Don’t Fade Lower for Longer In Long End
September 11th, 2016 10:06 amVia David Ader in Barron’s:
Economic Beat
Why Long Rates Will Stay Subdued
The Fed’s insistence on higher rates despite weak growth suggests it wants to curb enthusiasm for risk.
Reduced government spending due to partisan political battles, and weakness in trade owing to weak global growth and a firm dollar, are understandable. It’s the “I,” for investment, that should raise eyebrows.
Amid this recovery—especially in light of the strong gains in public stock prices—investment has been lousy in both absolute and, more dramatically, historical terms. Simply put, U.S. businesses are not investing for growth, which has repercussions for productivity gains over the long run and for wage increases that come with improved productivity and, ultimately, corporate profits.
Real net private domestic investment—the total of fixed investment in nonresidential structures, equipment, and intellectual capital, as well as residential investment after accounting for the consumption of fixed capital—came to $748 billion last year (the most up-to-date figure available). That’s well under the peak of the last recovery’s $916 billion and still shy of the prior cycle’s peak of $797 billion. While the figure has risen sharply since the trough of the recession, the seeming uptrend may overstate the improvement, according to Philippa Dunne and Doug Henwood of the Liscio Report. At first glance, net nonresidential private investment of $444.9 billion is reasonably near—at 96.2%—its 2007 peak. And net private domestic investment of $748.4 billion comes to 81.7% of its prior peak, hit in 2006. However, GDP has risen by 12% in real terms, or $1.7 trillion, since 2007. Thus, investment as a percentage of GDP has deteriorated. The picture for government and private residential investment is similarly soft.
Liscio’s Dunne and Henwood point out that net investment in equipment has been only marginally better than gross investment, suggesting that current investments are doing little more than replacing worn-out capital stock.
Surely, something is amiss. After all, the point of the Federal Reserve’s monetary accommodation is to encourage borrowing to support investment and lift productivity and output. The recent weakness would argue for continued monetary ease and no interest-rate hike at the Fed’s Sept. 21 meeting. And yet, clearly, investment is not benefiting, largely because corporate borrowing has been used to support companies’ equity valuations via share buybacks and dividends, something we noted a few weeks ago in this column.
SO WHY IS THE FED so intent on reminding the markets that higher rates are coming? Is there more reason to keep the markets on their toes beyond the central bank’s optimism that eventually the low rate of unemployment will provoke wage gains and that their inflation target will be breached?
We have a theory. Given the warnings about stock buybacks, the lack of investment, and deteriorating productivity, we suspect that the Fed wants to temper risk enthusiasm.
Go back to a speech by Fed Vice Chairman Stanley Fischer to the American Economic Association in January: When “policy makers say the economy is overheating, they may well be considering the behavior of asset prices as a critical part of that phenomenon and part of the reason to tighten monetary policy. Thus, I believe that the real issue of whether adjustments in interest rates should be used to deal with problems of potential financial instability is macroeconomic, and that if asset prices across the economy—that is, taking all financial markets into account—are thought to be excessively high, raising the interest rate may be the appropriate step.”
In the same speech, Fischer noted that slowing productivity growth was and has been “a prominent and deeply concerning feature of the past four years,” citing it as a factor constraining or reducing the real level of the short-term rates consistent with full utilization of resources. In other words, the Fed knows that the weak state of investment and its detrimental effect on productivity growth—negative growth for the past few quarters—can conspire to keep downward pressure on rates.
With the Fed seemingly keen to tighten a bit and growth constrained by the lack of investment, there’s more reason to believe that the spread between short- and long-term rates will narrow for a protracted period. Long rates will remain subdued. The divergence between equity-market gains and weakening investment encourages that view.