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Vince Foster: The Markets Are Not Ready for Rise in Short-Term Interest Rates


Markets are smarter than you think; prices don't just wait around for policymakers to tell them where to go.

There's a lot of speculation as to the outcome of this week's FOMC meeting and whether the Fed will taper asset purchases. Perhaps more importantly is this week's expected confirmation of Janet Yellen as the next chair of the Federal Reserve. Ms. Yellen is well respected as an economist and it's generally thought that she will continue the status quo of Chairman Bernanke's policy.

In March of this year Yellen gave a speech titled Challenges Confronting Monetary Policy that provided her view of how current monetary policy is working toward achieving the Fed's mandate of maximum employment in the context of price stability. The message is clear -- stimulate spending:
By lowering longer-term interest rates, these asset purchases are expected to spur spending, particularly on interest-sensitive purchases such as homes, cars, and other consumer durables.

I see the currently available evidence as suggesting that our asset purchases have been reasonably efficacious in stimulating spending. There is considerable evidence that these purchases have eased financial conditions, and so have presumably increased interest-sensitive spending.

However, even if the interest rate channel is less powerful right now than it was before the crisis, asset purchases still work to support economic growth through other channels, including by boosting stock prices and house values. The resulting improvement in household wealth supports greater consumption spending.

When I read this and think about how economists believe monetary policy can better improve employment conditions by stimulating consumption, I can't help but think of that classic Saturday Night Live character played by Steve Martin, Theodoric of York, the Medieval barber.
Intro by Don Pardo: In the Middle Ages, medicine was still in its infancy. The art of healing was conducted not by physicians, but by barbers.

Theodoric: Unfortunately, we barbers aren't gods. You know, medicine is not an exact science, but we are learning all the time. Why, just fifty years ago, they thought a disease like your daughter's was caused by demonic possession or witchcraft. But nowadays we know that Isabelle is suffering from an imbalance of bodily humors, perhaps caused by a toad or a small dwarf living in her stomach.
Theodoric's remedy for all ills is bloodletting. Enter the drunk played by Bill Murray who, after consuming too much mead at the festival for the vernal equinox, was hit by an ox cart and sustained two broken legs.

Theodoric: You'll feel a lot better after a good bleeding!

Drunk in agony: But I'm bleeding already.

Theodoric: Say, who's the barber here?

The Medieval barbers who practice medicine by bloodletting remind me of today's economists. These economists have immense power and utilize theories and methods that are widely followed yet scientifically unproven. They act like they know what they're doing, but no one really knows if what they're doing works -- participants just trust that it does. Like the barber giving a good bleeding in order to provide pain relief, economists believe if the Fed can just stimulate spending, jobs will be created.

The problem is the Congressional mandate and the economists nominated to execute the policy. Why do we appoint economists to run a banking system? Why not appoint bankers to run a banking system? Think about their different objectives.

Economists are focused on the top line: money supply, aggregate demand, the unemployment rate, inflation, and output. Bankers are focused on the bottom line: net interest margin, efficiencies, return on assets, return on equity, and compounding book value.

When an economist makes a loan, he wants to see money velocity as a means to an end regardless of collateral damage. The economist wants to see a spending multiplier, which he assumes will create jobs, which will create more velocity. The economist utilizes long-term costs to achieve short-term gains. For the economist, it's quantity, not quality.

When a banker makes a loan, he wants a risk-adjusted return on his equity capital. The banker wants to maximize his net interest margin with minimal non-interest expense, which will create earnings, which will create more equity capital, which will provide funds for future loans. The banker utilizes short-term costs to achieve long-term gains. For the banker, it's quality, not quantity.

Put simply, the economist focuses on money and the banker focuses on capital. Recall my discussion of Dylan Grice's explanation of the distinction between the two in Monetary Policy Myths Dubunked:
Capital is not money. One is scarce, the other is infinite.

