Listen as we discuss critical interest rate developments including: will the Fed raise interest rates, even without inflation; the flattening yield curve’s impact on recessions; interest rates and the Fed balance sheet; does municipal bond trading still look good; and the history of interest rates. Guest host: Matt Lloyd, Chief Investment Strategist, Advisors Asset Management
Hello, this is Michael Carlin, President of Henry+Horne Wealth Management with episode three of Manage the Funds Podcast. Joining us today is Matt Lloyd, Chief Investment Strategist at AAM. If you’ve never heard of AAM, or Advisor Asset Management, you’re missing out. They have 35 years of corporate experience. They oversee and advise on $22 billion, at least that’s the latest update that I’ve seen. Very impressive organization. I’m excited to have you on board to talk about interest rates.
I appreciate the invite, especially when I’m talking about interest rates.
Matt’s been in the business for 22 years. You can see him on CNBC, FOX Business, Wall Street and Forbes. It’s good to have Matt dive into this discussion on interest rates. The big picture for the listening audience, interest rates are critically important to your financial life. It will help guide things, how your conservative assets make money. It’s a principle force that drives the U.S. economy, that’s going to drive the world economy.
One of the things I would like to start with, Matt, is a little history on interest rates. I have with me a history of long-term interest rates for both Britain and the United States that goes back all the way to 1820 to today. If you look at that 200-year stretch of interest rates, it shows that the average long-term interest rate is only 4%. There was a pocket of time in the late 70s and 80s where you had double digit interest rate environment, but one thing I want to set the table with is should we be expecting, as shareholders and investors – is 4% the number we should be looking at? Right now, the 10-year treasury is 2.8%. Is 4% the number or something else?
One of the interesting aspects of interest rates is they are mathematical. You can compute them, so they seem quantifiable. There is a strong backdrop of relativity to them. To your point on those charts is you can go back 100 years, or 30 – you need to go back quite a bit to get some context. One of the things that’s lacking in the financial present is the lack of context. Some certain distance away, you can see order in things, but if you’re watching on a daily basis or minute-by-minute, it looks like it’s just haywire. Interest rates, in the same in that your chart that you’re talking about is a great example that you see the strong cycles that you see.
We talk about interest rates in two ways. You have a cycle which typically runs in a form of what the economy does. From when it’s recovering to the top to when it’s peaking, to when we have a recession. That is considered a cycle. Secular is another move that is a comprehensive consistent move of cycles inside there. So, a secular move over this 200-year time frame that you’re talking, you can maybe see three or four secular trends and they could be far more volatile early on when our economy was juvenile in that case. We are more mature now.
The aspect is that as you mature, you should see less volatility, less standard deviation. That doesn’t mean you don’t have volatility with seeing two big stock market corrections in the last 20 years. Bear markets you will. One enormous recession in 2007 and 2009 which is a once in a generation event. Compare that to the last time you saw something that severe was The Great Depression. The secular trend is one of those things where we’ve been in a secular bull market since 1982. So, those interest rates, as you look at them, do impact everything. What you’re going to pay for mortgages, what you’re going to pay on your credit card. If you want to do a loan or if you’re going to invest that money, what is your rate of return? There’s a lot more intricacies to it.
Ultimately, when we talked about interest rates, understanding where you’re at is key. You want to look at how many cycles is this in the new secular trend. When you look at the chart pattern over the 200 years, you notice one enormous anomaly and that is to hyperinflation stages from 1963 to 1987 when rates were double digits. Inflation was out of control. If you go back in time, you don’t see a replication of those types of rates. Unless, you go back 5,000 years, and there is a chart out there that goes back that far, there is a chart that goes back to 3,000 BC. The only thing I can think of why those rates are so high back then is there must have been a disruptive technology like the Bronze Age.
Again, we talk about secular markets. It’s really a long-term, multi-year trend and in this case, a multi-decade trend. Should we appreciate the fact that interest rates are so low now? Should we expect interest rates to go back a bit higher? I know we’re going to talk about the Fed and the Fed moves, but broadly speaking, should we be prepared for interest rates to move higher?
We should because it’s a little different and there’s a perspective like The Great Depression from 1933 to 1963. The ten-year average 2.84%, which is lower than we are at now. That’s a one in a generation event that affected an entire generation and we were a very juvenile type of federal banking system. If you look at it now, and the recovery and why rates are so low, part of it is because the harshness of the recession, the reaction from the Federal Reserve and other essential banks. So, the rates are going to go higher.
