The Fed Will Not Raise Rate s Why

Post on: 16 Март, 2015 No Comment

The Fed Will Not Raise Rate s Why

Summary

  • This jobs report changes nothing for the Fed. The market is completely overreacting for both equities and especially for Treasuries.
  • The U-6 is still above 11%. and inflation continues to remain subdued, with deflation continuing to be a serious concern for the developed world.
  • As long as this condition continues to exist, the Fed is not going to do anything on interest rates.

Source: The Wall Street Journal

Last Friday, we learned that the U.S. added 295,000 jobs in February versus an estimate of 240,000. In response, the equity market fell precipitously, dragging Treasury bonds down with it. The 25+ year Zero Coupon Treasury Index (NYSEARCA:ZROZ ) fell more than 3.4% in a day. Both stocks and bonds fell because of the market’s overzealous belief that the Fed will raise rates imminently. The fact of the matter remains that the market is getting a little too excited in anticipating the Fed will raise interest rates. Given my belief, I bought more 30+ year Zero Coupon U.S. Treasury bonds and swaps as I expect the Fed to remain on hold for longer than most expect. The current spread between the 10-Year U.S. Treasury and the 10-Year German Bund is the widest in 25 years, making the U.S. Treasury market a great buy at current levels.

Reasons the Fed Will Likely Not Raise Rates This Year

  • The U.S. needs low rates to service their excessive and mounting debt levels

High debt levels, whether in the public or private sector, have historically placed a drag on growth and raised the risk of financial crises that spark deep economic recessions. — The McKinsey Institute

I have written extensively on the matters of public and private debt and how they are deleterious to economic growth, so I won’t belabor the point here. The fact remains that with the U.S. debt-to-GDP levels being over 100%, the U.S. will not be able to afford the debt payments, should interest rates return to a normal range.

  • The Ghost of the 1930s Haunts Central Bankers

The current chair of the Federal Reserve, Dr. Janet Yellen is well aware of the failures of monetary policy across history, and the failure of the 1930s is present in the minds of central bankers. The 1937-38 mistake of raising rates too quickly led to a recession. The last thing the Fed wants to do is to raise rates, choke off growth, and send the economy into a recession. With this in mind, the Fed will likely keep rates lower for much longer than anyone believes.

From May 1937 through June 1938, the U.S. economy experienced a contraction just as it was beginning to recover from the 1929 Depression. The 1937 contraction was severe; in fact, it was the third worst recession of the twentieth century. Real GDP fell 10%. Unemployment grew to 20%, and industrial production fell 32%. The cause of this recession was the failure of monetary policy to take away the medicine before the patient was ready. Former Fed Chairman Dr. Ben Bernanke articulately laid out the fact that monetary policy had contributed greatly to the Depression Era, drawing heavily on the work of Dr. Milton Friedman and Dr. Anna Jacobson Schwartz.

the Federal Reserve’s misguided tightening of policy in 1937-38contributed to a new recession in those yearsfor a variety of reasons, monetary policy was unnecessarily tight, both before the Depression began and during its most dramatic downward phasecontractionary monetary policies can lead to declining prices and output. Friedman and Schwartz concluded therefore that they had found the smoking gun, evidence that much of the severity of the Great Depression could be attributed to monetary forces.

Many are making the claim that the U.S. is very close to full employment with a 5.5% unemployment rate. Yet the reality remains that the unemployment rate is distorted by the vast decline in the labor participation rate. The participation rate currently sits at 62.7%, the lowest level since the late 1970s. The U-6 unemployment rate continues to be elevated sitting at 11%, showing the real unemployment rate. If we get the participation rate ticking higher, we would see unemployment rising, thus illustrating that the current unemployment rate is being distorted.

Furthermore, the jobs being created in the current economy are not high paying jobs. In the most recent unemployment report, we saw that 22.4% of the jobs created were in leisure and hospitality, and 87.8% of these jobs were in bars and restaurants, not high wage jobs. After looking deeper into the report, maybe the 295,000 jobs created are not as good as we expected.

