The summer of 2008 was crazy. The credit markets were frozen and the federal government put Fannie Mae and Freddie Mac into conservatorship. And there was a presidential election coming fast.
That August, the Democrats made history by nominating the first black person as a major party candidate. It happened on a Thursday night, and was set to be the talk of the town on Friday.
That is, until Republican candidate John McCain took to the airwaves early on Friday morning to both congratulate candidate Barack Obama. And to announce that he’d chosen Sarah Palin as his running mate. The Palin news took some of the air out of Obama’s, just as intended, and was a brilliant move.
But it didn’t last. John McCain stole the moment, but not the momentum from the race.
I was thinking about that dynamic last Friday as I watched Fed Chair Jay Powell speak in Jackson Hole. Then read President Trump’s tweets lambasting Powell, and finally saw the President’s plan to increase tariffs on Chinese goods.
Trump moved from the Fed and interest rates to the trade war with China, pulling the spotlight back to himself, where it stayed on Monday after Trump’s comments about phone calls from the Middle Kingdom asking to negotiate. The markets and the press reacted as expected.
The trade war is important, but it’s a manufactured environment. Just as quickly as the tariffs were slapped on imports, they can be removed, and most likely will be when President Trump finds it politically expedient to do so.
But interest rates… there’s a conundrum that won’t be solved with a tweet.
The Name of the Game
There was a time when the Federal Reserve looked at the U.S. economy and tried to determine where to set short-term interest rates. The goal was to keep things from heating up too quickly, causing inflation, or cooling off too much, causing a recession and potential deflation.
But the days of navel gazing are long over. The calculus now includes the monetary policy of other central banks, most notably the ECB.
In the Continental economic bloc, German GDP went negative in the second quarter, the Italians are running a budget deficit in excess of the regulated limits, the Greeks are about to cut taxes and increase pension payments, and the Brits just want out. To say that things aren’t going well is a bit of an understatement.
In response, ECB President and short-timer Mario Draghi has his eye on another round of euro printing and bond buying, and possibly an interest rate dip from negative 0.40% to something even more abstract.
The situation drove rates across Europe so low that the German government was able to sell 30-year bonds last week at negative interest rates. Granted, they wanted to sell about $2 billion of the bonds and were able to place only $850 million, but that’s still a lot of money “invested” at a rate that guarantees a loss.
Compared to slightly negative rates, 30-year U.S. Treasury bonds at 2% look like high yield. On the same note, compared with negative -0.40% overnight rates, the U.S. Fed Fund rate of 2.00% to 2.25% also looks pretty attractive.
Fed’s Losing Out
And that’s the problem.
Our high rates attract global capital, which must buy U.S. dollars to invest in U.S. Treasury bonds, which drives up the value of the dollar compared with other currencies. To keep that situation from getting out of hand, the Fed can’t let U.S. rates remain too far above European rates.
Jay Powell isn’t fighting weakness at home; he’s fighting weakness across Europe. He won’t win, because he’s not playing the same game as the ECB.
While the Fed and Americans are concerned about economic growth and market stability among interest rates and equities, the ECB and Europeans are worried about economic growth and government survival. They’d like to see German GDP pop back above zero, but they also need to see Italy and Greece survive, which means keeping borrowing costs as low as possible. If the investment world is turned upside down for a decade or so in the meantime, well, that’s a small price to pay for national, and international, stability.
Luckily for the Fed, the U.S. growth remains lackluster, and official inflation readings are at or below the Fed’s targets. So far, the Fed doesn’t have to worry about low interest rates overheating the economy.
All of which leaves investors with a problem. Collectively, we’re giving up our interest income to support the countries and companies of Europe, whether we want to or not.