Point of View: Interest Rate Increase: Rebalancing and State and Local Budgets Challenges Imminent

Interest Rate Increase: Rebalancing  
“Inflation will remain moderate and shortterm interest rates low, but longer-term interest rates will rise in anticipation that the Federal Reserve will succeed in raising inflation.” So concludes the first paragraph of our Annual Outlook for 2011.

Fundamentals for growth, inflation, the dollar and federal finance as well as investor behavior are consistent with the rebalancing of credit markets interest rates. As evidence of sustained economic growth has become apparent to many investors the flight to safety trade has diminished in attraction. So, investors, at the margin,
have moved toward equities and corporate debt and away from Treasury notes.

Inflation and the Dollar 
As stated in our Annual report, “Inflation remains well below the level consistent with the Federal Reserve’s dual mandate, which has prompted a series of unconventional monetary policies such as quantitative easing. Concerns about rapid inflation in the near-term are overstated, but the long-term picture is more complicated given the massive amount of liquidity in the banking system. Our expectation is that “core” inflation will rise one percent in the year ahead.” With the Fed apparently committed to moving inflation toward its two percent target it should be no surprise that Treasury notes yielding below two percent are of little interest since after inflation the real return is negative.

While dollar depreciation may not be the direct aim of the Federal Reserve the risk of exchange rate depreciation must be considered by foreign investors. Increased perception of higher U.S. inflation and the acceptance by Washington policy makers of dollar depreciation would reduce the real return to foreign investors and therefore they will demand higher interest rates to offset that risk.

Deficits & the Kindness of Strangers U.S. Treasury finance remains dependent on the kindness of strangers (China, Japan,  and Taiwan) and that kindness cannot be assumed to be unlimited.

Credit Market Insights: Cash on the Sidelines Curtails Commercial Paper Issuance  

The commercial paper (CP) market, a vital source of short-term funding for businesses to finance payrolls, accounts receivables, and inventories continues to show a downward trend. CP outstanding on a seasonally adjusted basis fell by $26.2 billion in the week ending December 15, to $981.7 billion. CP is now down roughly  56 percent since peaking in late July 2007 with much of the drop due to declines in asset-backed commercial paper (ABCP).

What is driving the downward trend in the CP market? It appears that companies with large amounts of cash on their balance sheet don’t have the same short-term funding needs. The best way to test this theory is to look at the cash equivalent to total assets ratio to determine how much cash is actually sitting on the sidelines. We find that as of the third quarter, the ratio of cash equivalent to total assets is at an all time high of 5.9 percent and well above its long-run trend of 3.8 percent and suggests companies are indeed awash in cash.

Second, with the economy growing at such a modest pace the traditional uses for short-term funding are not as great. The private sector is hesitant to add new workers to payrolls and businesses continue their efforts to align inventories with slower sales. We expect that once economic growth picks up on a sustainable basis, companies will likely once again put cash to work, which should lift CP issuance.

State and Local Budgets: Challenges Imminent 
Over the next year, challenges to state and local budgets across the United States will take center stage. During the prior two years, state  and local budget problems were largely avoided via federal government assistance. In the coming years, however, less assistance is likely, due to federal budget concerns, necessitating spending cuts and tax increases at the state and local level.

Exceptional challenges confront a number of states. For these states the challenges are both structural and
cyclical. On the cyclical side of the equation, declining valuations for homes and commercial real estate will
continue  to  impact  local  government  property  tax revenues and thereby limit local budget flexibility. States
like Nevada, Arizona and  Florida have seen their revenue bases erode significantly due to the housing
collapse and associated negative wealth effects. With the percentage of households with negative equity on their home mortgages exceptionally high in states hit hardest by the housing collapse, key revenue generating industries that have provided crucial tax revenues flows to state and local governments in the past will likely remain weak in 2011, adding pressure to local budgets.

On the structural side of the equation, the road will be extremely difficult. In 2011, many states will be forced to deal directly with underfunded entitlement programs and unsustainable spending commitments. Public
pension retirement programs are one of the largest culprits of state and local structural budget problems. In
states like California and Pennsylvania, public pension retirement programs have resulted in enormous
payment obligations that far out-strip money set aside at public agencies to meet these obligations.

We remain optimistic that the U.S. recovery will continue to improve in 2011, though the aforementioned state and local budgets issues do present some risks. Our expectation is that state and local budget issues will
hinder growth somewhat in 2011, but our forecast still calls for growth of around 2.8 percent next year.
Full report: Point of View: Interest Rate Increase: Rebalancing  and State and Local Budgets Challenges Imminent