The U.S. Economy
Accelerates
The Buck’s at an
11-Year High
The U.S. Baby Bust
TARP Ends With a
Profit
Less Liquidity =
Bond Market Turbulence
The U.S. Economy Accelerates
The Great Recession ended in June 2009. The 5.5 years of
economic recovery and expansion since has been slow and uneven until 2014. The
year started off with negative economic growth of 1.9 percent in the first
quarter but GDP growth accelerated to 4.6 percent annualized growth in the
second quarter and 5 percent in the third quarter of 2014. These are the best
two quarters of GDP growth since 2003 and the 5 percent third-quarter growth
was the first since the recession ended.
The third-quarter growth was driven by personal consumption expenditures,
especially for services, government expenditures and manufacturing output.
Recent consumer confidence surveys are at the highest
levels since the recession ended. This increased confidence can be attributed
to the 2.7 million jobs growth in the first 11 months of 2014, plunging energy
prices, low inflation and interest rates, household finances in better shape
and a stronger financial system. The consensus forecast of 2015 GDP growth is 3
percent, which is the average U.S. growth rate since 1965. After subpar 2.3
growth since 2009, the average looks pretty good.
But there are headwinds, especially from abroad as the
U.S. stands alone among the developed countries of the world in economic
growth; Europe is barely growing; Russia is headed for a recession, and Japan
is already in one. China’s growth is down to 7.0-7.5 percent in 2014 and lower
growth is expected in 2015 as it tries to transition from an investment to a
consumption-driven economy. Any global economy that is dependent upon energy
production or commodities will have difficulty achieving positive economic
growth in 2015. A stronger dollar could also slow U.S. economic growth in 2015.
The Buck’s at an 11-Year High
2014 has been the year of the U.S. dollar. It has
strengthened (appreciated) 13 percent against a basket of global currencies to its
highest level since 2003; 12 percent against the Euro and Japanese yen, and 9.4
percent against the Canadian dollar, and 14.7 percent again the Mexican peso.
About the only countries not to have their currencies depreciate against the
dollar were those that peg their currency to the dollar; that would include
China, Singapore, Saudi Arabia and a few others.
Why the strength in the U.S. dollar? The U.S. economy is
accelerating relative to a stagnant Europe and slowing Asia. Plus the U.S. appears
to be about the only developed country ready to raise short-term interest rates
in 2015. A combination of better economic growth and higher interest rates
makes the U.S. a more attractive place to invest. So capital flows from abroad
have been somewhat responsible for the surging dollar, helping to lower U.S.
long-term interest rates and inflation.
The risk of a strengthened dollar to the U.S. is that
exports will be less competitive in global trade and may affect economic
growth. But the risks are much greater for those countries that are exporters
of oil and other commodities, as reflected in the dramatic fall in the value of
the Russian ruble and Venezuelan bolivar. The risks to any foreign country or
company that have borrowed in U.S. dollars will be particularly severe as it
will take more local currency to pay back a dollar of interest or principal. Another
concern is that the currency realignments may lead to competitive devaluations,
which used to be called currency wars. Japan has already used this to kick
start their economy and inflation. Others may follow.
The U.S. Baby Bust
The Great Recession and financial crisis of 2008-2009 has
impacted the fertility rate in the U.S., resulting in one of the lowest on
record. In 2007, the U.S. had 69.3 babies born per 1000 women of child-bearing
age; in 2013 that had fallen to 62.5 babies per 1000 women. The fertility rate
has fallen to 1.86 in 2013; a rate of 2.1 is needed to stability the population.
If 2007 fertility rates had prevailed, there would have been 2.3 million more
births than actually occurred from 2007 to 2013.
There has been a long-term structural decline in the U.S.
fertility rate from 3.7 in the 1950s to 1.8 in the late 1970s. This decline can
be attributed to later marriages, increased college attendance and labor-force
participation by women, advances in birth control, the higher costs of raising
a family and the higher divorce rate. There was then a gradual increase in the
fertility rate from the 1970s low to 2.1 in 2007.
The decline in the fertility rate since 2007 is a result
of the Great Recession. More than half the decline in births since 1970 can be
explained by a one-third decline in the birth rate of Hispanic women. In 2007,
Hispanic females accounted for 17 percent of the women in the 15 to 44 age
group but had 25 percent of the babies. Their birth rate of 2.4 today is
slightly above the replacement rate. The other half of the decline in births is
due to white and black women having a slightly lower fertility rate, again a
result of the recession.
The birth rate has declined in past recessions, but not
to the extent of the last six years. If the birth rate permanently stays below
the replacement rate of 2.1, it means less population growth, slower economic
growth, and less consumer spending. It also means the U.S. is following the
Eurozone countries, Russia, China and Japan in demographic trends. The economic
consequences will be noticeable and long lasting.
TARP Ends With a Profit
Remember TARP, the Troubled Asset Relief Program, which
was passed by Congress in October 2008 in the depths of the financial crisis?
