It's going to be a wild ride. Volatility is the name of the game, and we don’t know when it is going to end. The Dow dropped more than 1,000 points two days last week: Monday 2/5 and Thursday 2/8. Concerns over the bond market and inflation are capturing most of the headlines.
Ah, Interest Rates
There is an inverse relationship between interest rates and the value of bonds. In other words, the value of the bond declines when the interest rate increases. Thanks to quantitative easing after the 2008 market decline, interest rates have remained artificially low for a number of years. Until now. The Federal Reserve is committed to slowly unwinding the 2008 stimulus program. Former Federal chairwoman Janet Yellen started small interest rate hikes during her term, and her newly sworn-in successor Jerome Powell will likely follow suit.
My economic concerns extend far beyond interest rates. The U.S. federal deficit is out of control. In fact, current estimates indicate a $1 trillion deficit by 2020.
Have you seen how many times the U.S. government was close to shutting down or actually did shut down (albeit temporarily)? Each time this happens, think of it like adding a band-aid to a bodily injury. The key to recovery is eventually removing the band-aid and exposing the cut to fresh air. Except we have no fresh air. The band-aids continue to pile up.
If you’re ever short on money, you have four possible solutions:
1) Increase your income
2) Cut expenses
3) Sell an asset, or
4) Borrow more
Let’s take a look at each in the context of funding the Tax Cuts and Jobs Act of 2017.
Raise More Revenue
Trump is optimistic that the deemed repatriation of accumulated foreign earnings will raise a sizable amount of revenue in the short-term. But it is anyone’s guess if that tax revenue will truly offset the lucrative tax breaks.
After my article in Kiplinger, a handful or retirees reached out to me and expressed concern about Social Security. And rightfully so. For a federally-funded program already in trouble, the outlook is bleak.
According to the Committee for a Responsible Federal Budget, Trump’s second 2019 budget proposal has a total of $3.1 trillion in budget savings relative to current law. Rather than cutting benefits to beneficiaries, Medicare policies in the 2019 budget improve efficiency and value of care. Furthermore, there don’t appear to be any direct cuts to Social Security in the recently proposed budget, and that is good news.
Even with these changes, deficits would rise to over 4% of Gross Domestic Product (GDP) for the next few years and then gradually decline. Additionally, the budget calls for a 42% reduction in non-defense discretionary spending over the next 10 years that’s unrealistic.
Balance Sheet Items
The last two solutions in my list above, sell an asset or borrow more, relate to the balance sheet. Income and expenses, the first two solutions, are apparent on an income statement.
Have you ever looked at the Fed’s Balance Sheet? Section 5 outlines the Consolidated Statement of Condition of All Federal Reserve Banks. The Fed is reporting over $4.4 trillion of assets as of Wednesday, 2/7/18. Most of these assets are U.S. Treasury notes and bonds plus mortgage-backed securities.
U.S. currency (aka Federal Reserve notes) represents $1.6 trillion of Fed liabilities, and deposits held by depository institutions (i.e. banks and savings associations) constitute an even larger portion of the Federal Reserve’s liabilities.
The Federal Reserve system is the U.S. central bank. It’s employees promote the effective operation of our economy. So unless you or I go to work for the Fed, we don’t have much say in which assets to sell or how much to borrow.
Some Final Thoughts
I did not write this article to scare you or say we’re headed towards another bear market. I don’t have a crystal ball, and neither do the economists.
Instead, focus on the things that you can control. Re-evaluate your time horizon. See if the level of risk you’re taking in your investment portfolio matches the volatility you can actually stomach. Also, create a plan to achieve long-term goals such as charitable giving, education funding, or financial independence.
Hopefully, you learned something new from this article; I tried my best to present a non-partisan view of the challenges facing our nation. Although many of my blog posts last year were more “touchy-feely” than technical, that does not mean that I don’t care about the events impacting our economy. In fact, I am working to incorporate more technical content on the blog so meeting time with clients is reserved for the issues that matter most to them.
Do you like these technical articles? Please let me know what you think by emailing firstname.lastname@example.org or posting in the comments section below. And have a great week!