Look at what some of the core rates are showing. You would normally see that the Fed’s interest rate cycle would be 300 basis points. Three-hundred basis points from where they are at would equate to three and a half to three and three quarters on the ten-year under historical spreads. I think you need to, when you look at inflation and where the economy is going, you look at the correction we just had, even the correction in 2015 the equity and risk assets in the equity markets. There’s a fiscal stimulus that’s now taken the baton from monetary stimulus and you take a look at sediment numbers and deregulation on top of that. We are late in the cycle, but the last part of the cycle can last a long time.
I often get asked what part of the cycle are we in. This is a different day. This is more like cricket than baseball and it could last days. This cycle and this expansion is probably a long-term cycle and we have a few more years before we see an economic slowdown.
We are going to dive into more detail in regards to the economic movement. You brought up inflation. So, when I hear inflation, I‘m thinking interest rates. One I understand that the Feds mandate is multi-fold and what the Federal Reserve tries to do in the United States is manage inflation. Two, would be economic growth and three, to some degree, economic conditions.
Assuming inflation is one of the biggest components, we’ve had some benign numbers. Today’s inflation, the numbers came out a little higher than we’ve seen lately and the mid to high twos. Given that, is inflation high enough to warrant the Federal to keep moving? I know you wrote a blog on inflation and I have your chart in front of me. By the way, if you want to read good independent information, Matt’s team is uncovering data that’s never been seen before. Go to Matt’s blog https://www.aamlive.com to read good independent research. So, inflation hasn’t been high enough, the Fed’s moving anyway, help me piece this together.
That is a good question. I will say that if you look at the context, we are running at a 2.1% annualized growth rate of inflation. If you take a look at producer net, the producer is paying more than what consumers are paying as far as those costs go because it’s not being passed down. That’s a whole different discussion about what the means for corporations’ profits and the Federal Reserve. The historical average since 1988, and things started normalizing past the inflationary spikes of the 70s and 80s, the average of 2.6%, why should the Feds be raising rates when we are at 2.1%? We’re still a little precarious and we want to keep the momentum going.
What’s interesting is the Feds are completely on one side and they lowered rates to zero. That shift of dynamics, like Warren Buffet says, “You only know who’s not wearing a swimsuit is when the tide goes out.” The Federal Reserve knows they’re not wearing swim trunks with as low as the rates are and their balance sheets. So, they’re raising rates incrementally. In fact, it’s the lowest incremental rates in history. Normally, it’s like 18 basis points a month. We’ve been averaging six basis points a month. What this tells you is they’re trying to adjust their balance sheet and/or the interest rate to a more normal level so when the next recession hits they have some ammunition. But, if we would have double dipped in a recession prior to 2015, before they started raising rates, what could the Fed have done? So, the shift now, inflation has taken hold. It’s not of the norm. It’s not off the reservation that we’re so concerned, but it gives us the opportunity to raise rates a little bit so we can get to a 2.5% or 3% on a Fed’s fund rate. So, we have ammunition on the way down. If they could unload some of their balance sheet, mortgages and treasuries – that does have an impact on rate but allows a more flexible rate the next time a recession hits. Recessions serve a purpose. You don’t like them, but they flush out the leverage in the system.
It seems to me that the Federal Reserve wanted their favorite tool to help bail out the market. Your theory and data confirm my suspicion. I want to transition into the Fed expectations to raising rates and I know no better way than to google “Federal Reserve Plot.” If you google, you will see the chart we are talking about. I view it as a survey the Federal Reserve governs to get a sense for what they think short-term rates are going to look like in the future. You aggregate all those numbers which gives you a sense where they are going. If you ask the Feds the expectations when looking at the chart, they are not unlike the same expectations that you can see on interest rates from Wells Fargo to Citi Bank. I find it fascinating. Can you talk about this?
The first and foremost thing that we look at there is some reliable indicators out there and some that are marginalized are the ones you want to pay attention to the most. The ones that say this is the most obsolete, I would pay more attention to those indicators. The yield curves spread is one of them. By yield curve spread, we are looking at longer term maturities, as you said, and short-term maturities and what is the difference? Back in November, everyone was talking about the yield curve is flattening. If a curve is flat, what that’s telling you is the economy is slowing down. If the curve is steep, meaning there is a big difference between the long end and the short end that points to an expansion, meaning people are seeing inflation in the market place. They want to be rewarded for more return on fixed investment, fixed debt if it’s longer term because they can get it in robust returns in equity assets. That curve spread is vital to understand what the perception is market place.
