At the Strategic Investment Conference 2018, Grant Williams warned investors about the consequences of rising interest rates coupled with the Fed’s balance sheet roll-off.
He said that low volatility was the market’s response to accommodative monetary policy. Now the recent sell-off and rate hikes are set to bring volatility back.
Williams also pointed out that there is a high correlation between the S&P 500 and the Fed’s balance sheet. That was true on the way up, and it looks like it might also work the other way around.
That means as the Fed unwinds its balance sheet, a market crash might follow.
Fed Chair Jerome Powell now faces an intractable debt problem.
The US federal debt has surged to record highs. Yet, GDP has been stuck on a downward slope.
But due to falling interest rates, the interest on the national debt has been pretty constant.
Even with low rates, debt-servicing costs will become the second-largest item in the federal budget in the next 10 years.
The Congressional Budget Office has the US debt-to-GDP ratio pegged at 101%. Based on several aggressive assumptions, the Trump administration projects that it will fall to the mid-70s. But that projection assumes unrealistic GDP numbers.
If rates rise, it will push the cost of debt to unsustainable levels for the federal government. And according to Williams, that’s the reason the dollar has not responded positively to rate increases.
What happens next might be gleaned by reviewing what happened in the 1959–1971 era. During that time, Treasury investors lost one-third of their money.
Will Powell Have the Guts?
Grant Williams believes that inflation is about to become a significant part of the Fed’s conversation.
Powell’s dilemma is that he cannot possibly attack all the problems at once. Actions have consequences, and many of the outcomes will be at odds with other goals.
Importantly, all of Powell’s options have significant downside risk for the economy and markets.
Powell knows that he must wean the markets off the Fed. The question is whether or not he has the guts to stick with it no matter the outcome.
At an Inflection Point
Grant Williams believes we are at a monetary inflection point.
He thinks the US Treasury will greatly regret not borrowing at longer maturities at lower rates. The US could have issued 50- or 100-year bonds and locked in financing for decades. It didn’t and will now have to refinance at much higher rates.
On another point, Williams foresees rising wages for a different reason. He sees social movements gaining ground—demands on private companies to cut off NRA discounts are a good example. And he thinks we will see more of it.
He doesn’t think the Trump tax cuts will achieve the desired goals. Nothing about the tax cuts will significantly strengthen the current weak recovery. It will further aggravate the government debt problem.
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