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Awash in Liquidity, Part 2: The Long-Term Consequences of Falling Interest Rates

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There are going to be unintended effects that we can't yet discern, but there are some issues that we already know about.

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In the first installment of this two-part series (Awash in Liquidity, Part I: Why Interest Rates Are Falling), I discussed how the world has come to be knee-deep in liquidity.  As a consequence, interest rates, as seen through US 10-year Treasury yields, have surprised most pundits.  Since the start of 2014, rates have fallen significantly with the 10-year falling from 3.00% to 2.50%  (as of late May).  There are clearly going to be unintended consequences that we can't yet discern, but there are some issues that we already know about.

Tool-less Fed

The first concern is that, over the last five years, the Fed has destroyed the tools it has used for the last 100 years to carry out monetary policy.  Reserves in the banking system are now 34 times the level that is "required."  So, raising reserve requirements doesn't appear to be viable.  Selling assets from its balance sheet (open market operations) to reduce reserves would require an undoing of about $2.6 trillion before bank reserves would become an effective tool to control bank lending or the growth of the money supply.  And, the Fed as the "lender of last resort" simply doesn't make sense in a world awash in liquidity.

The creation of the Fed in 1913 was in answer to the need for there to be a liquidity provider or lender of last resort after several severe financial panics culminating in the Panic of 1907.  The Fed was created in 1913 to be available to liquefy eligible collateral during periods of financial stress, and, of course, the Fed would charge those banks an interest rate (the "discount rate") for doing so.  And, in the financial crisis of 2009, the Fed did exactly this, by liquefying bank assets (taking them as collateral against a loan or line of credit) that no other private party would buy.  In today's world, because the Fed has created more than $2.6 trillion over the past five years, it would be hard to fathom the need for more liquidity.  Money is cheap, and clearly almost any large institution can get it, even those with junk ratings. (Note, however, that regulatory considerations have limited small businesses and consumers access to this pool of money through traditional banking channels -- perhaps partially explaining the sub-par economic recovery.)

Experimental Tools

So, how does the Fed unwind all of this?  How does it actually raise interest rates when the appropriate time comes?  Today, it doesn't appear that the Fed actually knows exactly what it is going to do, nor can it model, with any precision, what the impacts will be of some new tools with which it is currently experimenting. 

Here are two such non-traditional experimental tools: 1) The Fed now pays .25% on bank reserves.  If it thought that the economy was heating up and wanted to discourage bank lending, it would have to raise the rate it pays on such reserves. 2) A variant of this has the Fed entering the "reverse repo" market with non-bank financial institutions, like hedge funds or money market funds.  Through reverse repos, the Fed gives one of these funds collateral from its swollen balance sheet in exchange for some of the cash that this non-banks fund holds.  At the end of the contract period, the trade is reversed.  The Fed gets back its collateral, and the hedge fund or money fund gets back its cash plus interest (i.e., the hedge or money fund has become the "lender").

Think about this!  Both the payment of interest on bank reserves and the payment of interest to the money or hedge fund is just the opposite of what the original Fed legislation of 100 years ago contemplated.  Instead of the market paying the Fed interest for the Fed to provide liquidity, the Fed is now paying interest to the market in order to reduce the tons of liquidity the Fed created over the past five years.  One thing is for sure: There are bound to be unintended consequences of the use of the experimental tools. Here are some possibilities:

  • If the reverse repos became the main policy tool, they could very well destabilize, or at least cause significant volatility in the interbank Fed funds market.  A destabilized Fed funds market would have huge implications for the $12 trillion of  interest rate swaps, derivatives, and other contracts tied to this market.
  • There are other long-term implications of a world awash in liquidity. The clear expansion and recent acceleration of income inequality has been supported by monetary policy that has fixated on the "wealth effect."  Zero interest rates and trillions of dollars of money creation benefits those on Wall Street (hedge funds and large financial institutions that can borrow at 0% and then leverage) and those with significant investible assets (rising stock prices and home values).  Meanwhile, zero interest rate policies penalize seniors and those living on a portfolio of fixed income investments.   A long-term zero rate policy forces these people to "stretch" for yield and duration.  And, when interest rates do rise, these investors will be hurt the most, both by the impact of falling bond prices (interest rate risk) and from a return to the mean of failure rates of these junk rated companies (CCC- to C-rated bonds fail at a rate of close to 45% per year when recessions occur).  So, a zero rate policy benefits the wealthy, and hurts the middle class.
The reality is that there are no real plans to reverse the bloated balance sheet.  According to NY Fed chief Dudley (in a May 20 speech), the discussion inside the Fed now excludes any concept of selling assets from its portfolio.  Such an admission means that the Fed has realized that it has destroyed its traditional tools, and only has those experimental ones.  Prepare for volatility and unintended consequences.

Editor's Note: Dr. Robert Barone is a Mangaging Partner / Portfolio Manager of Universal Value Advisors.
No positions in stocks mentioned.
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