Rising Interest Rates Mean Deficits Finally Matter - Kanebridge News
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Rising Interest Rates Mean Deficits Finally Matter

Investors ignored deficits when inflation was low. Now they are paying attention and getting worried.

Mon, Oct 9, 2023 9:23amGrey Clock 4 min

The U.S. has long been the lender of last resort to the world. During the emerging-market panics of the 1990s, the global financial crisis of 2007-09 and the pandemic shutdown of 2020, it was the Treasury’s unmatched capacity to borrow that came to the rescue.

Now, the Treasury itself is a source of risk. No, the U.S. isn’t about to default or fail to sell enough bonds at its next auction. But the scale and upward trajectory of U.S. borrowing and absence of any political corrective now threaten markets and the economy in ways they haven’t for at least a generation.

That’s the takeaway from the sudden sharp rise in Treasury yields in recent weeks. The usual suspects can’t explain it: The inflation picture has gotten marginally better, and the Federal Reserve has signalled it’s nearly done raising rates.

Instead, most of the increase is due to the part of yields, called the term premium, which has nothing to do with inflation or short-term rates. Numerous factors affect the term premium, and rising government deficits are a prime suspect.

Deficits have been wide for years. Why would they matter now? A better question might be: What took so long?

That larger deficits push up long-term rates had long been economic orthodoxy. But for the past 20 years, interest-rate models that incorporated fiscal policy didn’t work, noted Riccardo Trezzi, a former Fed economist who now runs his own research firm, Underlying Inflation.

That’s understandable. Central banks—worried about too-low inflation and stagnant growth—had kept interest rates around zero while buying up government bonds (“quantitative easing”). Private demand for credit was weak. This trumped any concern about deficits.

“We had a blissful 25 years of not having to worry about this problem,” said Mark Wiedman, senior managing director at BlackRock.

Today, though, central banks are worried about inflation being too high and have stopped buying and in some cases are shedding their bondholdings (“quantitative tightening”). Suddenly, fiscal policy matters again.

To paraphrase Hemingway, deficits can affect interest rates gradually or suddenly. Investors, asked to buy more bonds, gradually make room in their portfolios by buying less of something else, such as equities. Eventually, the risk-adjusted returns of these assets equalise, which means higher bond yields and lower price/earnings ratios on stocks. That has been happening for the past month.

Sometimes, though, markets can move suddenly, such as when Mexico threatened to default in 1994 and Greece did default a decade later. Even in countries that, unlike Mexico or Greece, borrow in currencies they control, interest rates can become hostage to deficits, such as in Canada in the early 1990s or Italy in the 1980s and early 1990s.

The U.S. isn’t Canada or Italy; it controls the world’s reserve currency, and its inflation and interest rates are mostly driven by domestic, not foreign, factors. On the other hand, the U.S. has also exploited those advantages to accumulate debt and run deficits that are much larger than those of peer economies.

There’s not much sign that this has yet imposed a penalty. Investors still project that the Fed will get inflation down to its 2% goal. At 2.4%, real (inflation-adjusted) Treasury yields are comparable to those in the mid-2000s and lower than in the 1990s, when the U.S. government’s debts and deficits were much lower.

Still, sometimes bad news accumulates below investors’ radar until something brings their collective attention to bear. Could a point come when “all the headlines will be about the fiscal unsustainability of the U.S.?” asked Wiedman. “I don’t hear this today from global investors. But do I think it could happen? Absolutely, that paradigm shift is possible. It’s not that no one shows up to buy Treasurys. It’s that they ask for a much higher yield.”

It’s notable that the recent rise in bond yields came as Fitch Ratings downgraded its U.S. credit rating, Treasury upped the size of its bond auctions, analysts began revising upward this year’s federal deficit, and Congress nearly shut down parts of the government over a failure to pass spending bills.

The federal deficit was over 7% of gross domestic product in fiscal 2023, after adjusting for accounting distortions related to student debt, Barclays analysts noted last week. That’s larger than any deficit since 1930 outside of wars and recessions. And this is occurring at a time of low unemployment and strong economic growth, suggesting that in normal times, “deficits may be much higher,” Barclays added.

Abroad, fiscal policy has clearly begun to matter. Last fall, a proposed U.K. tax cut triggered a surge in British bond yields; the government scrapped the proposal, then resigned. Italian yields have risen since the government last week delayed reducing its deficit to below European guidelines. Trezzi said that for the past decade the European Central Bank had bought more than 100% of net Italian government bond issuance, but that’s coming to an end.

Foreign investors, worried about inflation and deficits, have been selling Italian bonds, while Italian households have been buying, Trezzi said. “With a weakening economy, it is unclear for how long…households can offset the selloff of foreigners.”

