Linda Duessel: Hello, and welcome again to the Hear & Now podcast from Federated Hermes. I'm Linda Duessel, Senior Equity Strategist. Today I'm joined via phone by Don Ellenberger, Senior Portfolio Manager and Head of Multi-Sector Strategies. Hello, Don. Despite unprecedented fiscal stimulus, with the stock market making new record highs, we're seeing long term treasury yields hit and hold near record lows while inflation is missing in action. How long can this last? Aren't these conflicting messages?
Don Ellenberger: Well, it's a pleasure to chat with you today. I was reading something by Deutsche Bank the other day, and they said that treasury yields are the lowest they've been since 1790. That's a span of 230 years.
Don: I know. The average yield on the Treasury Bond Index, which includes bonds with maturities from 1 to 30 years, is only 0.5%. The vigorish in treasury yields are so low, in addition to the market's complacency on inflation, which I'll talk about in a minute, there is of course the Fed's massive bond-buying program, which is supporting not only the bond market, keeping rates low, but it's supporting the stock market as well.
Don: Now, the Fed is buying 80 billion USD of treasuries every single month and 40 billion USD of government mortgages and a host of other types of bonds as well. The Fed can do this because they have a superpower no other institution on earth has. The Fed can create an infinite amount of dollars, literally out of thin air. They're using that superpower to buy treasuries and other types of bonds, to both maintain liquidity in the bond market, and to lower borrowing costs for consumers and businesses, in order to support the recovery from the COVID-19 recession.
Don: It's not just the Fed that's putting a lid on interest rates. Central banks across the world are artificially suppressing sovereign bond yields. Some are even forcing yields to the negative territory. If you're an investor in European and Japanese bonds with negative yields, you're paying those governments for the privilege of lending money to them when you buy their bonds. I mean, it's crazy. Those bonds actually eat your money.
Don: Here in the U.S., the Fed hasn't thrown negative rates out of its tool box, but it's very clear from what they're telling us that they don't like negative rates, because it hurts bank revenue. Remember, banks are the vehicle through which the Fed conducts monetary policy. Negative rates would crash money markets funds, and they really haven't worked very well in Europe or in Japan.
Don: Linda, you also asked how can this go on? How long can treasury yields stay at 230 year lows? The answer is as long as the Fed wants, up to them. The Fed is in no hurry to raise rates anytime soon. That's because it's going to be a long slog to get the unemployment rate down from 10% all the way back to 4%, which is where the Fed wants it. That's what they consider full employment.
Don: On top of that, the Fed is likely to announce later this year, a move to an average inflation targeting regime. That means that because the Fed is worried that weak economic growth would create disinflation, or even worse, maybe even deflation, the Fed is not going to raise rates, even when the economy recovers from the recession. Even if and when inflation finally starts to move higher, the Fed wants inflation to overshoot the 2% target for a while, in order to anchor inflation expectations in positive territory and make up for years of undershooting their 2% target.
Don: For the next couple of years, the Fed may allow long term interest rates to rise a little bit if that increase is driven by organic domestic economic growth and not by illiquidity or panic selling, which we saw back in March. But short term rates, say five years and in, they ain't going anywhere.
Linda: Well, it really is crazy if you're saying that they're going to wait until a 10% unemployment rate gets all the way down to 4%. I do wonder when that is. We, on the equity side, we love low interest rates. We love an easy Fed. When our leader says, 'We're not going to think about think about thinking about raising interest rates,' that seems like a green light, but when you said printing an infinite amount of dollars, literally out of thin air, this leads to my next question. It seems that modern monetary theory as espoused by Bernie Sanders or AOC is now modern monetary policy. At what point should we be concerned then about a deficit that's grown by the trillion, Don?
Don: Okay. Good question. Modern monetary theory, maybe I'm oversimplifying a little bit, but basically what it says, is that a country like the United States is able to issue debt in its own currency, can print and spend as much money as it wants, and never worry about how big the budget deficit gets. Because according to modern monetary theory, the only constraint on government borrowing and spending is inflation, because inflation wipes out a big chunk of the real or inflation adjusted return to buyers of government debt.
Don: A spike in inflation would cause treasury bond investors to demand much higher yields, which would then lead to unsustainable debt service costs for the government and cause this whole stack of cards to collapse in on itself. If the government can't roll over debt because private investors don't show up with treasury bond options, or if investors demand too high of a yield, then the Fed would be forced to step up as the buyer of last resort and buy all the government's excess debt issuance.
