By now you should have seen my post indicating I believe the Fed has already begun its third easing campaign. What the Fed has done is told us it would keep the Fed Funds rate at effectively zero percent through mid-2013, two years from now. This is one step short of ‘rate easing’, the term I am using to describe a Central Bank’s targeting a specific non-policy rate, a form of quantitative easing where the Fed targets price instead of quantity.
While rate easing and its cousin permanent zero might have some salutary effect in the short term, these policies are toxic to the financial sector and consumption demand. Likely, they will not spur the economy but lead to a deepening malaise.
Fed monopoly power
See, the Federal Reserve is a monopolist. It has sole control of the price of base money via its policy rate. The Fed sets the Fed Funds rate and the financial sector must accommodate this rate. But this is only true for base money which is an interbank market for overnight borrowing of bank reserves. The interest rate – that is to say, the price of money – for longer-term lending arrangements is set by the marketplace. For example, the Treasury bond market is the most liquid bond market in the world where buyers and sellers transact in much the same way they do in the stock market to determine the price and yield of Treasury bonds.
There is a connection to the policy rate, however, because any interest rate can be represented as a series of shorter-duration expected future interest rates.
“For example, say you know the 5-year rate by looking at the current on-the-run 5-year interest rate on Bloomberg. Then, all you need to calculate all the expected future expected 3-month rates are quotes on U.S. zero-coupon bonds known as Treasury STRIPS. They are quoted in the Wall Street Journal daily.”
So in a very real sense, the Fed exerts a dominate influence on the entirety of American credit markets. The policy rate affects the entire term structure of interest rates. Clearly though, interest rate policy expectations become more variable as the term structure lengthens and other factors come into play. The Fed plays a dominate role but the market sets the price of 30-year treasuries based on the collective view of expected future policy rates and the risk associated with that policy path.
Defining rate easing and permanent zero
The Treasury market is pretty well defined. In the two- and three-year space, yields aren’t moving for the next two years. The question becomes 10- and 30-year bonds. Investors need to decide between the value of a 30-year U.S. Treasury and bonds of countries like Canada and Australia that have slightly higher yields. We want to make sure those higher-yielding countries are safe. We consider places like Germany, Australia and Canada “clean dirty shirts,” in that they are safe and their bond yields, while low, are still more attractive than Treasuries. If the global economy tips into recession, the safest place to be is in the cleanest dirty shirts. Our best idea therefore is a 10-year Australian or Canadian bond. A 10-year Canadian government bond yields 2.5%. A 10-year Aussie bond yields 4.5%.
In making his investment outlook thesis in Barron’s this past weekend, Bill Gross was telling us that the Fed has anchored his interest rate expectations. “In the two- and three-year space, yields aren’t moving for the next two years.”
When I talk about ‘rate easing’ or ‘permanent zero’, I define them as distinct concepts. With permanent zero, the Fed comes out and says something like:
“The Committee currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate”
With rate easing, instead of defining a period of policy accommodation, the Fed comes out and says explicitly that it will not let interest rates on Treasuries rise above a specific target level and they define the Treasury maturity.
Last month I speculated that the Fed would move to QE3, but only when the economy was in or near recession. I felt the Fed would avoid terms like ‘quantitative easing’ for political reasons and, therefore, avoid outright rate targets until the economy was in recession.
“My sense is that this will not be called quantitative easing or credit easing or anything like that. Those terms are dead because they are now politically radioactive. But operationally, the policy will be the same. This time the Fed will target price instead of quantity…
“P.S. – The Fed is likely to soft peddle this policy change… The Fed will want to stay to the shorter end so as not to risk its balance sheet by moving out the curve with interest rate caps. However, there could be internal dissent, so the Fed could start off by signalling to the market that it will conduct what I have been calling ‘permanent zero’.
“But the Fed was pretty aggressive in my view. two years is a very long time. To me, this is as close as you’ll get to full-blown rate easing – and I said so on Sunday.”
Toxic for savers
Unfortunately, the low nominal rates of rate easing and permanent zero are toxic over the long-term. We know that from Japan where these conditions exist.