As stock markets blink green on more QE supposedly making us all more wealthy, the developed world is saving less than it has at any time since World War II.... Capital comes from savings, and the policy of cheap credit with its inflation of time preference has encouraged spending, not saving. Scarce capital is growing ever scarcer. One day, the price of capital will reflect its underlying scarcity, because one day it must..

We need a new central bank regime with a different mandate. Instead of focusing on the short-term benefits of stimulating consumption, we need our central bank to focus on the long-term benefits of stimulating savings and investment.

This maligned mandate is evident in Robert Dugger and Angel Ubide's theory of a structural trap that in 2004 examined the Japanese deflationary experience and the implications for the central bank's response. He posits what would happen if the US were to enter a structural trap and the problems with the Fed's mandate (emphasis mine):
The Federal Reserve mandate is the most troublesome. The Federal Reserve appears to be more 'demand-oriented' with a mandate shaped by Keynesian views arising out of the 1930s depression and the 1970s recession and reflected in the 1978 Humphrey-Hawkins Act. If the USA were to descend into a structural trap, the FOMC would be under extreme and statutorily justifiable political pressure to do whatever necessary to support employment in the near-term.

Dugger's explanation of a structural trap is eerily applicable to the current state of the US economy. The cause of a structural trap is not insufficient-demand-driven deflation, it's excess-capacity-driven deflation. The prescription is not increasing liquidity to stimulate consumption, it's decreasing excess capacity by restructuring inefficiencies. Without a regime shift, the US economy will remain mired in a structural trap. We don't need more monetary policy, we need different monetary policy. The banking system has too much capacity and needs restructuring. This should start with the central bank's mandate.

It's pretty obvious that a restructuring of the central bank and a monetary policy regime shift is not in our near future. The Yellen regime will be the antithesis of radical, thus investors are going to continue to position for monetary policy that stays the course. However, it is possible that in 2014, the markets begin to reconcile the structural trap on their own.

Markets are smarter than you think. Prices don't just wait around for policymakers to tell them where to go; they will often take matters into their own hands. Just because the Fed is trying to distort price to achieve its objective doesn't mean that it can -- at least not forever. Potentially the markets will begin to reconcile the structural trap on their own. How might this unfold?

As I have said, the root cause of the structural trap is in the banking system, which is the result of too much credit capacity relative to the demand. Our banking system is too big relative to the size of the economy. One way excess capacity could be reduced would be if market interest rates begin to rise above deposit rates.

Bank Credit/NGDP

Bank Deposits Vs. Loans and Leases

Most assume this would need to be instigated by the Fed raising the funds rate, however it could be instigated by the market. For credit capacity to leave the banking system, short-term interest rates need to rise to a level that competes with deposit rates. If there is no credit demand, banks keep deposit rates low and the money leaves. If there is credit demand, banks will match market rates, thus raising the cost of funds. The marginal inefficient banks would be squeezed out of the market or forced to consolidate. Either way, banking-system excess capacity is reduced. This is going to happen, one way or another.

Absent a Fed rate hike, what could cause this?

This past year we found out that the very idea that the Fed would reduce the pace of increasing stimulus crushed inflation expectations and ignited a rise in real interest rates. This, in turn, strengthened the dollar. If this continues, the rising dollar will reduce the purchasing power of foreign investors, which on balance will reduce the foreign demand for Treasuries. This dynamic can be seen in the relationship between USDJPY and 5-year real rates and Japanese holdings of Treasuries.

Japan Holdings Vs. JPY Over 5-Year Real Yields

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 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. This position fades a necessary restructuring of excess capacity in the banking system. Is this a sustainable position?

As we look toward 2014 and position our portfolios, we need to keep two questions in mind: Will the Fed continue bloodletting the economy in a pursuit of short-term increased spending at the expense of long-term savings and investment? Or will the market begin to restructure the excess capacity in the banking system by raising interest rates to encourage long-term savings and investment at the expense of short-term spending? Everyone knows what Yellen will do, but no one knows what the market will do.

Twitter: @exantefactor
No positions in stocks mentioned.
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