"Kee" Points with Jim Kee, PhD.

Here are the facts: The dollar is up, US stocks are up, bond prices are down, interest rates are up, and US core inflation looks to be stabilizing (not going down) a bit above rates in Europe.


And here is an explanation for what we are seeing. I think it is helpful to start with the old maxim, “strong country, strong currency.” US growth looks to be exceeding that of the rest of the developed world, and differences among countries in rates of economic growth are a key factor affecting exchange rates. In this sense the dollar’s appreciation is due to increases in expected rates of return in the US relative to the rest of the world. Stronger growth in turn drives interest rates higher, not necessarily because inflation is higher but rather because underlying “real rates” are increasing or being bid up by demand. That is consistent with the fact that interest rates have risen more than core inflation measures have. The actions of the world’s central banks influence the dollar as well, but that usually manifests itself in differential rates of inflation. That is, higher inflation in one country relative to another usually leads to a depreciating currency on the foreign exchanges. That’s not what we’re seeing today as measured inflation rates, in say, Europe and the US are low, but are actually higher in the US. That leaves a “real rate” explanation as most plausible.


In fact, looking at interest rates and the bond market is helpful here. In general bonds are subject to two types of risks, (1) interest rate risk and (2) default risk. Higher interest rates which are driven by expectations for stronger growth should lead to lower bond prices (interest rate risk) but also narrowing “quality spreads.” Higher quality companies don’t have to pay as much in promised interest payments to borrow money, so yields on high quality bonds issued by financially strong companies are lower than yields on lower quality or “junk” bonds issued by companies closer to bankruptcy. The difference between yields of low quality and high quality company bonds is called the quality spread. Since stronger economic growth generally lowers the probability of default on bonds issued by weaker companies, quality spreads tend to narrow when stronger growth is expected (they do the opposite when a slowdown or recession is expected). That is what we’ve seen recently, even as overall rates have risen. But that’s all forward-looking or longer-term. Near-term expectations are for fourth quarter GDP growth to fall back down to the 2% range from the third quarter’s 3.2% rate.


Christine Lagarde was found guilty of negligence by a Paris court on Monday, which makes her position as managing director of the International Monetary Fund a little challenging. Right now most experts believe that she will be able to keep her post. Last week when I discussed the shenanigans of previous IMF heads several clients asked if I thought these problems were characteristic or systemic with the IMF. I would say it is more of an observation about bureaucracies in general than about the IMF in particular. Leaders in bureaucracies aren't subject to the discipline of profit and loss like leaders of private institutions, so forays into non-business endeavors are more common or at least tend to go on longer. Private sector leaders engage in these activities too, but they tend to be more constrained and disciplined more quickly. There is a long literature on the nature of bureaucracies, as necessary as they often are (would you want a court system or police system run by profit and loss?), but that is my high level take on it.


And what about the stock market? I believe markets can be more sentiment-driven in the short-run and subject to overshooting and undershooting, but in general I think markets tend to price in what is known. Think of the value or price of the stock market as equal to the expected value of the future profits that the companies comprising it can generate, discounted by the fact that dollars in the distant future are worth less than dollars today. The Trump program, which includes cutting corporate tax rates and cutting taxes on income earned overseas, should increase the value of future expected profits. Discounted rates are more driven by the aggregate interaction of individual investors. That includes a required rate of return, after allowing for inflation and taxes. Thus lowering investor taxes, which means dividend and capital gains taxes, lowers discount rates. Both an increase in future profits and a decrease in discount rate results in higher equity values. And as the late Nobel Laureate Merton Miller used to point out to all of the “bubble everywhere” theorists, it doesn’t take much in the way of changes in expected future profits and discount rates to cause really big changes in overall equity valuations and prices.


P.S. The Fed raised interest rates (i.e. federal-funds rate) by a quarter percentage point last week in line with market expectations.