Interest Rates Can Go Lower, But You Won't Like It

If Lacy Hunt had to fight a duel, he would arrive armed with an arsenal of very powerful charts. In his role as economist for Hoisington Investment Management, an Austin firm that manages over $5 billion in fixed income assets for major institutions, Mr. Hunt goes to meetings with a virtual barrage of economic charts, and builds his case.

I have always admired his data, his logic, and his measured approach. That approach is an existential necessity: With $5 billion of client money in the game, he’s quick to say he is a fiduciary as much as he is an economist. His charts are for real money, not window dressing.

“This wasn’t a Black Swan,” Mr. Hunt said in a recent interview, referring to the current recession. “It was highly predictable. We had a long period of over indulgence in debt. Now we’re living with the consequences.”

The most recent Hoisington newsletter, for instance, points out that private debt declined by a stunning $2.235 trillion over the last four quarters— some $789 billion more than the federal government was expanding its debt trying to stave off the recession.

Even as Treasury yields and home mortgage rates reach for new lows, Lacy Hunt believes they can go materially lower. This has not been the conventional wisdom. The conventional wisdom holds that we can’t have such a gigantic federal deficit and so much new federal debt without having inflation. But the conventional wisdom has been wrong. And it may soon be wrong again.

Most of the modern period, he explains, has been based on Keynesian economics— the idea that government could stimulate demand with deficit spending. That spending, funded through larger government debt, was supposed to have a multiplier effect. For every dollar of deficit spending, according to the theory, there would be several dollars of new economic activity. The multiplier effect is an idea politicians love because it makes government the hero-spender of economic recoveries.

There’s just one problem. Mr. Hunt says, “It’s wrong.”

“Deficit spending, rather than energizing the economy, is debilitating. Worse, after the spending is done, the private sector has to service the new debt.” He points out that different economists, studying deficit spending results in different countries and different times, have concluded that the multiplier for government spending is somewhere between zero and one. At its best, that means it creates some economic activity, once, and is gone.

How about an example, I asked?

“Cash for clunkers. Money for homebuyers. Those programs are prime examples,” he said. So when the stimulus goes away, so does the economy.

But that’s not all.

“Taxes have a negative multiplier,” he said. Research now shows that a $1 tax increase will put a drag on the economy of between minus $1 and minus $3. “The sun setting on the 2001 and 2003 tax cuts will yield $1.5 trillion over the next 10 years. Another $500 billion in tax increases is in the healthcare legislation. That’s $2 trillion in tax increases.”

“If you put a mid-range negative multiplier of minus 2 on that, it is $4 trillion out of the economy, or about $400 billion a year,” he said. To put that $400 billion in perspective, he pointed out that the growth in gross domestic product in the last 4 quarters was— you guessed it— $400 billion.

I asked how much lower interest rates could go and if lower rates would eventually turn the economy around.

“I don’t think there is a rate level that will turn us around. What will turn us around is deleveraging the economy. We’re going to have to go through a period of national austerity; we’re going to have to write down the excess assets. This will be a long process, not a short process. And we’ll make it longer by getting deeper in (government) debt,” he said.

One possible saving grace is that declining interest rates often mean higher stock prices. But they don’t mean that in an over-indebted economy. Two examples show history. From 1929 to 1941 in the United States interest rates fell while government debt as a percent of gross domestic product soared— but stock prices fell. From 1989 to 2009 in Japan, it was the same. Interest rates fell, government debt soared, and stock prices plummeted.

Bottom line: Oil those boots; we may be slogging for a long time.

Revenge of the Bond Holders

This table compares the 10- and 15-year performance of the legendary and largest bond fund, PIMCO Total Return, with the performance of both the Vanguard 500 Index fund and Wasatch-Hoisington U.S. Treasury fund. Note that both bond funds beat the broad index of common stocks over both time periods. Hoisington Investment Management manages fixed income investments for major institutions.

Fund Asset Class 10-year annualized return 15-year annualized return Assets in fund
Wasatch-Hoisington U.S. Treasury
Ticker: WHOSX
Fixed Income Long Government 8.50 percent 8.10 percent $166 million
PIMCO Total Return
Ticker: PTTAX
Fixed Income
Intermediate Government
7.33 7.17 $234 billion
Vanguard 500 Index
Ticker: VFINX
Large Blend Domestic Equity (1.47) 6.28. $86 billion