In the most recent labor report, we saw that wages only increased by 0.1%, but this is nothing new, as wage growth has eluded the American worker for over 20 years. Until we see real wage growth in the U.S. economy, I do not believe that Chair Yellen will raise rates.

The Fed’s mandate includes full employment within a context of price stability. While the market grows in its continuing belief of a rate rise, inflation continues to sit below trend. As you can see in the chart above, both the CPI and the PCE are below the Fed’s target of 2% and show declining trajectory going forward. Deflationary forces continue to be a concern, and risks are growing around the world. The ECB’s QE program will likely push yields in Europe even lower, pushing more and more capital to the U.S. bond market.

  • GDP is Being Negatively Affected by Excessive Debt

GDP estimates for the first quarter of 2015 sit at 2.7%. During the entire recovery, the U.S. economy only grew at 2.3%. In 2014, the U.S. economy grew at 2.4%. I am not quite sure why many investors believe a GDP growth rate of 2.4%, coupled with low inflation and low inflationary expectations, along with growing deflation overseas, necessitates a rise in interest rates. Going forward, GDP will likely come in below 3% as I outlined in my past piece, 5 Reasons the U.S. Economy Is Not Healthy. This will be a catalyst for the U.S. Treasury market, especially at the long end of the curve as earnings and GDP underwhelm investors.

  • Strong Dollar = S&P 500 Earnings Are Under Pressure

The meteoric rise in the dollar has been great for dollar bulls like me, and not so great for American businesses that have to translate foreign earnings into U.S. dollars. We have seen the effect of a strong dollar on the earnings of many multinational firms. In the most recent earnings season, big companies like Campbell (NYSE:CPB ), and Deere (NYSE:DE ), to name a couple, cited dollar strength as having a negative impact on their results. I believe we will continue to see the negative effect of the strong dollar on earnings. I believe this will drive further capital to the U.S. Bond market, and drive yields even lower. I expect the Euro to continue to fall against the dollar, and I believe dollar strength is a key theme for 2015.

A 10 percent strengthening in the trade-weighted dollar lowers the estimated 2015 profit for the S&P 500 by about $3 a share, according to an earnings model created by Goldman Sachs Group IncEarnings growth for companies in the S&P 500 will contract 5.1 percent for the first quarter of 2015, according to analyst estimates compiled by Bloomberg. As recently as Jan. 23, the forecast for profit growth was positive.

Conclusion

It is clear from the data that the world is engaged in a long-term deflationary cycle. The extensive actions of central bankers have been instrumental in combating this deflationary cycle, and I do not believe that the Fed is going to raise interest rates, when the BOJ and ECB continue to move in the opposite direction given the deflationary forces that exist. These same forces are a threat to the economic recovery of the United States, and the Fed knows this. They are not going to repeat the mistakes of history and raise rates too soon. I expect that the Fed will need to see real wage growth and an uptick in inflationary pressure before making the decision to meaningfully raise rates.

Investors continue to dismiss the belief in a deflationary cycle despite the data proving out this thesis in real time. U.S. Treasury rates continue to move lower, as negative data causes the entire yield curve to flatten. Low velocity on M2, low inflation, high global unemployment, stagnant U.S. wages, all point to danger ahead for the earnings of multinational firms. Add in the effect of a strong U.S. dollar, another data point signaling deflation, and we have to lower the expectations of earnings growth rates. The risk-reward prospects have become imbalanced in favor of risk in the domestic equity markets, and thus I continue to remain committed to my belief in the safety and total return potential of 30+ year Zero Coupon U.S. Treasury Bonds, and I remain long the U.S. Dollar.

Disclosure: The author is long ZROZ, EDV, TMF, UUP, 30-YEAR ZERO COUPON U.S. TREASURY BONDS. (More. ) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.


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