Take Five With Craig Elder: Will debt stifle U.S. economy?

During their late-October visit to Madison, we sat down with Craig Elder, senior fixed income research analyst for Robert W. Baird & Co., and Bruce Bittles, chief investment strategist for Baird and the author of Baird Market Notes. From their perspective, when it comes to predicting what the Federal Reserve will do with respect to interest rates, the key metric to watch is wage growth, as they explain in this two-part interview. In part 1, Bittles weighed in on the Fed’s likely response to economic indicators and a host of other issues. In part 2, Elder gives his take on the Fed’s hesitancy to raise interest rates and discusses the problem of high debt levels throughout the country.

IB: Craig, would you add anything to what Bruce has said? [See part 1.]

Elder: The same thing on the Fed. They are looking at the average hourly earnings to see if they can get any pop in them. First, they’d like to see about 3.5%; the first 2%, you get from inflation, and 1.5% from the productivity growth we’re seeing right now. The Fed has got the luxury right now, with inflation being low, that they don’t have to raise rates to fight inflation. This is buying them some time.

Craig Elder

Now the bond-buying business, they are getting out of that by the end of [October]. They realize they’re not getting much bang for their buck. It will be interesting to see. The bond-buying, I guess the printing of money is stopping. I’ll use that term, but they are taking the interest and putting that back to the Treasury Department on a weekly basis. With the principal, they are buying more bonds, so we’re not going to see that $4.3 trillion portfolio decline. I think it’s fairly stable until you get runoff as bonds mature and they do not purchase additional securities. But they’ve got the luxury right now where they don’t have to raise rates.

Three months ago, everyone thought they were going to raise rates in mid-2015, but now everyone is saying late next year. That’s saying we’re data dependent, so they are not going to do it midyear.

IB: If you were advising a business on how to plan for next year, both for short-term and long-term borrowing, what would you tell them?

Elder: I don’t think the long-term rates are going to go up that much. What they will do is take some of the steepness out of the yield curve, if they do raise rates.

IB: Would any rate increase be very gradual?

Elder: Very gradual.

IB: Are we talking a quarter of a point per month or per quarter?

Elder: I think it would be a quarter of a point per [Fed] meeting. I think there is a possibility that they would do a quarter of a point and then hold off for a meeting. They’re going to do it the old [Alan] Greenspan way. But when they do it, it will be very slowly because they are very afraid of raising rates too quickly and looking up a couple of quarters later and finding we’re back at recessionary levels. I think they are terrified of that.

And the other thing is they will look at how the housing market is doing. It’s come back a bit but very slowly, and the strong momentum we saw late last year seems to have been lost. Some of that might be a function of the fact that millennials don’t seem to want to buy houses, and so it’s a big question for government and a big question for contractors who build homes who are trying to decide whether to build more houses in the suburbs or do we go into the city and build up? The younger folks want to live in the city and ride bicycles to work. The growth in urban areas has been in multifamily.

IB: So you’re saying for business planning, don’t expect a lot of interest rate changes in 2015, but the very next year, when you’re making those plans for your 2016 budget, that’s when you’re really going to have to pay closer attention to the prospect of rate increases?

Elder: I think so. What Bruce has said is when you get much above 3% on the 10-year bond, everything just grinds to a halt. So that’s the question: What happens on the longer end? The forecast at the beginning of this year, for the end of this year, was 3.48%. That’s the consensus rate that Bloomberg compiles. It’s now 2.67%, so everybody was wrong on long rates this year, except him [Bruce Bittles]. So I think 2016 is the year, but it’s really too hard to predict at this point.

IB: It’s easier to see them continue to hesitate on raising rates, especially with what you’ve told me about wages.

Elder: Well, they are not just concerned about what’s happening in the U.S. They are also concerned about what’s happening with the global economy. Europe is struggling. They can’t seem to get out of first gear. China’s growth rate is slowing. Japan is problematic, and that’s a large economy. So the Fed is looking at all that and saying, well, we better be very careful here. The last thing the Fed wants to do is lose credibility. If they raise rates and the economy slumps, they could have a real problem with credibility, and therefore they will be very cautious.

I contend that the largest problem that the Fed faces, or the economy faces, is the extremely high levels of debt throughout the country. That is really what has stymied everything. Serving that debt, even at low interest rates, is proving difficult. If rates go up just a little bit, serving that debt could really be a struggle for the economy, and that’s why I don’t think you could have sustained inflation or sustained high rates because the debt just won’t allow it.

As we have said, in 2013, housing was beginning to show some momentum, some traction, and then the yield on the 10-year benchmark Treasury note jumped to 3% in January of 2014, and the housing market stopped. It stopped, and it has not fully recovered from that yet. So that tells me that at 3% or 3.25%, the economy just can’t absorb that and continue with any growth at all. I think rates are going to remain lower than most people feel for longer than most people believe because of that.

Germany’s two-year bond still has a negative yield, so people are willing to give their money to the German government for two years and pay them. So when you look at American yields, they look fairly attractive on a global basis. The Japanese rates have been down at these levels for 20-something years, to 50 basis points on a 10-year yield.

(Continued)

IB: Are we repeating the mistakes Japan has made over the past 20 years?

Elder: I don’t think so. I think the Fed’s policy was right, what Ben Bernanke did and what [Janet] Yellen is continuing to do. You basically run deficits during periods of stress, economic stress and wars, and so that’s what they did, and so far so good. I don’t think they are getting much from the bond-buying anymore, and that’s why they are getting out of that, but the policies have been aggressive on the monetary side to not get into that situation again.

IB: Getting back to what Bruce said earlier, you seem to be endorsing the tax reform being discussed in Congress, which includes lowering the corporate rate and simplifying the federal tax code overall.

Elder: You just about have to. We’re not competitive globally from that standpoint. Who would have ever thought we’d be losing jobs to Europe because companies are moving to Europe because of lower taxes? A generation ago, you would have laughed at that.

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