We have been hearing about curve flattening and people want to take it as an imminent indicator. What’s interesting is it’s so leading it’s almost lagging in a way. When we talked about that indicator back in November, I had a quick analysis – what has the past chart been 72 basis points, meaning the difference between the 10-year treasury and the two-year. I went back in time and said this is interesting. If we look at the times, it said out of the past three sessions back in 1990, 2001 and 2007, when it got to this level, you average basically five years before you had a recession and five years before you hit a margin peak in the S&P 500. At minimum, you have two and a half years. This one actually resembling more than the 1990s expansion, which was six plus years before you saw a recession by this stage.
When you look at the curve is flattening, it’s not eminent. In fact, what you find is time when it inverts. So, by the time the curve inverts, meaning where the long end is lower than the short end, that means that people saying eminent recession are coming on and they are willing to take that risk. What ends up happening is you have quite a bit of time before the recession happens, usually a year and a half to two. You shouldn’t be so concerned with it until it gets to zero, then you want to think how relevant it is. The only caveat I would put on this is this curve flattening is kind of anchored a bit because the Fed has bought so many treasuries and mortgage back securities that the long term and the tenured are anchored in a way to the short end which you normally don’t see. Because of that, if the Feds start to do the unwinding, then you start to see the outward longer part of the curve shift outward, which I can tell you is so contrary to the consensus out there because they’re not taken in consideration. But that would better represent the yield curve and the growth we are having in the economy.
So, we see it’s flattening, but is this going to continue? Maybe, but we still have an average of five years and on a worst-case scenario, maybe three years plus. This is like being a siren’s call, so to speak, that call sailors into their doom. We don’t think that’s the case at all. If you look at this last correction, if you take a look at how that happened and what it means, it really doesn’t exude the fact that the economy is slowing down. Fundamentals right now in the economy, corporate earnings, the lack of leverage, the amount of fiscal stimulus coming from tax cuts and deregulation. We are in a stage of fundamentals. It doesn’t mean it’s a linear straight up shot from here – risk assets or anything else. At this point in time, the curve flattening doesn’t indicate the economy isn’t doing well. We think it’s a more synthetic operation than not and we think it’s still good to be in the risk assets.
Looking at the interest rates as a tool figure out when the next recession is coming and right now it does not appear to be eminent. You brought up unwinding the balance sheet. Why don’t we look at that? My simplified view of the Fed balance sheet. You’re taking a long look at the history of the Fed balance sheet from what I read, owned mainly treasuries; and then enter the financial crisis, the Fed opened up the balance sheet. Money was created to swing over to the Fed balance sheet that they could go ahead and buy all sorts of things – mortgage backs to different agency bonds and other kinds of assets in an unprecedented move to bring market stability.
The Fed has been specific about wanting to unwind the balance sheet and, for some reason, this announcement of the Fed move to unwind the balance sheet hasn’t created concern within the market yet and I’m perplexed by that. It just seems if you look at the history of those that tried to fight the Fed, there are not a lot of people who win. It’s hard to fight the Fed with that kind of balance sheet. Should we be worried about fighting the Fed and should we be worried about their announcement to unwind the balance sheet and what that might look like getting it back to interest rates and the broader spectrum of investments?
If I could pick two fights and it was with Mike Tyson and any central banker, I would pick the fight with Mike Tyson first then get up off the mat and ask to fight him again. The point is, you never want to fight the Fed and you don’t necessarily invest with the Fed. You look at what their investment is going to impact. They have far more power in assets than we do.
There is only one class out there that I would argue that if any central bank starts to impact or influence, you go the opposite way with it, and that’s currency. Any central bank that is trying to support a certain currency, after a while, they will run out of leverage and the bankers and traders out there will overwhelm them with leverage. When you look at the standpoint of the balance sheet, and we saw this happen with RTC – the Revolution Trust Company – with savings and loans back in the 80s, and it happens every time. Quantum viewing can take on many forms. It’s just that this time it worked out well for us. Then the Bank of Japan started going heavy on it. Then the European Central Banks went into it. We see their markets two years lagging. When they gobble up all those assets they don’t have to sell, there’s not going to be a force liquidation.
