Last week in The Institutional Risk Analyst, my friend and former colleague from the Fed of New York, Richard Alford, opined on the Fed’s use of “quantitative easing” to help the U.S. economy. In “Double Dip Economy: Does Quantitative Easing Really Matter?,” Alford asks whether the Fed is actually taking effective action to boost the economy. He writes:
“It is unclear why proponents of quantitative easing or ‘QE’ inside the Federal Open Market Committee (FOMC) are confident that it will be the answer to our current economic woes. Many of the arguments and models linking QE to improved performance of the real economy are unsatisfactory… More importantly, the only available empirical analyses available suggest that QE, when employed in Japan, had little if any effect at all on GDP, inflationary expectations, or measured inflation.”
While many economists are worried about whether or not the Fed should increase quantitative easing, my concern has been and remains the toxic effect of the Fed’s intervention on what remains of the private financial markets. Fed officials and members of the Obama Administration wring their hands over individuals and companies saving too much, but perhaps they should ask why. It starts with zero interest rate policy.
The liquidity and market risk being created in markets by the Fed’s zero rate policy such as structured notes and OTC interest rate swaps should be all the argument needed to convince the Federal Open Market Committee to make changes to current policy and raise interest rates. Take an example.
The Fed is paying banks next to nothing to park $1 trillion in excess reserves deposited with the central bank. The Fed should drive rates for bank reserves down into negative territory, essentially penalize banks for not lending or investing in private assets. The Fed should also “suggest” very strongly that it is time for the large dealers to put some of these reserves to work in the market for mortgage backed securities and other private assets. See the prescient comment by Alex Pollock of American Enterprise Institute from May 2009 in this regard.
By imposing a negative interest rate on bank reserves of say 0.5%, the Fed would be signaling to banks that the party is over. Very quickly banks would take their cash elsewhere. As Alford notes and other risk managers know, assets move for price. But this is not to suggest that the Fed should be keeping interest rates low. Quite the opposite. As a growing number of analytics understand, the Fed should begin to manage up the target yield rate on short-term U.S. Treasury debt. This may sound like madness, but low rates are killing the U.S. economy and have created an interest rates trap for financial institutions and other fixed-income investors.
One of the things that most people do not understand about QE is that by purchasing massive amounts of government bonds and mortgage securities, and not hedging these exposures a la Fannie and Freddie, the Fed is removing equally massive amounts of duration from the fixed income markets. From an investor perspective, duration measures how much the price of a bond changes given a change in market rates. Duration is a measure of a bond's volatility, at least in normal markets. From the perspective of a borrower or issuer of securities, however, think of duration as the time value of money measured in weight.
When the Fed buys securities through QE, it is removing duration from the markets, pushing down yields and volatility. For a while this boosts the net interest margin (“NIM”) of leveraged investors such as banks, who are able to borrow at lower rates to fund current assets. As assets re-price to the low rates maintained by the Fed, however, NIM begins to disappear. Over the medium to longer term, think of duration and NIM as being linked, so obviously a sustained period of QE is bad for NIM. This is why NIM in the U.S. banking sector is starting to fall.
Let’s recall Inside the yield book: the classic tome by Sidney Homer and Martin L. Leibowitz, which created the science of bond analysis:
“The Macaulay Duration of any cash flow becomes large as interest rates fall. One might be tempted to conclude from this observation that very low interest rate environments can be very treacherous. When rates can only go up, and when the price sensitivity of any given cash flow is near its maximum, it’s a pretty toxic combination.”
Homer and Leibowitz wrote at a time when markets were artificially stable. Right now, the markets believe that equities are dangerous and bonds are safe, but the fact is that all financial assets have been rendered speculative by the Fed’s irresponsible pursuit of reflation via QE. Volatility levels indicated by major market indices are greatly understated and do not reflect the true degree of price risk facing all bond investors. In particular, banks which have used OTC derivatives and short-term funding to enhance NIM face major losses as and when QE ends and visible durations extend.
Over the next year, banks, retirees and other interest rates sensitive investors are going to see their cash flow fall further as zero interest rate policy drains the NIM from the dollar financial system. Not surprisingly, these same individuals and organizations are cutting expenditures to reflect falling cash flow on their investments. Could this be part of reason behind the retail flight from equities widely reported in the media? One of the smartest people I know, a retired Goldman partner, said this today in an email:
“I think the bond market is an error waiting to happen…The biggest buyer in the last 6 months has been the banks, but look at the price of JPM and BAC!!!! These guys think the Fed will stay at zero forever. They just bought a 1.36% 3 year note… Chris…if the price falls 1.36 points they lose all the coupon. Everyone from Grant to Rosenberg all think the long bond is going to 2%..they are nuts. Banks are losing commercial loans and credit card outstandings and replace it with TSY paper?????? Nuts.”
The Fed’s zero rate policy is feeding deflation by reducing the yield on all investment assets to below economic levels. And the huge price risk embedded in under-priced fixed income securities represents the next bubble in financial assets. This situation reveals and confirms yet again that there is no free lunch and also that they do not teach the real world rule of unintended consequences in economics class.
“It is not the cost of borrowed money that is stopping firms from investing,” notes my friend Richard Field, who argues that falling interest income to millions of American retirees is taking points off of GDP. “It is the lack of demand from the individuals who could previously afford to buy. Talk about a foreseeable negative feedback loop. The Fed apparently missed the real lesson of Japan.”
By keeping interest rates at zero, the Fed is forcing individuals and corporations to save more. If interest rates are zero, then savers must put away the terminal value of their required retirement nest egg, which is currently infinite. If short-term interest rates were 2%, that would require savers and corporate treasurers to save much less since interest rate compounding would help. Instead the big banks and mortgage giants such as Fannie and Freddie are milking the Fed’s zero rate policy as long as it lasts, while consumption and employment in the real economy literally implodes thanks to that very same Fed policy.
The answer? It is time for the Fed to declare the end of the crisis and raise interest rates.