Are The Deficit Chickens Finally Coming Home to Roost? 

We might have to get used to high interest rates for a while

There has been a very important shift in market expectations recently.  Until the last month or two, markets had assumed that as inflation cooled off, the Fed would lower rates, and we would go back to life as it was before. 

That assumption has been shifting – with a vengeance, with implications for stock investors, bond investors, and the economy as a whole. 

Markets are now assuming rates will stay higher for much longer than previously expected.  Part of the reason is that it is now widely believed that interest rates are high not just because of the Fed (which only controls very short term rates) but because supply and demand for bonds has fundamentally shifted in a manner that is going to keep rates elevated. 

The apparent reason for the shift is the speed at which government debt is ballooning.  With high interest cost on the debt soaring, and cost of government programs spiraling higher, the national debt snowball is picking up size and speed as it hurdles downhill.  There doesn’t seem to be much that can stop it.  Certainly not our dysfunctional Congress.  The ever growing deficit (which has grown exponentially larger with each successive administration since Kennedy) needs to be funded by the issuance of more and more US Treasury debt.  (thus a dramatically increasing SUPPLY of bonds).  Meanwhile, DEMAND for US Treasury debt has waned.  China’s economy and trade has slowed so they have less cash to park, Japan has buying less foreign debt as its own domestic investment market has improved, and the Federal Reserve has stopped its bond buying program that has been funding the government for the past 15 years since the financial crisis. 

With more supply and less demand, the interest rate on debt has to go up in order to attract more buyers.  But as the rate goes up, so does the future interest expense to the government.  And the snowball grows even larger…

Some will shrug and put this off as just more fear mongering over the debt.  And its true, there have been many boys out there crying wolf and predicting calamity over the past 2 decades.  The difference is that as long as rates were low, we could go on pretending that the government can borrow and spend forever.  Everyone knew there could be a hypothetical fiscal cliff out there, but it was easy to ignore while rates were low and the economy was strong.  Now – very suddenly – investors are waking up to find that higher rates may be pushing the country off that hypothetical fiscal cliff. 

Implications for the economy are profound.  While economic growth has continues to be strong even with the rate increases we have endured so far, it can’t absorb much more!  The higher rates move, the more likely a recession becomes.  A recession could reduce the pressure on interest rates – but it would also further inflame budget deficits.  And the snowball grows larger still…

It is a tough call for investors.  In some ways, as long as you don’t need to borrow money, we are kind of liking these high rates (for as long as they last!)  If the economy falls into a recession, bond prices may rally as rates fall, recovering some of the last 2 years of declines.  To take advantage of that (and to lock in today’s higher rates for an extended period) an investor would be wise to invest in longer term bonds, or perhaps a bond index fund.  But as noted above, rates may be sticky high even in recession.  And if rates move higher still, or just remain where they are, investors are best served in very short term bonds, money markets, and short term CDs which will quickly capture benefits of higher rates. 

As for stocks, obviously a recession is always hard on stock prices in the short term.  As higher interest rates on nice safe US Treasuries attract more investors, those investors may increasingly be forsaking stocks.  Less demand means lower prices.  So it seems stocks are in for a difficult stretch.  We are firm believers in “buy and hold”.  Through all different market conditions over generations, stocks have been able to generate positive returns for investors.  But I would advise investors to be cautious about committing large new sums of cash to stocks all at once.  Better invest slowly over time using Dollar Cost Averaging (and investing in those nice high rate CD’s while you slowly add stock positions over a year or two). 

The long term implications of this fiscal scenario are troubling.  If debt is allowed to continue spiraling higher, there will be no easy way out.  Already we are past the point of easy fixes.  Would it be too much to ask for a strong, popular, trusted leader who understands fiscal realities, and would speak difficult and nuanced truths to the American people, while browbeating Congress into making politically difficult but economically necessary choices?   Yeah, crazy idea.