Reader Question: “I keep hearing the media talking about “quantitative easing,” the “printing of money” and our government’s debt. What does it all mean?”
Our federal government spends a trillion dollars more than it collects in taxes each year. The cash shortfall is met with borrowing. Our country’s cumulative debt is more than sixteen trillion dollars and is expected to rise by at least another five trillion over the next ten years.
An 800-Pound Gorilla
The Federal Reserve (the Fed) was created by Congress as a quasi-independent arm of the government. The Fed is authorized to raise or lower interest rates and to increase or decrease the overall money supply in order to encourage job creation, keep inflation in check and maintain overall financial stability. One particular technique, called “Quantitative Easing” or “QE” for short, is currently being used by the Fed to stimulate the economy and to keep interest rates ultra-low. With a few keystrokes, the Fed creates eighty billion dollars each month and then buys newly issued federal government debt with it.
By increasing the overall money supply and forcing interest rates lower, the Fed has made stock market investments more attractive, reduced mortgage interest rates and encouraged investors to take on more risk. The Fed has said it will taper off its QE and bond-buying once the economy is healthier and the national jobless rate has fallen to 6.5%. When the Fed does stop buying, each month there will be less demand for treasury notes and bonds (to the tune of eight billion dollars!). The yields on government debt will have to rise (which means the price of such debt will have to fall) to encourage regular investors to buy what the Fed had been purchasing.
Here’s a suitable analogy for what’s happening now and what’s to come: Let’s say you are selling bananas on the street corner and an 800-pound gorilla starts showing up every day to buy your bananas. The gorilla will pay whatever price you ask. This goes on for a couple of years and then, suddenly one day, the gorilla stops coming. This is a real problem because you’ve purchased a boat full of bananas to satisfy the gorilla’s seemingly endless appetite. Now, what will you do to get rid of all the extra bananas? Since there was only one gorilla in town, how do you now get enough “monkeys” to buy your inventory? The solution is obvious . . . you’ll have to lower your price!
Bonds are Like Bananas
When the Fed (i.e., the gorilla) stops buying the debt, our government will be forced to drop the price of its bonds (i.e., the bananas) and start paying higher interest rates on new debt to attract enough regular investors (i.e., the monkeys). Investors will surely demand more than the current 2% yield on ten-year treasuries, but it won’t end there. Existing treasury notes and bonds, as well as corporate bonds, municipal bonds and high-yield bonds, should all fall in value. They will get “re-priced” by the market to bring their yield in line with the new, higher interest debt being issued by the federal government. Bond prices, in general, are tied to the price of treasuries, so a 2% jump in treasury yields could translate into a 20% drop in the price of a bond that matures in ten years.
A National Hangover
Not long ago, ten-year treasury notes were generating about a 4% annual return to investors and junk bonds delivered 8% or more. When the Fed stops buying government debt, it would certainly be logical for rates to go back to those levels. While many investors will cheer the opportunity to earn more on their money, rising Treasury yields could also have adverse economic consequences:
1. Home mortgage rates usually move with 10-year Treasury notes. Higher rates could translate into lower home values and fewer buyers. As we have seen in the past, a stagnant or slowing housing market is bad for everyone.
2. When investors can earn a solid 4% on super-safe 10-year treasuries, businesses have to pay considerably more interest to entice investors to underwrite their growth plans. The result could be less expansion, less profits and fewer jobs. The overall economy could suffer.
3. With a higher yield available on treasuries, investors might demand a higher return on their stocks . . . and that could cause stock prices to fall.
Logic, of course, would suggest that the Fed is well aware of these potential ramifications. The same logic would also predict that the Fed would only stop its QE and bond-buying if it thinks that the economy is strong enough to stand on its own and to withstand the impact of rising interest rates. However, individual investors would be wise to monitor the situation closely, and re-evaluate their portfolios carefully, when they see that bananas are starting to go on sale!
David D. Holland, a CERTIFIED FINANCIAL PLANNER™ practitioner, hosts a weekday radio show at 9AM on AM1380 Ormond Beach, AM1230 New Smyrna Beach and AM1490 Deland. He has also authored two books in his Confessions of a Financial Planner series. Holland offers investment advice through Holland Advisory Services, Inc., a registered investment adviser in Ormond Beach. He can be contacted at (386) 671-7526. Email your financial questions to info@DavidHolland.com.