It was just after the Lehman Brothers bankruptcy and the financial system was
on the verge of collapse. It was and still is a controversial bailout package
that never won public support. In fact, the first TARP bill was rejected by
Congress but a second version passed a week later. The U.S. government approved
$800 billion of bailout funds including about $426 billion of TARP funds.
TARP bailed out banks, including Citigroup and Bank of
America, American International Group, General Motors, Chrysler and hundreds of
other firms with debt and equity support. The government also took over two
major mortgage firms, Fannie Mae and Freddie Mac, which purchase mortgages from
originators. In total, the government funded almost $700 billion of bailouts
including the $426 billion of TARP funds. The takeover of Fannie Mae and
Freddie Mac required $187 billion of government funding but was not part of
TARP.
In December 2014, The U.S. government closed the books on
TARP when it sold its remaining shares of Ally financial, the former General
Motors Acceptance Corp. After six years, TARP was closed with a profit of $15.3
billion, a return of 3.6 percent. Probably not a sufficient return given the
risk involved, but most had not expected any profit at the time. The U.S.
government made money on the bank bailouts and AIG. It lost money on the auto
bailouts and the takeover of the two mortgage companies. About 35 small
community banks remain in the program, down from 700 financial institutions at
the height of the program. For all intents and purposes, the TARP books are
closed with a profit. The government still owns Fannie Mae and Freddie Mac,
both of which are profitable and will soon repay their $187 billion of bailout
funds in full.
The major criticism of TARP and other bailout funds is
that it put Wall Street ahead of Main Street by not helping troubled homeowners
who have received about $15 billion of assistance out of $75 billion promised.
But TARP and the whole bailout program has to be considered a success in terms
of stabilizing the financial system and the economy. The complete collapse of
several large banks, General Motors, Chrysler, AIG and others would have been
catastrophic and ended up costing taxpayers hundreds of billions of dollars
more than the cost of TARP and other bailout funds. Think trillions.
Less Liquidity = Bond Market Turbulence
October 15, 2014 will be a date long remembered in
financial markets similar to the May 10, 2010 flash crash when the Dow Jones
Industrial Average lost 1000 points in a few minutes and October 19, 1987, when
stock markets of the world declined 20 percent or more in a single day. Maybe
not a day of infamy, but an important day.
On the morning of October 15, 2014, the benchmark U.S.
10-year Treasury bond had been trading at a 2.2 percent yield to maturity. As
U.S. trading opened, the yield started to drop and within minutes it tumbled to
1.86 percent, a drop of one-third of a percentage point. This drop in yield was
of historical proportions and was considered a 7 standard deviation event; to
put that in perspective, this is something that should happen every million
years or so, given the historical volatility of U.S. 10-year Treasury bond
yields. By the end of the day, nearly $1 trillion of Treasury bonds had traded
and billions more in the derivative markets and the yield on the U.S. 10-year
Treasury bond had recovered to 2.14 percent. Bond yields are inversely related
to bond prices, so U.S. Treasury bond prices rose initially and then settled
back as yields rose. What had prompted the rush into treasuries was
disappointing economic news and a flight to safety because of geopolitical
events.
The Treasury bond market is the deepest and most liquid
of all markets in the world as $12.5 trillion of Treasury bonds are in public
hands. What bothers investors and regulators alike is that this October
experience in the Treasury bond market may foretell the future volatility in
the U.S. corporate bond market. The U.S. corporate bond market has about $9
trillion of bonds outstanding, an increase of about 50 percent since the Fed
started to lower interest rates in 2008. In the U.S. there are about 5,000
different common stocks that are publicly traded; however, there are 47,000
different corporate bonds outstanding. So the liquidity and ease of trading a
particular bond issue is not like trading a stock; it’s riskier on average.
This risk has become accentuated by an unintended
consequence of the Dodd-Frank law passed in 2011. Under the co-called “Volcker
Rule,” banks are prohibited from proprietary trading, trading for their
account, and new capital rules make it more costly for banks to hold assets and
securities needed to ensure liquid markets. So banks have dramatically reduced
the amount of capital devoted to bond trading; one estimate has dealers’
inventory of corporate bonds declining 75 percent from $200 billion to $50
billion since the financial crisis. Thus liquidity in the bond markets has been
dramatically reduced.
After the financial crisis of 2007-2008, investors placed
more than $1 trillion into bond mutual funds, exchange traded funds and other
institutional money managers. The money was invested in bonds because of low
Fed-induced short-term interest rates and stock market losses in 2008-2009. It
was deemed a safer investment and investors were chasing yields. Given the
combination of a much larger corporate bond market and less liquidity available
for trading corporate bonds, many worry about what happens when interest rates
start to rise and bond investors head for the exit. The big question is whether
the exit door is wide enough to let everyone out without causing major
disruptions in the market.
*Buck is Market Strategist at Wallington Asset Management.
