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Why "The Fed Is In A Bind" - Scotiabank Explains

Tyler Durden's picture




 

Via Scotiabank's Guy Haselmann,

Own Long Treasuries

Several weeks after recommending a core long in 10-year and 30-year Treasuries in front of 2.40% and 3.25% respectively, I endorsed adding to those positions in my July 17th note “Bonds are Back”. 

 

Today, I would again add to those positions.  I believe 10’s will take out 2.00% by the end of September and test the year’s low when it breaks below 1.75% before the end of the year (10’s/30’s curve will flatten further). Long Treasury yields are driven by expectations of global growth and inflation which I expect will both stay on a downward trajectory for the remainder of the year regardless of what the Fed does. (I also expect USD strength, commodity weakness, widening credit spreads, and an equity sell-off.)

The Fed is in a Bind 

The intention of Fed policy over the past 30 years has been to self-correct business cycles into a ‘steadier state’ by easing interest rates into weakness and hiking them into strength. Unfortunately, there is political-asymmetry between easing and hiking which has resulted in the stair-stepping of official interest rates down to the zero lower bound.

Interest rates that are held lower than the ‘natural or normal rate’ (discussed in a moment) may have short-term benefits, yet there are longer-term costs that aggregate and eventually need to be addressed. These costs are then typically dealt with by lowering interest rates even farther away from the normal or natural rate.  Eventually the Fed ends up worsening the very business cycles they intended to smooth out.

The fact that rates today have reached zero means that the day of reckoning is quickly approaching, because monetary policy has reached the practical limits of what it can do.  Thus, the multi-decade credit era is coming to an end.

  • Sustainable growth is better for an economy than boom-to-bust cycles.  A marathon is won by a distance runner with a steady pace, not by a runner who alternates between sprinting and walking and risking injury.

Credit-based consumption is unsustainable.  US corporate issuance has broken a new record in four successive years. According to David Stockman, the amount of total credit outstanding (household, corporate, government and financial) has expanded by over $50 trillion in the past 30 years, while GDP has expanded by only $13 trillion.  In addition, while the whole world has gotten significantly more indebted, it also has terrible demographics to contend with.

The S&P over this same 30-year period has returned just over 6% adjusted for inflation, while real GDP has been just above 2%.  The market has risen 3 times faster than national output in real terms. A sizable equity market correction could happen merely because the bubble-blowing machine is losing its wind.  Certainly, the magnitude of the monetary and debt-based fuel that has powered equities in the past will not be available going forward.

An economy runs most efficiently in the long-run when the price of money, i.e., the official interest rate, does not veer too far from the level where savings and investment can find a clearing price (i.e., the natural rate of interest).  This is called the Wicksellian Differential, i.e., the difference between the money rate and natural rate of interest.  It postulates that when the natural rate is higher than the money rate, the disequilibrium will drive credit expansion.

Destructive behavior occurs when the price of money is set too low.  When money is cheap, the lure of easy profit becomes too enticing.  Money is borrowed for speculation.  Since the cost of money falls, borrowed money can be deployed into ever less-productive assets.  The objective of borrowed money is to merely outperform one’s borrowing costs.

Low rates also increase longer run uncertainty, impacting the ability to determine the return of a fixed investment.  This is one reason why share buyback, and mergers and acquisitions, have surpassed capital expenditures, and research and development.  Investment in the future is too low.

Low rates lead to asset price inflation, which moves valuations further from their underlying economic fundamentals. As asset prices move higher, they can be used as collateral to push asset prices even higher. However, when the bust eventually unfolds, a negative wealth effect occurs. When the economy and asset prices reverse the effects of the boom, all of the accumulated debt built up during the period of central bank accommodation still remains.  The Fed has basically borrowed from the future to improve today.

This damaging circumstance is a direct result of rates being held too low, allowing for the inefficient use of capital. Furthermore, speculation from cheap money to boost asset prices creates the illusion that everything is better than it really is.  This can lead to complacency and poor decision-making.   Cheap money also provides the opportunity for over-capacity and over-production which places downward pressure on prices.

