive positioning after January/February’s earnings season. From our current vantage point it appears that good news will be hard to come by after that. Again, it seems more probable that next year will give investors a genuine correction in markets, which could be a great entry point for cash, or a great moment to re-align portfolios from defensive to offensive. Investors who “miss it,” however, should not be too concerned as it is likely to be short-lived.
The Details & Charts of the Week
With government spending, inflation, and the role of the Federal Reserve in the news, I thought it timely to take a closer look at interest rates and government debt, and what we can consider sustainable and unsustainable.
Of course, government debt is at an all-time high (first chart below). Though, government debt is always at an all-time high, so this is not a new situation. It has expanded considerably, of course, but what is of more pressing concern is the second chart, which shows the percentage of the federal budget spend on paying for that debt. We have been able to sustain considerably more debt than “normal” because of the third chart: the effective interest rate on government debt at an all-time low.
The ongoing debate, then, is over the third chart. What is sustainable when effective interest rates are less than 2% becomes less sustainable if those rates move to, say, 4%. Based on current debt figures ($28 trillion), a 4% effective rate of interest would force the US Treasury to spend $1.1 trillion per year on just interest payments. To put that into perspective: in 2019 total federal government expenditure was $4.7 trillion.
In other words, if effective interest rates move back to where they were in the early 2000s (not that long ago!), the US government would be spending about 23% of her annual budget on interest payments—more than double what was paid in the 1980s when interest rates were almost 4x higher.
And this is just assuming a return to a long-term average. If the Fed gets aggressive at fighting inflation and effective rates go to 8%, fully half of the federal budget will be consumed with interest payments. That is about the annual military budget of the United States. That appears unsustainable.
All of this matters because it affects how the Federal Reserve can respond to the threat of inflation. Aggressive interest rate hikes are, in reality, off the table. Some other mechanism will have to be used to pull excess cash out of the economy, though exactly what is an open question.
Investors, as I have said many times before, would do well to remain flexible and closely monitor the tug-of-war between policy, inflation, economic growth, and covid. And the sustainability of government spending will affect all of these.
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