Don: That would only exacerbate any inflation problem as all that money from the Fed gets recirculated back into the economy and money supply growth rockets higher. Now here's the key point, an exhaustive academic study done a few years ago, looked at 133 countries over a span of 40 years. It found inflation almost always goes up when two conditions are in place, number one, high government debt levels and number two, rapid growth in money supply.
Don: No matter how you look at it, according to modern monetary theory, inflation is the only thing preventing the government from sending me, you, and everybody else, a check for a hundred million dollars. Interestingly enough, those two ingredients I mentioned that sow the seeds of inflation, high government debt levels and rapid growth in money supply, most of those are actually in place right now. The federal debt was 80% of U.S. GDP in January, but by December we'll have jumped to 100% of GDP. That's the highest level since World War II.
Don: Two, money supply growth has started to come off the boil because the phase four stimulus plan has been delayed, but it's still running at a 23% annualized pace. Don't forget that the Fed's policy focus just had a seismic shift in recent months. In the past, the Fed was focused on putting a lid on inflation. Now the Fed is trying to put a floor under inflation. Inflation is the key to whether or not a deficit growing by the trillions is ultimately sustainable.
Don: Right now, with Treasury Inflation-Protected Securities pricing in less than 2% inflation on average, over the next 30 years, the market's telling us that there's absolutely no chance of a significant spike in inflation, but is that complacency justified? In addition to the growth in the deficit and the money supply, there's another important reason to think there could be a little bit of a pickup in inflation down the road.
Don: Today, the Federal Reserve and the government have become intertwined. The Fed is underwriting the ballooning federal debt while pegging interest rates below market clearing level. In effect, the Fed is working hand in hand with politicians to help the economy recover from the COVID-19 recession by basically lending its balance sheet to Congress to pay for trillions of dollars in checks to consumers and loans to businesses. While that's certainly the right thing to do as the economy struggles with the coronavirus, there are long term repercussions from the Fed handing its checkbook over to Congress and inflation could be one of them. Certainly not 10%, certainly not 5%, but enough that investors should not ignore this.
Don: The answer to your question about when we should start to be concerned about the growing federal deficit, is when inflation starts to heat up.
Linda: Here I always thought the bond market was boring and you have made it very, very interesting here, Don, some of the unprecedented comments that you're making. Now, can the best fixed income opportunities be found in this mind-twisting environment?
Don: Mind-twisting, I like that, Linda. Okay. The first rule, buy what the Fed is buying, but that also has some yields. I personally like corporate bonds, investment grade and high yield. Avoid nominal treasuries. With yields so low and the Fed reluctant to take rates negative, there's very little income, very little total return upside, and very little protection if stocks decide to crash again.
Don: Second rule, own some Inflation-Protected Securities. They're cheap to the Fed's 2% inflation target and they can actually increase in value if inflation rises, so they're a good hedge for any investor's portfolio. Corporate bonds, they can also benefit from mild inflation because that means the companies have some pricing power, which increases revenue. That's a good thing, but a bigger spike in inflation, say above 3%, while not our call at Federated, that would hurt all bonds except for Inflation-Protected Securities. I'll leave this to Linda, but I'm guessing would probably hurt stocks as well if that forces the Fed to start aggressively tightening monetary policy.
Linda: Excellent. With a very, very friendly Fed, corporate bonds could be a way to go to find some income. I love your idea of Inflation-Protected Securities, when in your last comment you just said that, that's what we really have to watch out for with this deficit, when inflation starts to heat up.
Linda: Thank you so much, Don, and thank you to our listeners. We look forward to you joining us again on the Federated Hermes Here & Now podcast. If you enjoyed this podcast, we invite you to subscribe to the Federated Hermes channel to get every Here & Now episode plus our other series, Amplified and Fundamental, for a global perspective on the issues, challenges and trends shaping the investment landscape.
Disclosure: Views are as of Aug. 21, 2020 and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector. Bond prices are sensitive to changes in interest rates and a rise in interest rates can cause a decline in their prices. High-yield, lower-rated securities generally entail greater market, credit/default and liquidity risks, and may be more volatile than investment grade securities. International investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards. Past performance is no guarantee of future results. (4:24: AOC refers to U.S. Representative Alexandria Ocasio- Cortez) 20-40409 (8/20) Federated Investment Management Company