There is lopsidedness in the setting of interest rates.  The benefits of an interest rate cut to the economy likely works differently when it is at 3% than when it is near 0.25%.  It also works differently when it’s been at some level for two quarters, versus the same level for seven years.  In addition, the absolute level of rates says little about whether the lender is being adequately compensated and incentivized to lend.  In any case, discussion of these factors would complicate Fed communication and even call into question their fallibility. Thus, they are not discussed.

Nonetheless, I do not believe the Fed’s current dogma that low rates today are necessary for long-run growth or to trigger consumer inflation.  How can it, when it is leading to over-capacity and massive global indebtedness? Low rates also allow insolvent companies to continue to exist through the ability to re-finance.   Bad companies should be allowed to fail.  Creative destruction is beneficial in the long run.

Bottom Line

Fed policy today and over the past several years may prove to be counter-productive in the long-run.

Sustainable growth is best served by an interest rate where capital is deployed efficiently.  The long-run consequences of policy during the past few years could easily mean lower long-run potential growth and inflation.  Today’s consumption and market speculation was paid for with huge amounts of accumulated debt.  Tomorrow’s revenues will have to be steered toward servicing that debt.  Future revenue will also have to replenish the deficient levels of R&D and infrastructure investment of the past few years.

China

The Chinese Yuan devaluation will increase currency war tendencies that have subtlety existed in the past few years.  Beijing is trying to balance increasing exports with limiting capital outflows.  Unfortunately, outflows happen quickly, while exports develop more slowly over time.  The devaluation will destabilize China’s financial problems further.  If Beijing was really in control as some suggest, then officials would not be in the position of having to implement so many extreme policy responses.

This action further complicates the FOMC’s argument.  More importantly, it will hurt US corporate earnings and cause a decrease in expectations for global growth and inflation, which will, in turn, benefit long Treasuries. 

“The highway’s jammed with broken heroes on a last-chance power drive” – Bruce Springsteen

 

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Tue, 08/11/2015 - 11:53 | 6414021 Haus-Targaryen
Haus-Targaryen's picture

She won't raise it.  She'll delay it again. 

Tue, 08/11/2015 - 12:10 | 6414087 mtl4
mtl4's picture

Don't be so sure...........I wouldn't be betting against it at this point.

Tue, 08/11/2015 - 12:16 | 6414109 negative rates
negative rates's picture

I say once again, the Fed will DEFAULT before raising rates.

Tue, 08/11/2015 - 12:42 | 6414254 Mr. Bones
Mr. Bones's picture

http://monopoly-game.net/Classic_Monopoly_Rules.html

 

 The Bank collects all taxes, fines, loans and interest, and the price of all MONOPOLY properties which it sells and auctions. The Bank never "goes broke". If the Bank runs out of MONOPOLY money it may issue as much more as may be needed by merely writing on any ordinary paper.

Tue, 08/11/2015 - 12:47 | 6414282 KnuckleDragger-X
KnuckleDragger-X's picture

It's good to be the king, but even better to be their banker.....

Tue, 08/11/2015 - 13:36 | 6414561 Kprime
Kprime's picture

I don't know, the King's printer is in the sweet spot.

Tue, 08/11/2015 - 13:21 | 6414494 JRobby
JRobby's picture

Is this the first large bank admitting that this is the end of the credit supercycle???

I think it is!

Tue, 08/11/2015 - 13:40 | 6414512 mtl4
mtl4's picture

I agree except where USD hegimony is concerned (not to mention the brewing pension funds crisis they are creating) and maintaining that is far more important than any rise in interest rates or any effect they might have on the budget (just look at what Volker did back in the late 70's when the budget sextupled).

 

Guess I'm not alone......

http://www.zerohedge.com/news/2015-08-11/did-chinas-devaluation-crush-ye...

Tue, 08/11/2015 - 12:20 | 6414137 BullyBearish
BullyBearish's picture

Re: S&P, it really was "Sell in May"...

