Perhaps the biggest uncertainty facing the market today is the future of Fed policy, and more importantly, the future trajectory of interest rates. When the Fed floated the tapering idea, they essentially told the bond market they were backing off their full commitment to a negative interest rate regime. With bond market participants having to fend for themselves, it has been a rocky ride back to normalcy, and it’s still not clear what normalcy is.
On May 13, with the 10-year yield still below 2.0%, I wrote in The Dark Side of QE: The Yield Curve Adjustment Process
"Whether you believe the Fed has successfully manipulated the yield curve or not, just the fact that they are in the market means no one really knows where Treasuries should trade. For this reason, we don’t know where asset prices should trade. However, it seems we are about to find out, and I think it is going to be a very uncomfortable process.
"I don’t think equity investors appreciate how the market will go about re-pricing from a 2.0% to fair value. It might be 2.0% or 4.0% or somewhere in between. We can make some assumptions based on historical relationships to consumption growth and inflation, but nevertheless, the market is not likely to take a smooth trip to get there and the price swings could be significant."
Needless to say this adjustment process has indeed been very uncomfortable for bond market participants, and the scars run deep. Once the Fed reneged on their commitment, the yield curve was free to trade, and now the bond market is looking for equilibrium. The question now is where we go from here. What is normal?
All else equal, interest rates find equilibrium between the supply of and demand for money. At a minimum, the demand for money can be thought of as nominal GDP, and lenders will supply money at a fixed rate of return where they are compensated for that nominal growth rate (real growth plus inflation) which is interest rate risk premium plus defined credit risk premium. The inflation risk premium is a function of the term structure of the loan, or put more simply, the mighty yield curve.
On the surface, interest rate equilibrium is a very simple concept, but in practice every day in the bond market, it’s quite complicated. Bond market participants employ a lot of leverage and must make big-money long term decisions in real time. These decisions thus have immediate and long term consequences.
Due to these high stakes, the bond market, left to trade on its own devices, is remarkably efficient. For example, when interest rates shot higher in May and June, the 10-year went straight to 2.74% where it peaked on the July 5 NFP employment release. I was curious where this yield measured against the average yield since the 2008 financial crisis. Would you believe me if I told you that the average yield on the 10-year between June 2008 and June 2013 was 2.75%?
Treasury Yields 5-Year Average
With the bond market open to trade the 10-year it immediately reverted to the 5-year mean. Not only did the 10-year revert to the mean, but the 5-year went to 1.60% versus a 5-year mean of 1.65%, and the 30-year went to 3.75% versus a 5-year mean of 3.75%.
This is not what we are told. We are told the bond market is controlled by the Fed and the market is discounting the Fed tapering purchases in September. We are told the Fed is going to stop buying bonds in 2014 and start raising interest rates in 2015. We are told the bond market is a bubble and that interest rates are going to spike. Some even suggest long term interest rates are going back to 5.0% or worse. In reality, the bond market is finding equilibrium. Interest rates are reverting to the mean.
The mean isn’t just the average yield over a set period of time. Interest rates find equilibrium where the supply and demand for money meet, thus the mean is the average of this equilibrium over a period of time. With or without the Fed, the 10-year yield is going to the interest rate level that discounts the future growth rate in the demand for money.
In fact, just as the average 10-year yield over the past five years is 2.72%, so too is the average growth rate of personal consumption at 2.8%. Personal consumption is the biggest contributor to GDP. This is not a coincidence.
Currently the supply of credit inside the banking system is massive. Depositories are flush with lendable cash with loan-to-deposit ratios at the lowest in decades. Bank liquidity portfolios are also near records currently with $2.6 trillion in available-for-sale securities according to the Fed’s H.8
On the other hand, the demand for credit as measured by the growth rate in NGDP and personal consumption remains soft. There is a close correlation with these growth rates and the growth rate of loans and leases on commercial bank balance sheets, and while the economic data is monthly- and quarterly-lagging, the loan data is reported weekly.
Last week the Fed’s senior lending officer survey
claimed that credit demand was strong because credit conditions were easing. Does this make any sense? If the demand was so strong, why are lenders lowering the price? It stated:
"In particular, a moderate fraction of domestic respondents reported having eased their standards on C&I loans, and moderate to large net fractions of such respondents reportedly eased many terms on C&I loans to firms of all sizes. Most banks that eased their C&I lending policies cited increased competition for such loans as an important reason for having done so."
Aha! Increased competition is too much credit capacity chasing too few borrowers.
How can interest rates rise in an environment where the supply of credit dwarfs its demand? Conceivably the Fed could raise interest rates, but lenders could lower them because the stock of lendable cash exceeds the demand.
Friday’s H.8 data showed total loans and leases to be $7.323 trillion for year-over-year growth of 2.75%. Over the same period a year ago, loans were growing at 5.0%. Since April, when the bond market started unwinding, the QE discount loans have only grown by $22 billion and are flat over the past three weeks. These growth rates are consistent with the trends in NGDP and personal consumption, so it will be important to monitor the developments in the commercial banking system for bond market direction.
The bond market works. If the Fed would get out of the way, the market would price equilibrium accordingly. For argument's sake, let’s assume the Fed funds rate was at 1.0%, PCE inflation was 1.5%, and nominal GDP was 3.0% similar to today. In that scenario, all else equal, you would expect the 10-year at 3.0% and the 2-year at 1.5% with the term structure of the curve discounting a 1.5% inflation premium.
If the demand for money were weak at that level, the inflation premium would fall and the yield curve would flatten in order to provide accommodation. The Fed might consider lowering the funds rate to help raise the inflation premium. If the demand for money were strong, the inflation premium would rise and the curve would steepen in order to reduce accommodation. The Fed might consider raising the funds rate to help lower the inflation premium.
Bond market participants will calibrate long term interest rates based on the carry provided in the yield curve that is a function of the inflation premium. When inflation risks are higher, long term bond investors will command a higher term premium, raising rates; conversely, when inflation risks are low, these investors command less compensation for term and will lower yields.
Wall Street strategists who rely on Fed guidance for interest rate forecasts have been obliterated by this move in yields. These same strategists are now trying to recalibrate their forecasts based on when the Fed tapers and by how much. This is futile. The Fed’s control over the long end of the curve was largely psychological, and once they broke the confidence, they lost control. From here on out, the curve is in search of equilibrium.
In their Q2 letter
to investors Lacy Hunt and Van Hoisington lay down the law:
"The effect of each of the quantitative easings was the opposite of the Fed’s intentions. During every period of balance sheet expansion long rates rose, yet when securities purchases were discontinued yields fell. The Fed cannot control long rates because long rates are affected by inflation expectations, not by supply and demand in the market place."
Bingo! I agree, and this gives credence to my discount theory I put forth in QE Not Working Out as Planned, but Hey, I'm Just a Caveman Economist
back on July 8:
"I subscribe neither to the stock nor flow theory. I have put forth that it is the QE (inflation) discount that governs bond yields and asset prices. The QE influence was found in the real interest rate that was a function of the inflation premium.
With no inflation the line between real and nominal growth is blurry. Sure we can celebrate real growth of 2% but with little inflation that growth is also nominal. The demand for money is nominal and so are interest rates. The mean reverting bond market is looking for this equilibrium where supply finds demand and as it stands today at this stage of the cycle the sell side is still looking for buyers."
As I implied last week, the baby boomers are driving this bus, and what looks like a cyclical decline in the growth rate of consumption is more likely secular. If that is the case, the demand for money should remain subdued and the supply of credit capacity should keep a lid on bond yields for the foreseeable future.