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The Critical Connection Between Confidence in the Federal Reserve and US Interest Rates

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Remember, mood drives changes in laws, not the other way around.

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The long-term effects

I don't mean to beat this first point to a pulp, but there are two other very important (and I believe woefully underappreciated) long-term consequences of increasing confidence in the Federal Reserve and lower interest rates.

The first is low corporate and consumer default rates. Overleveraged borrowers' ability to repeatedly refinance debt at lower and lower interest rates has significantly reduced bank and bond investor credit defaults. But please appreciate how at this point, banks, banking regulators, the rating agencies, and bond investors all believe that the loss rates of the past twenty years are "normal." I can't emphasize enough how much this benefits both corporate spreads and consumer borrowing rates today, which in turn benefits...

Finally, and on a related note, without the perception of stable interest rates and consumer credit losses, the securitization of consumer loans would have been impossible. And having witnessed it firsthand, I can't emphasize enough what this meant (and continues to mean) for consumer spending, automobile manufacturing, and, of course, housing.

US rule of law and the rights of creditors – I believe a second long-term confidence component to last year's low in interest rates is the perceived stability and strength of the US bankruptcy system. While hundreds of thousands of companies failed and millions of consumers filed for bankruptcy from 1981 to 2012, there was a clear and compelling framework for creditors. Rights were well-documented and the court system regularly reaffirmed those rights. What's more, particularly in consumer lending, bankruptcy laws were rewritten to further benefit creditors.

The fact that lenders took -- and most still take -- the system for granted says it all about our level of confidence. But please appreciate what a tailwind that level of certainty was for the credit markets.

Asset allocation – A third long-term confidence component to the decline in interest rates from 1981 to 2012 was modern portfolio theory and the empirical work done by folks like Brinson, Hood, and Beebower. Bonds mitigated risk and boosted long-term returns. As more investors adopted formal asset allocation guidelines, institutional portfolio management all but guaranteed that there would be natural buyers for bonds, irrespective of price.

But note what happened at the bottom of the banking crisis in 2009. Large numbers of institutional investors bought bonds -- particularly high-yield bonds -- rather than equities, due to the belief that bonds offered equity-like returns with superior creditors' rights should bankruptcy then occur. For many institutions, bonds became a significantly overweighted asset class; needless to say, those overweights grew as bond prices ripped higher as perceptions of the economy improved and confidence in the Fed soared.

Finally, I believe there were two shorter-term elements that helped pushed bond prices to record highs.

Prolonged weak confidence – While institutional investors overweighted bond positions in 2009 based on thoughtful risk/return frameworks, retail investors, having sold equities at the bottom, began to move into bonds due to continuing low consumer confidence. Having lost significant money in equities twice in less than ten years, bonds were about as far out on the risk spectrum as retail investors were willing to go. But please appreciate, too, how as long-term interest rates continued to fall, their decision was validated. Like their institutional brethren, they, too, earned equity-like returns.

But consider how, as long-term interest rates were then crushed, these same retail investors then turned to riskier and riskier bond alternatives. Bonds were safe, so why not go further and further out on the credit and maturity spectrum?

Finally, please consider what low confidence combined with central bank liquidity meant for bank balance sheets. As the Federal Reserve charts below show, bank treasurers piled into fixed income and even 30-year mortgage loans at the very peak in prices in an effort to stem net interest margin compression coupled with weak organic loan demand.






The relative strength of the US – As to the particular summer of 2012 peak in bond prices, I think Greece and the European debt crisis all but put the cherry on the top. As the best house in a bad neighborhood, the US debt markets attracted global flows. With secession/break-up rumors swirling, 1.40% 10-year Treasury rates were better than any kind of euro-denominated debt.

And again, I can't emphasize enough how important the global perceptions of the Federal Reserve were at that time. In many ways, the US was the best house in a bad neighborhood because the Fed had been the most aggressive national central bank during the 2008; Chairman Bernanke knew the Great Depression and how not to repeat it again; and, relative to the ECB, the Federal Reserve was unencumbered by bickering national political leaders.

In the storm, the US was the best place to seek refuge.
Position in SH and JPM.
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