There’s only two reasons, in my opinion, why the Federal Reserve would do liquidations beyond what they are scheduled to do right now and that’s if inflation got out of control and they couldn’t raise rates fast enough and then you want shock market rates. The other one is a currency issue. That one, even more remote with us still being the primary currency of the world out there. So, I think in a sense what they are trying to do is get prepared for the next wave. If they can unfurl their balance sheet in the next three years to cut it in half from 4.5 to two trillion to 2.25, that would be a major victory. You might be able to do that, and they’re probably going to run in to some headwinds, and they’re going to have to increase treasury funding to fund the deficit in the next two years. That’s going to impact them a bit. Then on top of that, with rates rising a bit, so the new coupons will be higher than the ones that are maturing.
I see the basic unwinding does one of two things. When you look at the yield curve, the way to look at it is the short term the Fed anchors and the Fed controls. If you want to look at the 10-year, that kind of market place what is the economy really doing? But you want to look at the 30-year. You want to look at the inflation side. If all of this inflation is rising, let’s say they start to unwind a little bit, accelerated all their assets, mortgages and treasuries. What this does is shift the curve outward. When they were in massive amounts of buying quantitative, using the best estimate we could come up with is it’s having an impact on the market by a negative 125 basis points, which means that we were running. If you were to take that into consideration when the Fed funded at zero, there was an actual negative 125 basis points in the shadow rate.
Now, it doesn’t necessarily give you something you can materially look at, but what we know is quantitative has an impact on lowering rates in general. One-hundred-twenty-five basis points on the negative side. What happens when it starts to do the opposite where the biggest fires become the net sellers at this point? It doesn’t mean mass liquidation; so, when we talk about inflation or talk about rates rising or unwinding balance sheets, it’s not a flip of the switch. This is just a matriculating type of move. Inflation is going to slowly increase, rates are slowly going to increase here. It’s not going to be a hyperinflation and you’re not going to see a secular move in interest rates or inflation in the cycle, but them unwinding their balance sheet slowly but surely shifts that from a minus 125 basis points to get it to a more neutral versus having the positive 125 basis points on the other side. That shift is going from 125 to a minus 75 now just from the switch that’s gone on right now.
I would caution the ECB is probably going to be later this year changing their tone in what they’ve been doing. They’ve been kind of mass buyers of all their debt and corporate debt and so forth. Bank of Japan is worse. They are buying equities. They are a top 10 holder in the Nikkei 225 Index and basically every company, so they’ve gone a little overboard and that’s a demographic issue more than anything. The issue being it’s probably going to shift and that’s going to have a tectonic move in the global bond market because so much of their debt is still trading at negative yields over there. I would say that what’s happening here is a little bit more methodical and it’s not going to impact the equity markets in a negative way but could if they go radical that way.
What I also see happening is they are going to unwind a bit more than what they said once they feel the market can absorb it. So, they can get their balance sheet down a bit, so they have more ammunition when that recession comes. It could be two years, three years, five years – whatever that is then they need that ammunition. That’s why the Fed needs to go instead of quantitative using to buy all those assets, it’s a quantitative tightening by unwinding those assets.
First, you’ve blown my mind again. I could do this all day. I have some questions for you. One, interest rates and borrowing. One of the things that we need to be worried about because we have talked about interest rates rising to some degree, we’ve gone through so many ways and reasons why we should see this happening and to what extent it will happen. Are we okay here to be a little less concerned about U.S. household debt, because it seems like our total debts to assets ratios, they look pretty good certainly in comparison to where they were in the 90s and early 2000s. Looks like our personal balance sheets are okay. Should this rising rate move, given the total amount of indebtedness, be a huge concern?
If you look at it from an asset standpoint, net worth 97 trillion, we have 11.3 trillion in cash and households. We’ve shifted dramatically in the amount of liquidity that’s in the system. Not only the households but into corporate America which is going to get a bigger boost this year. The leverage in the system isn’t quite there. In fact, we have shifted dramatically the event that we talked about, The Great Depression impacting that generation.
After 2008, we have seen commercial papers from corporations cut in half and we’ve seen the fact that the financial obligation ratio for debt for U.S. households right now is 9.91%. The average over the last 35 years is 11.39%. The peak was much higher, almost 14%, so we are roughly in a way there is a lot more that can be added before we get even the average. I believe you can add $2.5 trillion in debt that doesn’t go into investment to housing or anything else but pure consumption debt before we get to be average out there. So, I say that the households have been very pragmatic in a lot of ways. They have been doomsday prepping since 2008 because of what happened there. I think the households are pretty strong and a little more wage increase will help them more.
