With the U.S. economy having achieved lift-off momentum, the Federal Reserve has ended, at least for now, large-scale bond buying — better known as quantitative easing. Furthermore, the Fed is taking a big gulp and is working up its collective courage to move to interest rate “normalization,” if anyone can remember what that is.
The thinking is that by merely removing the Fed’s large-scale demand for U.S. Treasury bonds, those prices would revert to whatever private buyers will sustain. And with less demand and lower prices, we would get to the correspondingly higher market interest rates. If so, this would be the normalization of rates on autopilot, as no further Fed action would be needed.
That intuition is so strong that a recent Bloomberg survey of economists showed they forecasted not just higher interest rates for 2015 but also that the 10-year T-Bond yield would rise from its year end lows of near 2% back to the 3% level as it was in the beginning of 2014 (shown below).
Moreover, not only was this the economists’ consensus, but all participants forecasted higher rates in defiance of the multi-year downward trend, including last year. It is indeed a rare event when economists’ forecasts are not merely a trend extrapolation but rather based on deeply ingrained training and historical experience.
The intuition behind this forecast is, no doubt, based on the classical idea that absent a Fed intervention, market demand rests solely on the shoulders of motivated savers and with the bond sell-side being dominated by businesses that offer bonds up to the point at which their borrowing cost is just supported by investment returns to real capital.
For the sake of argument, let’s call this the Robinson Crusoe island world of finance. It’s quaint, uncomplicated by government actions and constraints, and all bond buyers and sellers are domestic investors. It is the veritable island economy without a central bank.
However, with the advent of globalism, government buying and selling, and regulatory manipulations of all sorts, market-determined interest rates have moved to a new setting. With the elimination of capital barriers, the global financial industry can now move capital across borders for many purposes and reasons and, in so doing, move U.S. financial prices. Of all markets that are not islands, it would be the U.S. Treasury bond market that is still the main holding for other countries’ external reserves and global investors’ go-to asset.
The U.S. 10-year Treasury bond is nearing a 2% yield, and while that is very low both in absolute terms and by historical comparison, it is much higher than similar 10-year government debt in a host of countries that matter.
With Germany at 50 basis points, Switzerland and Japan at 30 basis points, and even troubled Spain at 60 basis points, these countries make the U.S. 10-year T-bond’s 200 basis points very appealing, especially when the U.S. dollar is appreciating against other currencies.
And then there have been institutional developments and a regulatory framework that influences asset choice. Accumulated consumer savings now reaches the demand-side of bond markets via pension funds, banks, wealth managers, and insurance companies where interest rates reflect many categories of private risk. The one that stands out most is the fear of deflation taking place in Europe and Japan and with falling oil prices in many other places as well. This biases the demand toward fixed rate financial contracts in the strongest currency.
Bingo, dollar-denominated Treasuries win again.
And then there are other contortions to market demand for Treasuries when fearful regulators weigh the default risk of different assets in an institutional portfolio and assess a charge in the form of risk-weighted capital. And, as you might have guessed, U.S. government regulators assume U.S. Treasuries are absolutely riskless and, as a result, no institutional capital need be set aside for owning Treasuries as compared to private debt.
Well, the recent push for more stable and capitalized banks suddenly makes the U.S. Treasury asset class more desirable for regulated institutions even at extraordinarily low interest rates because U.S. Treasuries provide capital shields in addition to their puny interest rates. As a result depository institutions have added over $120 Billion to their portfolios in the last three years.
And then, as discussed last month, there are the central banks of the rest of world. They are lining up to buy U.S. dollars (and in turn U. S. Treasuries as a foreign exchange reserve) with their own printed currency. This is a bi-product of the “currency wars” for the purpose of depressing the relative value of their own currency in order to recapture lost global exports.
Just behind the official foreign government purchases are the foreign private investors that are sucked into US dollar assets as a result of the twin appeal of higher U. S. yields and the US dollar appreciation that is occurring relative to 31 currencies. None of this was ever seen in a Robinson Crusoe bond market.
And this phenomenon is likely to kick into higher gear shortly as the European Central Bank (again) reassures its constituents that it will have a QE of its own. It will be directed to Eurozone Sovereign bonds in the first instance, but with Euro domestic yields already so puny, the expectation of a Euro QE is already causing private investors to redirect their wealth away from Euro investments into higher yielding, dollar-appreciating U.S. Treasuries.
As you look up and down the line-up of players and motivations, interest rate normalization will not likely take place by the Fed simply sitting on the sidelines of the Treasury bond market. There are too many other sources of Treasury demand in this divergent, deflationary, regulated economic world causing T-Bond demand to wash up on our shores. Rising rates attained on autopilot, as a result of the Fed’s ceasing to be a buyer of Treasury bonds, will not be enough.
So then if rates were to return to historically normal levels, it’s likely to require not just a hands-off autopilot approach by the Fed but also that it enter the market as a seller of U.S. Treasuries (and if not Treasuries, then something else). That would be a reverse QE, if you will.
And it’s possible that the Fed doesn’t have enough 10-year Treasuries on its balance sheet to sell to drive the price downward in the face of these motivated foreign buyers. But it does have a larger supply of shorter dated Treasuries that can be sold. Additionally, by raising the rate that it lends to banks, it can drive short rates higher and pull some private demand out of the long-dated Treasury market, effectively leading to a yield curve flattening.
In general, it’s a good bite easier for central banks to drive bond prices upward by turning on the printing press and buying something in large enough quantity so long as they do not run out of paper and ink. But to directly lower prices of a financial asset, it needs a sufficient inventory of the item to sell.
There are other manipulations possible to push rates higher: the Fed could raise the cash requirement of commercial banks to take bank-allocated funds out of the treasury market and even force commercial banks to shrink their balance sheets. But this runs counter to all their efforts during the Great Recession and seems unlikely.
And then there is the new, interesting weapon in the Fed’s arsenal to raise rates: sell Federal Reserve debt. That would be a refinancing of the Federal Reserve’s liabilities side of its balance sheet. Sell Federal Reserve bonds that are paid for by Federal Reserve Notes (cash). But does the Fed have the statutory ability to sell Federal Reserve debt? Well technically no, but it has been engineered around to functionally do so.
The Fed has entered the “Reverse Repo” market, selling claims collateralized by its U.S. Treasuries holding, of which it has an abundance on its balance sheet. This end-run provides the same result, and the Fed has been running about $200 billion as an experiment of the technique. Allowing the Fed to issue bonds or interest-bearing debt is a novel idea to suck some of the cash out of the system, and it has finally come to fruition. In this complicated global world, it needed an additional instrument of market control.
So whether or not the market self-corrects to the Fed’s interest rate target, it can still achieve its objective. But it will not be Robinson Crusoe on autopilot.
The interest rate environment is not what it used to be in the good old days of a closed country home central bank monopolized game. Now there are other central banks effectively creating monetary policy in U.S. markets.
Achieving policy objectives in a global financial system is a far more difficult, multi-faceted problem when foreign flows, both private and governmental, offset the domestic policy dictates. The Fed is no longer all-powerful over U.S. markets.
Slow or chronically weak economies with deflation and with foreign governments hell-bent on achieving export share are causing financial spillover into the U.S. market that would be difficult to offset, leaving the future course of longer maturity Treasury yields a major question. Rising rates would depend on how determined the Fed is for normalization, even if it has to sell a lot of something to mop up excess currency.
Welcome to the Brave New World of domestic policy constrained by open global financial markets. Robinson Crusoe would hardly recognize it, and for that matter, many Fed Governors don’t recognize it either.
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