Politics Do Indeed Impact Interest Rates and Borrowers
We have another eleven months of campaign rhetoric, posturing, clashing personalities, and hearing the results of hundreds of polls. Whether you’re a Democrat or a Republican, this can be very distracting, to say the least. Some would say paralyzing. Regardless, as an industry we are focused on helping borrowers, or in the case of vendors, helping companies help borrowers. So what can we expect for borrowers leading up to the election of 2020? Unfortunately bonds, stocks, and the economy can be impacted by a single tweet. But we will do our best!
On the day President Trump was inaugurated in January 2017, the DJIA stood at 19,827. Roughly 11 months later, the president signed into law the Tax Cuts and Jobs Act (TCJA) which, among other things, cut corporate income taxes from 35 to 21 percent. Over roughly that same period, in anticipation of and because of these tax cuts, the DJIA increased from 19,827 (January 20, 2017) to 26,071 (January 21, 2018), a surge of 31 percent.
Although past history does not indicate future performance, Finance 101 tells us that this roughly 36 percent drop in Federal corporate taxes would, when coupled with average State corporate tax rates of roughly seven percent, increase overall corporate after-tax earnings by roughly 25 percent; and, assuming that the price-earnings ratio (P/E) of the market remained unchanged, cause each of the major stock market indices to increase by this same 25 percent. So roughly 80 percent of the 6,244 increase in the DJIA occurring over the president’s first year in office can simply be explained by the reduction in the Federal corporate tax rate.
Over the first three quarters of 2018, the DJIA fluctuated within a relatively narrow range. Then, in the fourth quarter, there was a sharp 16 percent drop in the Dow resulting from the president’s declaration of a tariff war, mainly with China, and fears that a world-wide recession was possible. Since then, the DJIA has run up 20+ percent and recently has traded about 27,000 as fears of an escalating trade war with China have abated.
Equities (stocks) don’t drive interest rates, but the same factors influence both. Fears of a recession prompted the Federal Reserve Open Market Committee to reverse its previous course of gradually raising interest rates and begin lowering rates, causing the 30-year mortgage rate to drop from nearly 5.00 percent in November 2018 to 3.50 percent at the end of August 2019, now hovering around 4.00 percent. As every lender knows, this sharp drop resulted in a resurgence of mortgage origination volume, especially refinances.
From Wall Street’s perspective, the pessimistic scenario is that the Democrats win the presidency and both houses of Congress. If that happens, it is highly likely that corporate taxes will be raised to their pre-Trump levels, or even higher, resulting in a 20-25 percent decline in the DJIA and other major indices as after-tax corporate earnings decline proportionately. This is simply a reversal of the 25 percent increase in the market that occurred as a result of the Trump tax cut.
Every underwriter knows that a 20-25 percent decline in stock values, as well as other financial assets, will eat into down payment money and impact how much of a down payment a homebuyer can afford. It will remove some potential clients from the market. For others, it will affect how expensive a home they will buy. And a sharp drop in the stock market typically affects consumer confidence even though the states of the stock market and the economy do not go hand-in-glove. A decline in consumer confidence is never good for homebuying.
Are originators looking for lower rates, predicting their path is a series of coin tosses. Remember that interest rates were at historic lows during Obama’s second term, when the corporate tax rate was at 35 percent. Higher taxes are nearly impossible if President Trump is reelected. If a Democrat is elected president but Republicans retain control of the Senate, a tax increase is highly unlikely. If we have a Democrat as president, and a democratically controlled Congress, then it very well may be the actual Democrat elected: There is a big difference between Michael Bloomberg and Bernie Sanders.
To state the obvious, a lot can happen in the next eleven months. The fact that the stock market is strong, or at least not falling, is telling us that Wall Street does not believe that the Democrats can win both the presidency and Congress. And that may a very good thing for interest rates if you like them where they are now.