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There is plenty of speculation about the coming increase in interest rates. The economy is improving, the Fed will stop buying bonds and this will cause interest rates to increase. In reaction, bond investors are abandoning bond funds. As evidence, PIMCO recently reported a 7.5 billion dollar outflow in its bond funds.

But, what if the hypothesis is wrong? What if the Fed can't taper without tanking the economy. What if interest rates don't go up, or don't go up much, or instead go down?

There is strong evidence in the economic data that a significant interest rate rise will be very difficult, even with the Fed's help.

Inflation Drives Interest

Interest rates are a function of inflation. Bond interest rates are a combination of the natural interest rate plus an adjustment for expected inflation. Fixed income buyers want an inflation cushion in their investments. If investors foresee higher inflation rates, they lower their demand for bonds that pay less then the predicted rate of inflation and this lowers the price of bonds. Bond buyers want to beat inflation not just keep up with it, otherwise they don't make any money.

The graph below shows the relationship between interest rates and inflation.

(click to enlarge)

Inflation Sources

In simple terms, inflation is caused by excess demand for the current supply of goods and labor. If there is more demand for goods and services than the available supply of goods and services then prices will inflate.

Everything else equal, the overall demand for goods and services comes from the money supply. No money, no demand. A lot of money, a lot of demand. Money drives demand and economic capacity supplies it. That's why it's commonly believed that an increase in money alone will cause inflation. In reality, it is more complicated.

The money pushing demand comes from wages, profits and savings. But, where does the money for the wages and profits come from? Money is not a natural resource, it doesn't come from the ground, and as our parents reminded us it doesn't grow on trees. Money must be created.

Without getting too deep, the money for wages and profits and everything else ultimately comes from untaxed government spending (deficit spending) and bank loans.

Money Sources

When the government spends, it circulates money into the economy. When it taxes, it removes money from circulation. The difference between what it spends and what it taxes, the deficit, remains circulating inside the economy. The accumulated deficit money is located in the bank and brokerage accounts, the sock drawers, and pockets of citizens and business.

In a nutshell the dynamic works like this, the government buys a submarine for 25 billion, the check is deposited into General Dynamic's bank account, out of its account it pays for materials and wages and keeps what's left as profit. The paid wages and material payments are deposited, at least temporarily, into bank accounts, creating 25 billion dollars more in accumulated bank reserves.

To earn interest, the banks use the reserves to buy Treasury bills. After this the government account balances. The government has a 25 billion dollar asset - a new submarine, and 25 billion in liabilities - Treasury bonds. The economy has 25 billion more in wealth - a submarine. For investment decisions the mechanics are this: more deficits = more money = more wages = more demand for goods and services.

If the consumer lacks the wages, or the business lacks the profits, they could also borrow the money from a bank. This process works similar to the above example. When banks loan, they deficit spend money they don't have. The money goes through the spending chain and is deposited, at least overnight, into checking accounts. This increases bank reserves. The new bank reserves are then used to meet the bank's reserve requirement. This balances the accounts. The bank has a new asset - your loan and a new liability- the increased deposits. The economy has more money. The simple equation is: more loans = more money = more demand for goods and services.

So there are two primary sources of money to fuel demand for goods and services - bank loans, which represent about 85% of our money supply and government deficit spending, which represents about 15% of the total.

A Quick Review

The chain of events driving interest rates goes like this:

  • Interest rates are driven in part by inflation.
  • Inflation is driven by demand.
  • Demand is driven by money.
  • Money is driven by government deficit spending and bank loans.

To generate inflation we need an increase in money (demand) and/or a shortage of productive capacity (supply). After World War One we had inflation from an increase in money. In the 1970s and 80s we faced a shortage of capacity from a shortage of oil. Both caused high inflation (and high interest rates).

In simple terms, if money grows slower than economic capacity we get deflationary pressures. If it grows faster than economic growth we get inflationary pressures. There are other factors outside the scope of this article like savings and imports.

A Shortage of Money

Today, the economy faces several headwinds on the demand side - 1) decreasing government spending, 2) slow credit creation, and 3) flat money growth. On the supply-side: 4) high unemployment and 5) excess capacity. Taken together there is little inflationary pressure in the economy.

Government spending. In spite of claims otherwise, government spending has been flat - shown in the chart below. This means relatively less new money. With the sequester, the government is spending even less. Less deficit spending = less money = less demand.

(click to enlarge)

Credit creation. Currently, banks are loaning a little more than they had been, but still not very much. As shown in the below chart lending is pretty flat. Less bank lending = less money = less demand.

(click to enlarge)

Money supply. All of this together means very little money. As shown below, the broad M4 money supply growth is lagging economic growth. Less money = less demand.

(Source: Cato Institute)

Slow growth. It's no secret the economy is lagging. The mechanics are simple. Less money = less demand = less GDP. GDP is the sum of demand.

(click to enlarge)

It is not a coincidence that all of the above charts look similar.

An Excess of Capacity

The other side of the inflation equation is the supply of goods and services. In the short run, even if money growth is flat, when the capacity to provide goods and services is constrained, prices are driven up and we get inflation. On the other hand, when the economy has ample capacity, additional money creates economic growth.

