From the July 01, 2009 issue of Futures Magazine • Subscribe!

Interest rates and the economy: What's next?

A bomb was dropped on the financial world and the economy at large when the financial sector collapsed in the fall of 2008, and the United States and the rest of the world are still working through the damage in 2009. Unemployment in the United States hit 9.4% in May, the housing market hasn’t begun to recover from its three-year tailspin despite happy talk of “green shoots,” and with the bankruptcy of General Motors in June, the U.S. auto industry has officially cratered. Experts say that this economy could recover, albeit closer to 2010.

The interest rate outlook will be based on the continued desirability of U.S. debt, which is being scrutinized more than ever, especially by the Chinese, even with the Fed buying Treasuries. Interest rate yields hit rock bottom in December, with the Federal Reserve setting its target rate at zero to 0.25%. With the Fed out of bullets in terms of the Fed Funds rate, it embarked on a quantitative easing program in an attempt to hold down interest rates. On March 18, the Fed announced a plan to purchase up to $300 billion longer-term Treasury securities over the following six months. While it had an immediate impact, it appears to be a case of diminishing returns as Treasuries have dropped (yields have risen) since the initial spike following the announcement (see “Buy bonds”).

Mike Kimbarovsky, principal at Advocate Asset Management, expects the Federal Funds rate to remain unchanged in 2009 and for most of 2010. “With the budget deficit that we have, with the funding requirements, we’re going to have to issue more debt. We’re already issuing trillions of dollars of debt and our creditors demand higher yields to compensate for the extra risk from such a high deficit. Yields on Treasuries will go up, yields on mortgages will go up, three-month Libor will stagnate or go down,” he says. “It’s hard to predict around the world where [interest rates] are going to go. It’s a competition of which countries can quantitatively ease faster. Yields all over the world will probably continue to increase as everyone prints money.” He expects the equivalent Federal Funds rates for each country to be stagnant through 2010.

“We’ve seen some movement in the long-term side of U.S. bond markets showing less interest for the nominal bonds. That indicates that more investors are geared towards an inflationary environment,” says Michele Gambera, chief economist for Ibbotson Associates.

Cary Leahey, senior managing director for Decision Economics, calls the dramatic jump in Treasury yields a return to normalcy in the bond market. “The sky is no longer falling, so you’re returning to normal. At the same time, expectations of inflation which are tied to that, which had fallen to close to zero, have moved back towards 2% in the last couple of months.”

Leahey points out corporate borrowing rates such as the BAA Moody’s Corporate, the lowest investment grade, actually rallied from April to June, which suggests the economy is doing better. “We’d like to see the corporate market move back to normal but we don’t want mortgage spreads, at least the Fed doesn’t want mortgage spreads, to widen back to normal. The 4% Treasury rate would suggest a historically 5.5% mortgage borrowing rate, which is probably not consistent with any kind of recovery or stabilization in the housing market,” he says.

STIMULATION GENERATION

In an effort to jumpstart the sputtering economy, the Treasury Department unveiled the American Recovery and Reinvestment Act in February, which includes tax credits for first-time home buyers and tax benefits for the middle class. Throughout February, Treasury released more plans to assist homeowners in reducing mortgage payments and a Capital Assistance Program to ensure that financial institutions have enough capital to lend, which included stress tests for banks that were designed to determine each bank’s stability. Stress test results were released in May, but some economists question their worth. Kim Rupert, managing director of fixed income for Action Economics, notes that the stress tests “lost a lot of [their] importance when the government indicated that none of the banks were going to fail. There wasn’t a huge impact and there’s not going to be much follow-through,” she says.

Rupert expects the stimulus to have a medium to longer-term impact. “The housing market’s still in disarray and even with the stimulus and tax credits, with the labor market under pressure and the unemployment rate rising, there’s disincentive for the home purchase market [that will] limit home buying even with the tax credit,” she says.

Kimbarovsky notes that the stimulus plans will have a positive effect in the short-term with bigger consequences in the long run. “In the short-term it will have the effect of supporting inefficient industries that cannot survive on their own. It’ll reduce counterparty risk — people will have a sense that [the U.S. government] is standing behind their transactions. Those are positive [effects], but at an enormous cost. Corporations’ ability to distinguish between more risky and less risky endeavors will be impacted,” he says.

Leahey says, “It’s a massive effort to right the ship, but the economy is no longer in free fall. We’ve stopped falling in an appreciable sense and we’re now trying to crawl along the bottom.”

HARDLY WORKING

The rise in unemployment in 2009 has been swift and steep. The unemployment rate in the United States reached 9.4% in May, up from 5.5% in May 2008. The FOMC estimated, in its April meeting minutes, that unemployment in the fourth quarter could rise as high as 9.6%. Most economists agree, as unemployment tends to be the last indicator to reverse in any recovery (see “First fired last hired”).

The jobs picture “looks awful,” Gambera says. “Employment will keep lagging. After the last recession, jobs took years to recover.”

