Your Weekly Market Update – June 5

Stocks rallied this week, continuing their strong advance since the most-recent low on March 23rd. While we have seen improvement and progress regarding COVID-19, much of this rally happened before these positive developments. This rally has also continued regardless of political and social turmoil resulting from the death of George Floyd. While these events obviously have wide-ranging social and societal impact, the economy and corporate earnings have a more direct impact on market returns.

Recently, to help combat the economic fallout from the coronavirus pandemic, the federal government enacted the CARES Act to temporarily support workers and businesses. As you may know, the federal government typically runs deficits, which means they spend more than they receive in tax revenue. They make up the difference by issuing Treasury bonds, which are repaid over time with interest. The CARES Act resulted in an estimated borrowing of $2 trillion, increasing the total federal debt to about $25 trillion.

Many investors are wondering how long we can continue to borrow this much money. The answer is – it’s complicated.

A big factor in how much debt is sustainable is the cost of its interest. The higher the interest rate, the less debt that can likely be supported. The following chart from JP Morgan shows actual (nominal) and inflation-adjusted (real) 10-year treasury rates going back over 60 years. The real interest rate is calculated by taking the actual (nominal) rate and subtracting the current inflation rate.

Some observations from the chart:

  • Nominal rates are historically low – As of June 2nd, the ten-year treasury rate was 0.68%. This is probably a much lower rate than any of us could get personally, and it means the current interest costs for the government are at all-time lows.
  • Real rates are negative – By taking the nominal yield of 0.68% and subtracting current inflation of 1.44%, you arrive at a negative real rate of borrowing: -0.76%. This means that an investor in the 10-year treasury bond will lose money after accounting for inflation. This is great for the government, but not so great for investors.
  • This affects your portfolio – Our firm is not currently investing client accounts in longer-term government bonds because of their paltry return, especially after considering the risk of rising interest rates. This means we are more likely to turn to alternative bonds, such as shorter-term treasuries, mortgage-backed securities, corporate bonds, or high-yield bonds.
  • This won’t last forever – As you can imagine, lenders are not willing to put up with negative real rates permanently. Looking back over time, negative real interest rates occurred in the 1970s, when inflation was very high, and more recently, as nominal rates have been low. But even during these times, negative real rates tended to be temporary. Investors want to preserve their purchasing power after inflation. Over time, negative real rates tend to resolve as nominal rates increase. If this happens over the next few years, the government will pay higher interest costs on debt.
  • As a nation, we will collectively figure it out – The bottom line is this: right now, the bond market is very willing to lend the US government money at low rates because many investors are valuing safe assets during these uncertain economic times and current market volatility. So, there really isn’t a problem, for now. If interest rates go up in the future, then our political leaders will have to decide how to deal with those higher costs. This might result in a decision to pay down the debt. That is a discussion for another day. Right now, the government is more focused on getting through the pandemic and supporting the economy. They will worry about tomorrow when it comes.

Please reach out to us if you have questions regarding your accounts or would like to discuss this further.

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