Investors looking for U.S. political will to rein in deficits would take note that both former President Donald Trump and President Biden, their parties’ front-runners for the 2024 presidential nomination, have signed deficit-busting legislation and that both of their parties have pledged not tocut the two largest spending programs, Medicare and Social Security, or raise taxes on most households.

They would also notice that the Republican speaker of the House of Representatives was just ousted by rebels in his own party because he had passed a bipartisan spending bill to prevent the government from shutting down. True, the rebels wanted less spending. But shutdowns, Barclays noted, represent “erosion of governance.” This isn’t how a country trying to reassure the bond market acts.


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These stocks are getting hit for a reason. Instead, focus on stocks that show ‘relative strength.’ Here’s how.

Wed, Jun 12, 2024 4 min

A lot of investors get stock-picking wrong before they even get started: Instead of targeting the top-performing stocks in the market, they focus on the laggards—widely known companies that look as if they are on sale after a period of stock-price weakness.

But these weak performers usually are going down for good reasons, such as for deteriorating sales and earnings, market-share losses or mutual-fund managers who are unwinding positions.

Decades of Investor’s Business Daily research shows these aren’t the stocks that tend to become stock-market leaders. The stocks that reward investors with handsome gains for months or years are more often  already  the strongest price performers, usually because of outstanding earnings and sales growth and increasing fund ownership.

Of course, many investors already chase performance and pour money into winning stocks. So how can a discerning investor find the winning stocks that have more room to run?

Enter “relative strength”—the notion that strength begets more strength. Relative strength measures stocks’ recent performance relative to the overall market. Investing in stocks with high relative strength means going with the winners, rather than picking stocks in hopes of a rebound. Why bet on a last-place team when you can wager on the leader?

One of the easiest ways to identify the strongest price performers is with IBD’s Relative Strength Rating. Ranked on a scale of 1-99, a stock with an RS rating of 99 has outperformed 99% of all stocks based on 12-month price performance.

How to use the metric

To capitalise on relative strength, an investor’s search should be focused on stocks with RS ratings of at least 80.

But beware: While the goal is to buy stocks that are performing better than the overall market, stocks with the highest RS ratings aren’t  always  the best to buy. No doubt, some stocks extend rallies for years. But others will be too far into their price run-up and ready to start a longer-term price decline.

Thus, there is a limit to chasing performance. To avoid this pitfall, investors should focus on stocks that have strong relative strength but have seen a moderate price decline and are just coming out of weeks or months of trading within a limited range. This range will vary by stock, but IBD research shows that most good trading patterns can show declines of up to one-third.

Here, a relative strength line on a chart may be helpful for confirming an RS rating’s buy signal. Offered on some stock-charting tools, including IBD’s, the line is a way to visualise relative strength by comparing a stock’s price performance relative to the movement of the S&P 500 or other benchmark.

When the line is sloping upward, it means the stock is outperforming the benchmark. When it is sloping downward, the stock is lagging behind the benchmark. One reason the RS line is helpful is that the line can rise even when a stock price is falling, meaning its value is falling at a slower pace than the benchmark.

A case study

The value of relative strength could be seen in Google parent Alphabet in January 2020, when its RS rating was 89 before it started a 10-month run when the stock rose 64%. Meta Platforms ’ RS rating was 96 before the Facebook parent hit new highs in March 2023 and ran up 65% in four months. Abercrombie & Fitch , one of 2023’s best-performing stocks, had a 94 rating before it soared 342% in nine months starting in June 2023.

Those stocks weren’t flukes. In a study of the biggest stock-market winners from the early 1950s through 2008, the average RS rating of the best performers before they began their major price runs was 87.

To see relative strength in action, consider Nvidia . The chip stock was an established leader, having shot up 365% from its October 2022 low to its high of $504.48 in late August 2023.

But then it spent the next four months rangebound—giving up some ground, then gaining some back. Through this period, shares held between $392.30 and the August peak, declining no more than 22% from top to bottom.

On Jan. 8, Nvidia broke out of its trading range to new highs. The previous session, Nvidia’s RS rating was 97. And that week, the stock’s relative strength line hit new highs. The catalyst: Investors cheered the company’s update on its latest advancements in artificial intelligence.

Nvidia then rose 16% on Feb. 22 after the company said earnings for the January-ended quarter soared 486% year over year to $5.16 a share. Revenue more than tripled to $22.1 billion. It also significantly raised its earnings and revenue guidance for the quarter that was to end in April. In all, Nvidia climbed 89% from Jan. 5 to its March 7 close.

And the stock has continued to run up, surging past $1,000 a share in late May after the company exceeded that guidance for the April-ended quarter and delivered record revenue of $26 billion and record net profit of $14.88 billion.

Ken Shreve  is a senior markets writer at Investor’s Business Daily. Follow him on X  @IBD_KShreve  for more stock-market analysis and insights, or contact him at  ken.shreve@investors.com .