We have seen wage increases and that’s great. Next question. Should we avoid foreign currency income? We have to worry about the U.S. dollar. Is this something we should have in our portfolios? This is the kind of thing where you’ve got global bond funds. Those are the more commonly used instruments, or certain ETFs that are fixated on foreign fixed income. Is this something we should run into or run away from?
Here is an answer that’s a little more complex. I would stay away from a lot of foreign debt in general and the reason is more the interest rate scenario because a lot of people that like emerging market debt. The problem with emerging market debt is that what you get and yield and the risk on that. You can do a lot better on the underline equity. So, I would rather have the emerging market equities in the debt. If I look at develop market debt, they’re trading at negative or right at it. That’s not a good enough appeal, so then you have to hope for a currency move to offset the duration issue that you might have. I don’t see any benefit there.
But I love currencies exposure in portfolios for no other reason than there’s not one single way to lower the average correlation of your assets in your portfolio than having some sort of currency exposure. If I could, I would have currency exposure in some of the equities to offset some of the correlations. Correlation is a way to mitigate the risk and what it does do is it mitigates some of the returns because currency is buying. There you measure them versus something else. This day and age we’re trying to work off some of the return of our principal, not just the return on.
I guess I would sum that up and say I’m not a big fan of foreign debt in general because yields are so low, and coupons are so low you can’t keep your duration, but I like the foreign currency exposure equities.
Last question. One of my favorites, and favorites of clients, is the municipal trade, municipal bond, tax rate bonds. One way we look at it is one of the higher quality securities that you can still invest in. I see a market that is where the supply is shrinking. I see a market that has municipal bond market that’s reacted very negatively to the Tax Cuts and Jobs Act that we just got recently and I’m seeing a little bit of fear in the municipal trade, but to me it looks like it holds some promise. Can you share your viewpoint on the municipal marketplace?
My favorite place to be in the dead instruments is the municipal market whether it’s tax exempt or taxable. Credit quality, you mentioned, is a lot more enhanced there than it is in corporate. You have a lot more volatility and credit ratings in corporations. If I’m building a portfolio, I probably need three times the diversification in corporates because I’m going to have to maneuver through different credit cycles, but I did a study on this and we can talk about this more in-depth next time.
The number one opportunity that gets out there is the municipals. If you look back in time, when I did a comparison in municipals tax-free and I looked at the index and I looked at the lowest yield on municipals out there – the broad space index – and what I found is that it typically out performs and it stabilizes much quicker than what happens in every other asset class. The federal funds’ rate shoots the yield. What this means is that interest rates are rising. At some point the municipals kind of start stabilizing because your after-tax yield is already pricing in. So, many more Fed fund types and if I look at that compared to every other debt asset class out there, the municipals are offering to me the best after-tax yield, the best credit risk reward and in general, this year we are going to have a net decrease in supply of roughly $25 billion.
There is not one other debt class that’s going to be negative, so at a time when there’s demand for yield, demand for good credit quality, and we’re starting to increase credit quality, at this point a little early, we’re not thinking there’s going to be massive defaults in corporate land, but we think we want to start setting up credit quality. I think the municipals are often one of the best opportunities. You’re still going to have some volatility as interest rates rise, but the way I see it is the Fed funds and what happens with that and where the municipals are, they’re offering probably your best insolated way of doing it. And you’re able to control duration, increase your coupon, which is what you want to do, and then ultimately have a better credit quality.
When this market kind of tops out and we get to the terminal Fed funds’ rate somewhere down the road, high quality assets are going to be doing the best and after-tax yields, now that the new tax law goes through, is telling me that the municipals right now for the people that need yield is probably the best place to be than any place else
This is amazing. You realize that in 40 minutes we unpacked the history of interest rates, inflation, the Fed, unwinding the balance sheets, foreign bonds – we’ve packed in a lot. We need to do a podcast on unpacking what we just packed in.
Listeners, go to https://www.aamlive.com to check out Matt’s blogs. I read this because it’s unbiased and free from conflict. It’s great data from Matt and his team. Matt, I can’t thank you enough and look forward to our next conversation. Thanks for tuning in to the Manage the Funds podcast episode three.