Tue, 08/11/2015 - 11:55 | 6414031 bnbdnb
bnbdnb's picture

Not at all. 60 and 100 year notes are going to be the new norm.

Tue, 08/11/2015 - 12:03 | 6414062 FrankieGoesToHo...
FrankieGoesToHollywood's picture

At least until the 150 year note becomes available.

Tue, 08/11/2015 - 12:22 | 6414154 tarsubil
tarsubil's picture

Weren't there forever notes in England at one time? Maybe a couple still around?

Tue, 08/11/2015 - 12:49 | 6414289 KnuckleDragger-X
KnuckleDragger-X's picture

"Heat death of the universe bonds" will have a great rate...

Tue, 08/11/2015 - 11:58 | 6414045 thunderchief
thunderchief's picture

Once again,  fed interest rate talky talk is exactly that.

A waiting game and delay tactic while the world goes negative interest rates and trash their currencies. 

When the time is ripe, the fed will also wade into negative rates and a cashless society. 

Count on more fed talky talk, and maybe a paltry .?? interest rate move as a show.

Then it's a March down the ant hill, at the base of the mole hills, at the base of the foothills, at the base do the mountains for Janet and her fed rate hike army.

Tue, 08/11/2015 - 11:59 | 6414046 Mr. Bones
Mr. Bones's picture

People criticise businesses because they're allegedly all about short term gain, record moral hazard from the banking sector aside I think it's abundantly clear that government has also fallen into this trap.  Which begs the question: if government is supposed to be the alternative then what's the actual problem they intend to solve by subverting capitalism's response to failure?

Tue, 08/11/2015 - 12:08 | 6414082 NotApplicable
NotApplicable's picture

Elimination of useless eaters, of course.

Tue, 08/11/2015 - 11:59 | 6414050 buzzsaw99
buzzsaw99's picture

this sentence sums it up nicely: The objective of borrowed money is to merely outperform one’s borrowing costs...

Tue, 08/11/2015 - 12:01 | 6414054 arbwhore
arbwhore's picture

Just in time for Congress to pull the limit on the debt ceiling this fall. 

Tue, 08/11/2015 - 12:18 | 6414086 astoriajoe
astoriajoe's picture

debt ceiling. Haha, I remember that. 

That's good theater. Put that into an election cycle and you get the makings of oscar worthy performances by the leading performers of our political and economic system.

Tue, 08/11/2015 - 12:27 | 6414178 Dr. Engali
Dr. Engali's picture

Politics, theater for the ugly......, and stupid.

Tue, 08/11/2015 - 12:37 | 6414221 arbwhore
arbwhore's picture

Makes a nice distraction for the masses.

Tue, 08/11/2015 - 12:04 | 6414066 Dr. Engali
Dr. Engali's picture

These people are so unimaginative. The fed still has NIRP in its back pocket.

Tue, 08/11/2015 - 12:20 | 6414133 negative rates
negative rates's picture

Right, cause the fed is always wrong, but NEVER in doubt.

Tue, 08/11/2015 - 12:06 | 6414077 In.Sip.ient
In.Sip.ient's picture

Heres a thought...

 

Everyone has heard the FED wants to raise rates.

 

I'm here to tell you they will lower rates sometime

before X-Mas.  No real choice at this point. Virtually

all major and minor central banks have lowered rates

and devalued.  Any pressure to raise US rates has

essentially desolved into a need to "adjust" the

US$ FX position.

 

Tue, 08/11/2015 - 12:16 | 6414107 Tasty Sandwich
Tue, 08/11/2015 - 13:33 | 6414552 Kprime
Kprime's picture

Chinese finger trap

Tue, 08/11/2015 - 12:21 | 6414141 David Rockefeller
David Rockefeller's picture

"The intention of Fed policy over the past 30 years has been to self-correct business cycle" is equivalent to saying:  "The intention of Mafia policy over the past 30 years has been to alleviate crime in the USA."  What hogwash.  The private Fed exists for one--and only one--reason: Fleece the American and world people.  At the end of their successful scheme, we'll have no power and wealth and they will have both.

