SPY: Higher For Longer Could Be Good News (NYSEARCA:SPY)

Preamble

For what feels an eternity, countless market commentators have been blabbering on about interest rate cuts in the near future and how these cuts will provide a tailwind to the stock market. But what if the reverse is true and that higher for longer will boost the value of S&P 500 (SPY) instead. This may appear to be counterintuitive. However, there are a number of factors that imply this statement is not as bonkers as it seems.

Government Spending

In the United States, government spending as a proportion of GDP has fluctuated over time, although there is a general upward trend. As of Q3 2023, the US Bureau of Economic Analysis estimates government spending to be around 36.2% of GDP. And some forecasts predict a continued rise in this proportion to reach 38.82% by 2028.

Now you might be thinking that a figure of 36.2% is a tad high, however, this is not as high as other so-called developed countries. As recently as 2017, a report concluded that the US was in the bottom quartile by this measure.

There are plentiful reasons why government spending is ballooning year by year. Part of it is the social safety net, including Social Security and Medicare. As the population ages, this translates to rising costs. Clearly there’s defense spending, and a hefty chunk of the national pie goes towards supporting the various conflicts the US is involved in. In addition, there is the amount of interest that needs to be paid on the debt.

According to a recent analysis by the Congressional Budget Office. Federal spending on the interest payments is predicted to hit $870 billion this year, well in excess of the $822 billion that the nation will spend on defence in 2024.

On the surface, government spending might seem counterproductive, however on closer inspection a number of advantages are revealed.

A Positive Aspect Of Borrowing

Adherents of Keynesian economics advocate expansionary fiscal policy during economic downturns. This approach emphasizes increased government spending, often financed through borrowing, to stimulate aggregate demand and propel the economy out of a slump or compensate for reduced manufacturing output.

In a period of sluggish economic growth or contraction, businesses become cautious with investments, consumers pull back on spending, and unemployment rises. This creates negative feedback leading to an ever-declining economy.

Keynesian theory posits that governments can intervene as a countercyclical force. By strategically increasing expenditure on infrastructure projects, social programs, wars, or by simply giving money to all and sundry.

• Demand Injection: Increased government spending puts borrowed funds directly into the hands of businesses and individuals. Businesses utilize these funds to hire workers and expand production, while individuals spend them on goods and services. This creates a ripple effect, boosting overall demand and economic activity.
• Confidence Boost: Proactive government intervention aimed at stimulating the economy can inspire confidence among businesses and consumers. This renewed optimism can lead to increased private sector investment and spending, further accelerating growth.
• Monetary Policy Alignment: Central banks often complement Keynesian fiscal policy by lowering interest rates. This incentivizes borrowing, encouraging businesses and individuals to invest and spend more.

So, the above is all well and good for investors, given that increased government spending generally finds its way into the pockets of companies, thus improving revenues and earnings. We may therefore speculate that US bonds need to look attractive for buyers of this debt, a key component of which is the interest paid on said debt along with the desirability of the USD.

Holdings of US Treasuries

There have been mixed reports concerning bond auctions, some have been negative whilst others have claimed that they have been a resounding success.

On February the 21^st, traders were saying that the 20-year bond auction results were “ugly”, which apparently was the explanation given for a sell off. The complete opposite to the auction 5 days earlier.

On the 16^th of February, Reuters reported that foreign investors snapped up record amounts of U.S. government debt throughout December. This marked the second consecutive month of rising foreign ownership of treasuries.

Total foreign holdings of Treasuries reached a staggering $8.06 trillion by December, surpassing the previous record of $7.8 trillion set in November. This represents a year-over-year increase of 10.5%. The trend coincides with a recent decline in Treasury yields, as investors anticipate interest rate cuts from the Federal Reserve.

Japan, China, and the UK, the top three holders of U.S. Treasuries, led the buying spree. Japan increased its holdings to $1.138 trillion, the highest since August 2022. In recent years, treasury holdings by China have declined.

However, Reuter’s article stated that China’s Treasury holdings also climbed to $816.3 billion, reversing a seven-month decline. The UK joined the party, setting a new record of $753.7 billion in Treasury ownership.

Overall, foreign investors injected a net $139.8 billion into U.S. long-term and short-term securities, although this figure is lower than the previous month’s $223.3 billion.

You may wonder why it is that central banks are loading the boat with US debt, and thus supporting the US government spending, and with it, to some extent, GDP

Why Are Central Banks Buying US Debt

We are by now all familiar with the national debt and the low likelihood of the debt ever being repaid. Also, in a previous article, a figure for the depreciation of the USD since President Nixon it was taken off the gold standard in 1971 was calculated to be circa 78%. So, why on earth are countries buying treasuries as though they are going out of fashion?

Well, one reason is that the USD is appreciating against the currencies of other countries. For instance, the British pound is down versus the USD by around 26% over the last 10 years.

Also, over the same period, inflation has increased by 54%, meaning that a pound in 2013 is worth 54% less in 2024. Over the last decade, official US figures show that US Dollar inflation has been around 29%. What this means is that UK investors in Treasuries would have gained from USD appreciation, purchasing power. Of course, these gains could to some degree have been offset by variations in interest rates over the period.

Likewise for currencies such as the Argentine Peso, the loss versus the USD has been over 99%. As an Argentinian, had you been a holder of US treasuries over this period, you would have been handsomely rewarded.

In addition to the slumping values of many currencies against the USD, there have been reports of rate cuts in the near future, I suspect some central banks are locking in significant interest rates in a currency that is rising against their own.

So, a recession might be looming, but as long as US debt remains attractive to central banks, this will allow US government spending to continue to prop up GDP, meaning that the stock market could still see some support.

Summary

Despite concerns about rising U.S. government debt, foreign central banks continue buying U.S. Treasuries due to the relative strength of the U.S. dollar and higher interest rates offered. This persistent demand enables the U.S. to sustain elevated spending levels, potentially supporting economic growth and equity markets like the SPY ETF, even amid recession fears.

Counterintuitively, “higher for longer” interest rates could benefit stocks by maintaining the attractiveness of U.S. debt and facilitating government spending that props up GDP. Increased fiscal stimulus during downturns, as advocated by Keynesian economics, can inject demand, bolster business activity, and inspire private sector confidence, complemented by accommodative monetary policy. Therefore, prolonged high interest rates may, surprisingly, provide a tailwind for the stock market.