Rupert says it will take a while for jobs to come back. “Right now we’re only seeing signs that the deterioration or the contraction is slowing so that’s a little different than the economy actually growing,” she says.

Leahey calls the picture for jobs “lousy” and notes the labor market continues to sag even if the economy is bottoming in terms of expectation, sales and production. “You don’t really hit bottom until the unemployment rate peaks, and that’s generally a year after the economy has peaked in the business cycle sense. Even if [the economy] bottoms at Labor Day 2009, it won’t be until Labor Day of 2010 that the unemployment rate will be close to its peak.”

Kimbarovsky says the job creation outlook for large business is fairly negative with the exception of healthcare and the small business employment outlook is even more negative because of the credit picture. “Small businesses don’t have access to credit, so they don’t have a lot of choices. They either have to lay off or close,” he says.

The automotive sector driving itself into a ditch in 2009 could have consequences for the larger employment outlook. On June 1, General Motors filed for bankruptcy protection. “The auto sector has been hit hard by the bankruptcies of several of the major automakers and the financing arms of those automakers are also having a pretty difficult time. You’ve got several disincentives for both the auto and housing markets. It’s difficult to purchase a car from Chrysler or GM if you’re not sure they’ll stand behind their warranties,” Rupert says.

GIMME SHELTER

Despite signs of so-called “green shoots,” the housing sector is still struggling. Leahey notes the sector’s been badly battered for three years and single family housing starts, probably the best barometer for the health of the marketplace, have been flat since December. “Production appears to have hit rock bottom and inventory sales ratios in the new home market appear to have peaked in terms of the month’s supply of available homes. The bad news is, few people think there will be a meaningful upswing in the housing sector. It’s very anemic,” he says.

Gambera says the stimulus plans for housing are too limited. “If the stimulus plan for first-time homebuyers was $50,000, it would make a dent. It’s $7,000. It doesn’t make a lot of sense to me. We have a substantial inventory of unsold homes and rents are decreasing, reducing the incentive to buy a home. While there is a bit of movement on the housing market, there’s such an amount of unsold homes that it will take quite a while to sort out,” he says (see “Backlog,” above).

Crude oil prices have doubled since mid-February to $70 per barrel the first week of June, which some experts say is a positive sign for the U.S. economy. “[It is] a measure of an improvement in the U.S. and global economy. Rising commodity prices [are] another sign that things aren’t so bad,” Leahey says.

There are, of course, other not so positive interpretations of the move. For instance, rising commodity prices are a reaction to a weakening dollar and there are expectations of a huge uptick in inflation due to the government’s multiple economic stimuli.

RALLY CAPS

Analysts are split on whether the stock market has bottomed or is simply in a bear market rally. “Because investors have access to the capital markets with much greater ease now, there’s a lot of money that can flow into the markets, which is why retail trading is up but institutional trading is down,” Kimbarovsky says.

Rupert says that equity markets got oversold. “This is more of a bear market rally, but there are seeds that it could turn into a full-fledged bull market by next year,” she says.

The FOMC minutes of April 28-29 predicted that the economic downturn would slow in the second quarter of 2009. “The forecast made by the Federal Reserve is in line with consensus. Positive growth rates in the economy at some point in the third or fourth quarter and an anemic recovery of 2% or better next year does seem to be the consensus view,” Leahey says.

Kimbarovsky is more skeptical of the FOMC’s predictions. “It depends on how you define recovery. In a practical sense, [job] loss after loss after loss does not lead to a recovery. Actual jobs lead to a recovery, actual home sales outside of foreclosure lead to a clearing of the market,” he says, adding that this recession is different. “We’ve never had this type of consumer credit reduction post-World War II. Unemployment is going to be more coincident with GDP growth rather than a lagging indicator,” he says.

Gambera says that unless interest rates come down for corporations, there won’t be an end to the recession. “Consumers are prudent because they’re afraid they’ll lose their jobs. The housing market has an excess in supply so new construction is unlikely to happen. Corporations have difficulty borrowing money because interest rates are high. As long as corporations cannot borrow money to build new factories or create new jobs, I don’t see what can bring the economy back,” he says.

Rupert, on the other hand, expects the economy to grow over the second half of 2009. “We’re optimistic that the economy has signs of life. The huge inventory drawdown that we’ve seen is going to force industries to gear up again,” she says.

Leahey sees a base for recovery. “You’ve got extraordinary liquidity, a big stimulus from Washington, low interest rates, some improvement in the overseas economy and from that you can grow a little bit so it’s not the end of the U.S. economy,” he says.

Kimbarovsky says the government’s interventionist role could prolong the downturn as inefficient companies will not be purged from the economy as in prior recessions. “The recovery is more of a malaise than a true recovery,” he says.

It looks like regardless of your outlook on the economy, long-term interest rates will be heading higher. Hopefully it will be due to a steady and growing economy, but it could be to combat a burgeoning inflation outlook caused by steps taken to bring the economy out of its current crisis.

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