The capacity to supply of goods and services can be constrained by 1) a shortage of raw materials, 2) a lack of capacity to convert the materials, and 3) a shortage of labor. The current situation is as follows.

Labor supply. Presently, we have a high unemployment rate and a lower-than-average percentage of the population working. We have a surplus of labor and lots of workers to provide additional goods and services if they are demanded. As shown in the below chart, the civilian labor participation has decreased 7.5% from 65% in 2000 to 58.5% now. That's about 12 million workers that were working in 2000 but aren't working now. Less money = less demand = less workers.

(click to enlarge)

Capacity utilization. Capacity utilization has been declining for over a decade going from 85% in 2000 to 77.5% currently. The economy has plenty of slack capacity to provide additional goods and services if they are demanded. Less money = less demand = less capacity utilization.

(click to enlarge)

Commodity prices. The price of raw materials is currently flat. Commodities prices are driven by world supply and demand. Currently, there are no price constraints on the raw materials needed to meet additional demand.

(click to enlarge)

GDP Below Potential

The combination of less money, unemployed workers, and low capacity utilization creates a GDP gap between our economic potential at full employment and our actual GDP. The chart below shows a gap of about 5% (16,000/17,000). A negative gap is dis-inflationary and a positive gap is inflationary.

The Mechanics of the Process

  • Flat government deficit spending + flat low bank loan issuance = flat money
  • Flat money = flat demand
  • Flat demand + unused capacity + a surplus of labor + flat commodity prices = low inflation rates
  • Low inflation rates = low interest rates.

As long as we have slow money growth combined with excess workers, excess capacity and flat commodity prices, we will have low inflation. As long as we have low inflation we will have low interest rates. The Fed's actions may influence the level up or down to a degree, but they will not overcome the natural rate.

The Fed is unlikely to curtail bond buying significantly as long as we have a negative GDP gap. Capacity utilization and labor utilization is low because there isn't enough demand. Demand is low because there isn't enough money circulating.

It is also unlikely that the current Congress will address this issue with additional deficit spending. Banks may slowly become more accommodating to new loans but not at a sufficient rate. This all points to continued Fed presence in the bond market.

Inflation and the money supply will be a problem only when we reach labor and industrial capacity, not before. This will be a low inflation, low interest rate environment.

Portfolio Strategy

Stocks. This circumstance creates a very difficult investing environment. Equities (SPY, DOW, VTMI) do well when inflation is low and companies can generate profits and dividends even when the economy is well below economic capacity. Stocks are also susceptible to a decrease in quantitative easing. Stocks are currently risky and overvalued, but that doesn't always stop them from going up even for long periods of time. The easy money has probably already been made. Be cautious and don't stand too far from the door. Dividend stocks can be a smart play, but everyone is in that trade making them very expensive.

Bonds. Bonds are expensive and at some risk from a change in Fed policy. There may be money in the bond market, but there is no easy money. As explained, interest rates may move up from Fed actions, but a large move upward is unlikely. They could also surprise investors by decreasing.

Because of their increased volatility, non-speculative investors should avoid bond funds, and indexed ETFs that never mature (NYSEARCA:LQD)(NYSEARCA:BND)(NYSEARCA:BOND)(NYSEARCA:TLT). They should concentrate on buying straight bonds with defined maturities. The new dated maturity ETFs (NYSEARCA:IBDD) (NYSEARCA:BSCG) may also provide an inferior but workable solution for individual investors uncomfortable buying bonds. For more sophisticated investors premium bonds are a way to hedge against rising rates.

For investors that understand them, mortgage bonds are another option. Mortgage bonds represent about half of the Fed purchasing. They reacted much less to the recent Fed announcements and it is unlikely the Fed can allow mortgage rates to creep too much higher without slowing the recovery. To avoid upsetting a fragile housing recovery it may taper Treasury purchases before mortgage bond purchases. Purchase these in UITs or directly. Avoid the ETFs (NYSEARCA:MBB) that have no defined maturity.

Inflation Protected Bonds. TIPS (NYSEARCA:TIP) may provide short-term speculative opportunities due to market overreaction. But, unless the above outlined economic environment changes they will struggle as long-term investments.

Preferred stocks. Preferred stocks can benefit in slow-growth environments and can have many of the characteristics of cushion bonds. There are limited opportunities for sophisticated investors but many high-dividend issues are being called.

Commodities. These are more influenced by international demand. But, with the U.S. economy slow, China slowing and Europe struggling it is difficult to conceive of a large increase in the demand for commodities. No matter what, commodities don't generate profits, or pay interest or dividends, so they are always a speculative investment, that should be avoided by non-speculative investors.

With both stocks and bonds relatively expensive it will be difficult for investors that simply use indexes or mutual funds. Unsophisticated buy and hold investors will struggle in overvalued markets. The best opportunities are in hand-picking common and preferred stocks with potential that are not overpriced and do well when the economy muddles along. Investors can also find opportunities in preferred stocks, and cushioned municipal, corporate, and agency bonds.

Disclaimer: This article is for informational and educational purposes only. The views expressed in this article are the opinions of the author and should not be interpreted as individualized investment advice. Investment objectives, risk tolerances and the financial situation of individual investors may vary. Please consult your financial and tax advisors before investing.

Source: Low Interest Rates Ahead