Most everybody knows that prices are determined by the “Law of Supply and Demand”.  If supply of a product decreases while demand increases, then buyers will “bid up” the price.  Likewise, if demand increases more than supply increases, buyers will again “bid up” the price.  However, if supply increases more than demand, buyers will not “bid up” the price and will expect discounts, driving the price down.

The same is true for borrowing money.  If there are ample funds to lend, the price (interest rate) will be less, in order to get the funds loaned out.  If lenders don’t have ample funds to lend, they will raise the cost of borrowing (interest rate).

The stock market has been volatile for the last few weeks because borrowing costs have increased.  Is that because the demand for borrowed funds has increased or that the supply of funds to lend is reduced?  The answer is YES!

The U.S. economy is roaring, with GDP growth around 4%.  As the economy grows, businesses need to borrow more.  Thus, the demand for available funds to borrow is increasing.  This is perfectly normal and is healthy.

At the same time, three things have happened this year to reduce the funds available for borrowing or the buying of bonds.  First, the expected federal government borrowing has increased from $600 billion to $900 billion this year, due to the tax cut.  (This is sometimes called the “crowding-out” of non-governmental borrowers by raising interest rates too high for non-governmental borrowers.)  Second, the Fed continues to reduce their balance sheet.  You’ll recall their balance sheet swelled to $3.5 TRILLION as they bought bonds of all sorts, during quantitative easing (QE).  They need to reduce those holdings, but every time they sell one of those bonds, the amount of money to buy new government bonds goes down.  Thus, reducing the Fed’s balance sheet drains funds from the market and puts upward pressure on long term interest rates for everybody.  Third, some of the largest buyers of government bonds are Europeans, who have benefited from the “easy money” of the European Central Bank (ECB).  Just as the Fed eventually stopped quantitative easing in the U.S., the ECB has announced the end of QE in Europe.  This reduced European money available to buy US government bonds.  The combined effect of these three causes has raised 10-year Treasury rates from 2.8% to 3.2% — sounds small and insignificant, but it is not, and it has scared our stock market, because nobody knows if the rates are going to 3.5% or higher.

So, why doesn’t the Fed do something about this?  Because the Fed controls only short-term interest rates and has little control over long-term rates.  Nobody really controls long-term interest rates except the “market.”

It is widely believed that rising interest rates cause stocks to fall.  Consider this — interest rates have been rising for two years even though the stock market is reaching new highs.  Rising interest rates can initially be viewed as positive when reflecting healthy economic conditions.  However, there is some inflection point or neutral point after stocks suffer from higher interest rates.  For most of my life, we have used a “rule-of-thumb” that long-term rates over 5% or more will crush stocks.  Yet, after such a long period of exceptionally low rates, the neutral point has probably fallen somewhat.

Because Congress is utterly useless, in controlling their own borrowing, the only governmental agency with the cajones to do the right thing is the Fed, and I hope they will temporarily stop reducing their balance sheet.