Monday, November 8, 2010

Interest Rate Watch and Credit Market Insights : Fed Easing, Tax Cuts: Growth and Rising Interest Rates.

Interest Rate Watch
Fed Easing, Tax Cuts: Growth and Rising Interest Rates.

Hitting the Daily Double is exciting, especially when that suggests economic growth going forward. This week the FOMC announced a policy of quantitative easing while the Obama administration suggested it might compromise on extending the Bush tax cuts for everyone. Both these policies are pro-growth.

For now the liquidity effect of quantitative easing will support the case for continued low short-term interest rates. The economic outlook is for continued modest economic growth and low inflation. Our outlook is consistent with the Fed’s view of modest growth of two percent over the next two quarters and core inflation, measured by the core PCE deflator of one percent plus over the same period. Therefore our outlook was, and remains, for a steady fed funds rate and a 10-year benchmark rate of 2.5 percent plus over the same period.
Quantitative easing should keep the short-rates low and maintain lower long-term rates as well.

Risks over Time
Given the level of rates today, all the risks are on the upside. We would caution against the complacency expressed in the view that rates will remain low for a long time.

Markets are forward-looking, and therefore the explicit goals of both fiscal and monetary policy for growth and higher inflation suggest that rates will rise. Moreover, dollar devaluation suggests that foreign investors will require a risk premium in interest rates to compensate them for the risk of further currency depreciation. In addition, despite the election results, Congress will have great difficulties cutting federal spending and therefore our expectation is that large federal deficits will still need to be financed.

Complacency on rates cost many their careers in the 1970s, 1980s and 1994-95. Complacency is not an investment strategy.

Credit Market Insights
Overblown Municipal Bond Concerns

Recently there has been concern expressed about increased risks associated with municipal bonds primarily due to declines in state and local tax revenue. State finances around the country are indeed fragile, but at this stage in the recovery, some cyclical weakness is expected. While some concerns are overstated there is some merit to increased concern due to weak fundamental factors, mainly tax revenues collections.

State-level tax revenues increased by 4.9 percent in the second quarter of 2010 led by gains in sales tax revenue. Much of the recent revenue increases are likely due to temporary state tax increases. Outside of the gains in sales taxes, corporate income taxes declined 19.8 percent and individual income tax collections fell 0.2 percent during the second quarter of this year. These declines along with state budget gaps indicate likely continued weakness in state budgets for the near future. Property tax revenues will also become a point of concern over the next 12 months. In most states property tax collections lag a year or two. With continued declines in real estate valuations local governments that rely primarily on property tax receipts may face further declines in revenues.

These aggregated trends are not representative of all state and municipal governments. However, widespread stability in the fundamental factors of the municipal bond market will likely be a ways off.

Topic of the Week

Brazil: The Workers’ Party (PT) Retains the Presidency, As Expected
As expected, Luiz InĂ¡cio “Lula” da Silva, the current president of Brazil, delivered the presidency to his chosen successor, Dilma Rousseff, during a second round voting process. But before wining by a large margin, 56 percent to 44 percent for Jose Serra from the PSDB, Dilma Rousseff had to tone down her radical views on some issues, especially on abortion rights, after religious groups started to second guess their potential support to the front runner.

And this is a good signal in that it gave a chance for Dilma to show whether she was as pragmatic as her predecessor, Lula da Silva. Of course, anything could happen now that she has won the presidency, but our guess is that she will be very careful not to compromise her ability to succeed, especially because the political alliance that took her to power is very heterogeneous.

According to her own explanation she wants to get rid of poverty in Brazil during her presidency without increasing the fiscal deficit of the country. While ending poverty is a very noble objective, the comment is basically geared towards her followers, who are the poorest of the poor in the country. However, fulfilling this promise will, of course, be impossible. Nevertheless, she will have to come clean on her second promise, which was keeping the budget under tabs.

But if Dilma believed that her experience during the presidential campaign was difficult, the truth is that managing the Brazilian political system and the Brazilian economy will likely be much more difficult than wining the presidency, especially because she probably won’t have the daily advice of Lula da Silva.
Thus, while we believe that the Brazilian economy is going to continue to outperform those of other Latin American countries, the road will not be without some bumps and bruises, and Dilma will have to learn on the job and very fast if she expects to be successful at the helms of the up-and-coming Brazil.
Full report: Interest Rate Watch and Credit Market Insights : Fed Easing, Tax Cuts: Growth and Rising Interest Rates.

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