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Vince Foster: Rate Hikes or Not, the Federal Reserve Does Not Set the Cost of Credit


The Fed controls the cost to lenders of funding credit -- and that's a big difference.

Wednesday's non-event FOMC meeting turned into a forward guidance discounting disaster when Fed forecasts showed the committee expected a 1.00% Fed funds rate by the end of 2015. Then Janet Yellen brought forward expectations of the first rate hike, commenting that it would probably occur six months after the Fed finished QE, which is due to expire in October.

This revelation elicited a massacre in the belly of the yield curve with the 5-year Ttreasury off as much as 20 basis points (bps) before settling down 16bps. Despite the carnage in the Treasury curve, the real bloodbath was in eurodollars which price futures on the 3-month Libor rate; it closely tracks the Fed funds rate. The "green" and "blue" strips that represent 2016 and 2017 3M Libor dropped as much as 30bps. These were indeed historic one-day moves in prices that are supposed to exhibit low volatility.

The immediate spin from the financial community was both shock and hubris. Those who were long the Fed's forward guidance, namely Wall Street interest rate strategists, proclaimed a hawkish monetary regime shift. Those who were short forward guidance pounded their chest that the Fed was finally recognizing economic acceleration and wage pressures. My reaction: amateur hour.... My view was that participants were making a typical mistake -- they were interpreting the Fed's position flush as a re-pricing of a discount.

This violent move in short-term interest rates was easily predictable because as usual the consensus was focused on the wrong catalyst. I stated the following on December 16, 2013 in The Markets Are Not Ready for Rise in Short-Term Interest Rates:

As the Fed removes stimulus, inflation premiums are going to fall, the yield curve is going to flatten, and the dollar is going to strengthen. While everyone is sitting in the front end of the curve waiting on the tapering impact on the long end, the volatility could be in short rates. Conceivably, tapering is already discounted in long-term interest rates and most of the Fed action is going to be shifting from long end to front end. And it's the front that is more mispriced than the back.

The big story for 2014 could be a rise in short-term interest rates despite the Fed keeping the funds rate low. The market is not prepared for this. Friday [Dec.13] the CME reported that December 2015 "green" eurodollar futures (EDZ5) for 90-day Libor recorded the largest open interest in history at 1.246 million. This is a notional value of $1.246 trillion, presumably betting that futures pricing 90-day Libor currently around 1.00% is going to converge toward current spot rates around 25bps.

This position is short economic and market volatility. This position is long the Fed's forward guidance and ability to hold short-term interest rates lower for longer... Is this a sustainable position?

My rhetorical question was answered last Wednesday, and the "green" eurodollars were ground zero. But it didn't stop there. On Thursday there was record volume in eurodollar options with a vast majority of the volume focused on June 2016. So the market went into last week heavily long December 2015 eurodollars at around 1.0% implied Libor, anticipating lower interest rates for longer, and ended the week heavily short June 2016 eurodollars at 1.75%, anticipating higher rates and sooner.

On Friday (March 21), Wall Street strategists piled on the hawkishness and began raising their targets for long-term interest rates based on Fed rate hikes. As an example, economic perma-bear turned perma-bull David Rosenberg took the opportunity to issue rate forecasts into 2016:

Looking out to 2016, if indeed the Fed ends up taking the funds rate to 2.25%, a normal yield curve would place the 10-year very close to 4%... We are in the 3-3.5% camp for the Fed funds rate by the end of 2016, which by the way would still be 50-100 basis points south of "neutral." That would place the peak in the 10-year note somewhere in a 4-4.5% range.

Despite this renewed bearish stance on interest rates the long end the curve was trading very strong and by the end of the day the 30-year had rallied a full point pushing the yield back to 3.60% which was unchanged on the week. In fact the 30-year yield is 10bps below the level that was reached at the peak in July 2013 when the tapering unwind was at maximum stress.

Rosenberg, like many other strategists and participants, is making a classic analytical mistake. The Fed does not control the cost of credit, the market does. The Fed controls the cost to lenders of funding credit, and that's a big difference.  The long end of the curve does not price off the FF rate; it prices off the supply and demand for money -- namely, mortgage credit (see For Interest Rates, Mortgages Are the Tail Wagging the Dog).

Interest rates are not low because the FF rate is at zero but rather because there is a massive supply of credit capacity in the banking system and little demand. Mortgage purchase demand is at levels not seen since the mid-1990s, and banks are flush with deposits. The banking system's aggregate loan-to-deposit ratio is at 75%, a level not seen since the 1970s. This is one reason the velocity of money remains stagnant.

Loan-to-Deposit Ratio Vs. Velocity of M2

On Tuesday (March 18) the Federal Home Loan Bank (FHLB) in my district of Dallas lowered term money on 12-month advances by 4 bps to 23 bps and down from 33bps at the beginning of the year. It dropped again on Thursday to the lows of the recovery. The FHLB is where banks can draw term money to make loans, and this lowering of term money is indicative of weak demand for credit.

FHLB 12M Advance Rate

Not coincidentally my bank learned that Wells Fargo (NYSE:WFC) in East Texas had dropped 3-month and 6-month term CD rates by 4 bps to 1bps. We saw similar levels at Bank of America (NYSE:BAC). Wells Fargo and BofA, being the largest mortgage lenders, conceivably are seeing a drop in mortgage demand and thus do not need money to fund these mortgages. By taking CD rates to 1bps, they are saying they do not want money at all. This drop at Wells Fargo corroborates the drop at the FHLB and is an actual indication that banks don't want money, even at zero cost.

With interest rates at zero there is little demand from banks to extend credit. So if the Fed were to raise this cost, the banks would be forced to pay for something in the future that they already don't want for free today. Think about that. Can you name anything that is currently free of charge that you don't need or want but may be forced to pay for in the future? Banks are about to be put in that position.

There are only two reasons to tighten monetary policy: when credit is loose or when inflation is high. Neither of these conditions are in place. I can see how the Fed wants to move away from  the zero-bound, but with credit demand already weak and inflation benign, it's hard to see the incentive to take the funds rate much above the 1.5%-2.0% rate of inflation.

I have said it many times before: The bond market is not stupid, and it is not waiting around for the Fed to tell it what to do or where to price the cost of credit. The long end of the curve is telling us that the demand for credit is weak. Absent a significant pickup in economic activity, a material increase in the cost of funding for weak credit demand will be met with a flat and possible inverted yield curve at a very low level.

Twitter: @exantefactor
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