Twisting the Market

The Federal Reserve’s August 1 statement gave strong hints that the Fed will launch another round of bond purchases (QE3) in September unless the economy picks up. While the August 3 employment report showed an improvement, job growth is still slow, and the unemployment rate in July rose to 8.3%. Since the Fed has a “full employment” mandate, Fed Chairman Ben Bernanke may decide to go forward with more large-scale asset purchases (Treasury bonds or government-guaranteed mortgage bonds). In addition to QE3, we think the Fed has other technical steps it might consider, including tinkering with the 0.25% interest rate it pays banks for excess reserves. However, none of these steps would be powerful. Instead, the economic and market outlook will be increasingly dominated by November’s election and the tax increases scheduled for year-end. The Fed funds rate has been near zero for almost four years, unique in history. At the same time, the Fed has expanded its balance sheet by $2 trillion (to $2.9 trillion from $900 billion) through large-scale asset purchases during QE1 and QE2. It has also lengthened the duration of its assets during Operation Twist as it worked to push interest rates down toward zero for longer maturities. Real GDP has slowed year by year, to 1.75% so far in 2012 from 1.8% in 2011 and 2.4% in 2010. As the Fed “twists” (by selling Treasury bills and buying Treasury bonds), the buyback of longer-term Treasury bonds has pushed the effective maturity of Treasury’s marketable national debt down to 47 months. The Fed finances most of its long-term assets with $1.6 trillion of overnight funding from commercial banks while maintaining only $55 billion of equity capital. In effect, the Fed is operating as a giant, heavily leveraged speculator, borrowing short and lending long while ignoring the conflict of interest this creates when it sets interest rates. Treasury announced on August 1 that it is developing a floating rate note program. If Treasury increases its reliance on short-term funding, it further reduces the effective maturity of the national debt. A third round of Fed quantitative easing would do the same. This will add to the fiscal deficit when interest rates eventually rise back toward normal. Recent FOMC statements have projected very low rates for a long time: “The Committee currently anticipates that economic conditions… are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.” There’s speculation the Fed may extend this date into 2015 at its September 13 meeting, suggesting a highly distortive zero-rate era lasting over six years. In a recent congressional Q&A, Chairman Bernanke went even further. Discussing eventual rate hikes, he said: “It will be a similar pattern to what we’ve seen in previous episodes where the Fed cut rates, provided support for the recovery, and when the recovery reached a point of takeoff where it could support itself on its own, then the Fed pulled back, took away the punch bowl.” This shifts the Fed’s view toward an even longer period of market distortion than the 2014 date. The previous interest rate cycle saw a 4.75 percentage point cut in the Fed funds rate from December 2000 to December 2001 followed by “measured” or limited 0.25 percentage point rate hikes every six weeks in 2004-2006 (about 2 percentage points per year). In that episode the Fed didn’t take the punch bowl away fast enough. This contributed materially to the 2008 financial crisis, and it is worrisome that the Fed is basically saying it intends to repeat that same pattern. The longer the current monetary policy persists, the more the risk of unintended consequences and the greater the difficulty unwinding the distortions. Massive Monetary Policy Distortions The net result of current policy has been a massive and growing distortion of credit markets. The distortion is causing a weak and artificial environment and a progressive breakdown in the functioning of important financial markets. The value of loans outstanding in the interbank market has fallen to $10 billion from an $80 billion level prior to the 2008 crisis. Similarly, the value of loans outstanding in the Fed funds market (in which banks lend to each other with the Fed as counter-party) has fallen to $100 billion from a $400 billion level prior to the 2008 crisis. Once viewed as critical to efficient capital allocation, these markets will take time to rebuild when interest rates normalize. With the Fed a heavy buyer of longer-maturity Treasuries, the yield on a 5-year Treasury fell to 0.54% on July 24. Except in the highly-distortive monetary policy of the 1970s and the bubble policy of 2002-2005, the 5-year yield has generally tracked or exceeded nominal GDP growth, which is now running at 3.9%. The logic behind this is that a system of market-based capital allocation will tend to pay investors at or above the nominal growth rate. The large gap gives a measure of the credit market distortion. The Fed’s excess short-term liquidity stance is spilling to markets around the world, distorting them and exacerbating problems. Japan’s two-year yield is down to 9 basis points (U.S. at 0.23%.) In Europe, many interest rates are now negative, causing a new level of pain for savers. Switzerland’s two-year yield has fallen to a negative 42 basis points. On July 18, Germany auctioned 4 billion Euros in two-year zero-coupon bonds at a price of 100.106, meaning the investor pays over 100 Euros now and in two years gets back 100 Euros for a negative annual yield of 6 basis points. The Bank of New York said recently that it was considering imposing a fee on bank deposits in Europe. Due to the credit market extremes, the U.S. Treasury is exploring options for handling a negative yield in our auction system (meaning charging savers). Treasury currently sells bills at a “discount from par” and sells longer maturities with a positive coupon that is paid to the bond holder during the life of the bond after which time principal is returned at par. If U.S. yields move negative as Germany’s have, the new system could be thought of as a zero-coupon offering (Germany uses this terminology) or an extension of the T-bill system to allow Treasury to charge a “premium over par” for maturities above one year. The goal would be to allow lenders to pay say $101 today and expect $100 in two years. Treasury’s July 19 auction of 10-year TIPS (inflation-protected Treasury bonds) showed a negative yield of -0.637%, meaning the federal government is borrowing money at an annual rate of CPI inflation minus 0.6%. As a result, investors are having to lock in 10-year total pre-tax returns that are below CPI inflation, evidence of a massive market distortion. Growth Impact Five-year TIPS yields generally reflect the economy’s real growth prospects, yet they are now offering negative 1.25% per year real returns, a sign of either a massive monetary distortion or a very bad economic outlook. The latest GDP data show the massive shift in income underway in the economy toward government payments and corporate profits, and away from small businesses, sole proprietors, and dividends and interest earnings. In sum, the U.S. zero-rate policy and asset purchases are contractionary. By under-pricing credit, it has to be rationed — in effect, the regulators overseeing the banking industry impose a quota (financial repression) by assigning different capitalization requirements for different types of lending. As low rates are pushed out along the yield curve, capital is increasingly misallocated toward government and big corporations. This will show up in slower growth and less economic dynamism in coming years.