“Remember, Japanese government debt to GDP is 200%. It’s not like the Bank of Japan would actually want to raise rates. As I wrote in March:
- Japan’s long-term rates reflect private portfolio preferences as determined by expected future interest rates… So 10-year rates are low because expected inflation and expected future short-term rates are low.
- Japan’s Debt to GDP is over 200%, meaning that any uptick in expected future short-term rates due to inflation would be disastrous in terms of interest due.
- So, to avoid this scenario, Japan must leave short-term interest rates at near zero percent or risk the crowding out of public spending that higher interest payments would entail. Only if the debt to GDP ratio declines significantly can it relax this stance.
“So, this means the Japanese elderly have to save a lot to make ends meet in a retirement where long-term yields are minimal. Some have turned to theft. (See update at the bottom recanting this somewhat)
“Question: should we expect a different outcome in the U.S.? The last post I wrote on the housing and foreclosure crisis highlights a CBS video about declining house prices and a foreclosure epidemic in the U.S. Isn’t this an environment that lends itself to permanent zero? And If long rates are largely determined by expected future short rates, the longer short rates are at zero percent, the lower long rates will go. That’s toxic for bank interest margins.Look at 77 bank as an example.”
Toxic for banks
I’ve already written this up so I’ll just quote from the piece:
“I am starting to take the view that the Fed is reducing net interest margins. Back in 2008 and 2009, US banks benefited from low rates as their net interest margins were huge. For the first quarter of this year, JPMorgan Chase even had a negative net borrowing rate of interest while it made 324 basis points in net margin. They were effectively paid to borrow, leading to a more than 3% interest rate spread on loans. That’s a great story. Can it last, though?
“The short answer is no. As the long end of the yield curve comes in due to either QE or what I have been calling permanent zero (PZ), as zero rates become a permanent state of affairs, interest margins have compressed. Rates will compress even more the longer rates stay at zero percent because the expected future rates will start to come down (see here on bootstrapping the yield curve).
“What’s more is that PZ will be a big problem in a Shiller double dip scenario because banks will be set up for huge loan losses despite recent under-provisioning. Meanwhile they will have no way to make it back on net interest as long rates come down in a recession while short rates remain at zero percent, killing net interest margins.
“This is the problem with QE and PZ money: it works in the short run, but is toxic in the longer-term. Now if liquidity was the real problem for banks, then the banks will have enough capital to ride through this. They will recover as many did in the early 1990s during the last banking crisis in the US.
“If solvency is the banks’ problem, QE and PZ will be toxic.”
To me, the probability of a Shiller double dip seems even more likely than it did last year and of course that has been my baseline scenario for two years now. If we do get this second recession, Fed policy will be toxic because the yield curve will stay flat just as it has in Japan.
When recession hits, over-indebted consumers will be forced to delever aggressively and consumption demand will crater. This will invite an even more aggressive policy response from the Fed which could include the purchase of municipal bonds among other more drastic measures. It will be, as FT Alphaville puts it, “Desperate measures for *really* desperate times”
The bottom line is this: easy money will not create sustainable growth.
Update 2145ET: John Hempton rightly pointed out the following about saving in Japan’s deflationary environment to me by e-mail saying the implication that the low returns turn old people in Japan to theft is just flat wrong:
In Japan there has been about 4 percent DEFLATION for twenty years. That means that cash-in-the-bank yielding zero has a 4% post tax real return. 4% post tax real is better than the US stock market (one of the better ones in the world) for the whole of the 20th century. It’s way better returns than most Americans earn (though less than they think they can earn)…
The point is that in a true smash-em-up liquidity trap the savings at zero percent are perfectly rational. There is no need or desire to chase yield because 4% post tax real is about as good as you get. Anywhere.
In a deflationary environment this works, yes, because it is about the real return. So, John’s right – point taken on Japan (although 4% CPI deflation since 1990 doesn’t sound right). I would say, however, an eroded social safety net is very much still a factor. In the US, the situation is different, however. The point holds for savings and the soon to be eroded social safety net. If the US moves from the present mode of financial repression into outright deflation, my points about savers being robbed won’t hold and John’s points will be more important.