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The direction of longer-term interest rates this past quarter has been trending lower, in spite of two increases of 0.25% to the fed funds rate. Both on May 3 and June 14, the Federal Open Market Committee of the Federal Reserve Bank stayed on course to increase the overnight lending rate back to what many have characterized as interest rate “normalization”—normalization from what was extreme emergency monetary policy that kept the rate at zero from December of 2008 until December of 2015. This latest tightening of monetary policy is the fourth increase since December 2015 and is in the range of 1.00%-1.25%. 

However, as we have noted since the beginning of the year, interest rates of longer maturities have not been rising and have actually declined. The 2-year U.S. Treasury note yield (which is most sensitive to movements in the fed funds rate), began the year at 1.19% and currently is at 1.38%. The 10-year U.S. Treasury note yield began the year at 2.45% and currently is at 2.31%. Historically, the difference between the two yields has been considered an indicator of future economic activity or growth. When the difference (spread) increases, it projects increased growth, and conversely, when the spread decreases, the markets anticipate slower growth. At the extreme, when the spread goes negative (2-year rates higher than 10-year rates), it has usually signaled the anticipation of recession.  

Currently, this spread is 93 basis points or 0.93%, almost the same as prior to the election. We’ve mentioned before that the capital markets reacted enthusiastically to the election results and the anticipation of pro-growth policies. At this point, the bond market is not as convinced about growth prospects. Shortly after the election, bond yields climbed significantly, anticipating more inflation and growth. The spread between the 2-year Treasury and the 10-year Treasury reached a high of approximately 136 basis points on December 22, and it has steadily declined since. The decline or flattening of the yield curve is most likely due to lower expectations of inflation. 

One measure of expected inflation is the breakeven rate between Treasury inflation protected securities and nominal Treasury securities. The 5-year breakeven rate peaked at 2.16% in early February and at the end of June was 1.67%. The Fed targets 2.00% as an appropriate measure of inflation that promotes stable prices. The decline in inflation expectations is likely tied to the decline in the price of oil. Much of the inflation increase we experienced in 2016 was driven by oil prices bottoming out between $25-$30 per barrel and rising to slightly above $50 by year end. In order for oil to have the same impact on inflation in 2017, the price would have to increase by another $40-$50 (it’s currently in the mid-$40s). Even with the reduction in supply by OPEC, we believe that independent drillers, especially in the U.S. and Canada, can certainly make up for any shortfall in OPEC supply. 

Even if we consider the Core Consumer Price Index (excluding food and energy prices), the trend for this measurement is lower. This index peaked in January at 2.3%, and as of the end of May, it was down to 1.7% year-over-year. Perhaps one of the reasons we have not seen a broader increase of inflation recently is due to moderate wage inflation. One component of inflation that is normally felt throughout every sector of the economy is increasing wages. For almost 60 years economists have either tried to affirm or reject the relationship between unemployment and inflation. The Phillips Curve basically theorizes that there is an inverse relationship between the rate of unemployment and the rate of inflation. As unemployment decreases, inflation should increase and vice versa. This relationship does not always materialize; consider the period of stagflation in the 1970s where both unemployment and inflation were high. In the current environment, as unemployment in the U.S. has steadily decreased since 2010, we have yet to see inflation increase substantially. What would spark wage inflation? Certainly, if our pool of labor were the only one in the world, we could see wage pressures increase as we approach full employment. Given the number of goods that we import from countries with cheaper labor, it’s reasonable to expect that wage inflation would be slowed. It may be that the kinds of jobs being created are lower paying and would not add to the wage inflation story either. 


These are not the historically higher paying manufacturing jobs that were created in past economic cycles. Furthermore, you have the fewest people working now since the 1970s. The labor participation rate is approximately 63%. The number of people working has been steadily declining since the turn of the century. In March of 2000, close to 67% of those able to work were doing so. Could it be that the health of the labor market is not so great after all? With fewer participants in the labor force and a mismatch of employee skills to available jobs, perhaps some of the higher skilled ones are being filled overseas where the cost of labor is lower? These are possible explanations to the conundrum of low unemployment and low inflation. Wage pressures could begin to appear in the future, but it is unlikely to have the same effect on the overall economy. 


It is expected that the Fed will continue to tighten this year, bringing the fed funds rate up to 1.50%1.75%. This is expected not because the economy is overheating but because the Fed realizes that it needs to have more room to effect monetary policy during the next economic downturn. Right now, if it were faced with another economic downturn, it has little room to stimulate the economy using short-term rates and would have to rely on more asset purchase programs. It may have to resort to asset purchases in any event. Europe is still easing credit and adding liquidity, as is Japan. While these economies have shown some signs of stability recently, they are nonetheless fragile. So, we continue to believe that this economic cycle is indeed different in many respects and the outcomes we have experienced in the past may take longer to materialize, if at all. 


This Trend is Not Your Friend

Alarm bells have been sounded about the financial condition of one of the country’s most populous states: Illinois. These concerns should not be taken lightly. In the aftermath of Detroit’s bankruptcy in 2014 and, most recently, the defaulted obligations of Puerto Rico, the uncertainty surrounding Illinois’ ability to honor its debt obligations is growing and could have a negative impact on other state and local government bonds. 


I’m reminded of a well-publicized and controversial forecast made by a very well respected credit analyst about the fate of the municipal bond market in late 2010. Meredith Whitney, who had correctly predicted the financial troubles of Citigroup prior to the financial crisis, made some ominous predictions about the municipal bond market and the future of some local and state governments on 60 Minutes. She was sure that we could see some 50 to 100 sizable municipal defaults that could amount to hundreds of billions of dollars in losses. Was she perhaps a bit early in her prediction? 


I am not making the same forecast but am merely questioning how long local and state governments can go without addressing the major financing issues facing their institutions. While the problems and challenges are not identical, there are common threads that aren’t limited to just these state and local governments. The primary underlying trends are: fewer working age citizens, higher than average unemployment, and growing public debt burdens. 


Illinois’ (along with 20 other states) growing fiscal imbalance comes primarily from its unfunded pension liabilities. The imbalance between pension debts and revenues is widespread. In fiscal 2015, 21 states had pension liabilities that were higher than the revenue they generated, according to an October report by Moody’s, which uses an adjusted measure of states’ net pension liabilities. It’s the last thing states like Illinois, New Jersey, Connecticut, and Kentucky need when revenue growth is already trending lower, healthcare costs are rising, and delayed infrastructure repairs need to be prioritized.1 


Unlike federal governments that can literally print money, state and local municipalities can only pay the bills by taxing or borrowing. Taxing becomes more difficult in states where citizens are already highly taxed because those individuals and businesses can choose to move to another state. The other option of deficit borrowing cannot go on in perpetuity as we have seen with Detroit and Puerto Rico. At some point it becomes too expensive to borrow because lenders require higher interest to take on the risk. So, it is time for some of these government entities to put together long-range plans to address these fiscal imbalances. Prioritizing how money is spent is essential. While cutting back is never a politically popular solution, it is necessary. We’ve all heard that “Money does not grow on trees,” and pretty soon we run out of other people’s money.2  Let’s hope that those responsible have the courage to act before that happens.




1 Bloomberg Briefs – July 10, 2017; States Billion-Dollar Pension Bills Getting Bigger: StoryChart 

 2 Quote is attributed to Margaret Thatcher during a TV interview in 1976.

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