Tue, 08/11/2015 - 12:27 | 6414175 Arthur Schopenhauer
Arthur Schopenhauer's picture

First there is the 2% Chinese Yuan devaluation that sent markets into a nosedive. 

 

Then there is the news that Iran is pumping the most oil since 2012.

But Iran is not the only country opening the pumps. Iraq, Saudi Arabia and the Arab Emirates are following suit.

As a result, the West Texas Intermediate Crude Oil futures price is down over 4% today.

Declining oil prices? 

Yuan devaluation? 

Oh my...what will The Fed do???

Tue, 08/11/2015 - 13:32 | 6414545 Kprime
Kprime's picture

I bet they raise rates....

Wait,  I bet they lower rates....

Wait, I'm broke, will you take a check?

Tue, 08/11/2015 - 12:27 | 6414179 gregga777
gregga777's picture

To the American People! Save America:

(1) Destroy the privately-owned Federal Reserve System;
(2) Destroy the POSEDs* and POSERs**;
(3) Destroy the rich who are waging Class Warfare against YOU;
(4) Destroy the fraudulent, credit-based money and banking system;
(5) Destroy the system of rigged elections that the rich use to keep their Uni-Party POSED and POSER whores in office;

*POSEDs—Pile Of Stinkin' Excrement Democrats
**POSERs—Pile Of Stinkin' Excrement Republicans

Tue, 08/11/2015 - 12:38 | 6414230 orangegeek
orangegeek's picture

Guy Haselmann has an incredible grasp of the obvious.

 

If rates go up, the US economy gets crushed - the 3 month yield is currently at 12 basis points - a 14 month high.

 

Curve flattening is here and this is going to hit the retail banks shortly.

 

The Fed is a market maker and forecasts yields like the rest of us - and then tries to short term influence them - short term only.

Tue, 08/11/2015 - 12:46 | 6414272 Grandad Grumps
Grandad Grumps's picture

Bad banks need to be allowed to fail. Crooks need to go to jail.

That power of creative destruction does not exist in the US. Currently the worst thrive and are protected by force.

Tue, 08/11/2015 - 13:19 | 6414481 Clowns on Acid
Clowns on Acid's picture

Yo GranDaddy - Where were you in 2007/08 when Hank Paulsen was saving his own wealth and then Goldman Sachs in that order ?

Tue, 08/11/2015 - 12:49 | 6414293 MrBoompi
MrBoompi's picture

Why would anyone think any corporation owned by the billionaires who fund these corrupt politicians would be allowed to fail?  Don't you know how capitalism works these days?

Tue, 08/11/2015 - 12:53 | 6414318 Thisisbullishright
Thisisbullishright's picture

First thing I ever learned in my first economics class...

"There's no such thing as a free lunch".

I truly believe it all comes back to that very simple classic statement!

 

Tue, 08/11/2015 - 12:58 | 6414343 Arthur Schopenhauer
Arthur Schopenhauer's picture

The highway's jammed with broken heroes on a last chance power drive

Everybody's out on the run tonight but there's no place left to hide

Together Wendy we'll live with the sadness

I'll love you with all the madness in my soul

Someday girl I don't know when we're gonna get to that place

Where we really want to go and we'll walk in the sun

But till then tramps like us baby we were born to run

[Janet]

Tue, 08/11/2015 - 12:59 | 6414349 SoDamnMad
SoDamnMad's picture

"it will hurt US corporate earnings"    What earnings?  The accounting earnings tricks or the stock buy-backs. Just keep laying off until inventory blows the back wall out of the warehouse. 

Tue, 08/11/2015 - 13:03 | 6414376 Consuelo
Consuelo's picture

 

 

There were those who said there would never be a QE-2.   Then 'never' an Operation Twist.    Then double-never, QE-3.   Then... Rates were certain to rise by spring of 2015.   Then June.   Now September...  As we can see, this little bit of theatre can go on for quite a long time.    Credibility certainly isn't lost in domestic U.S. markets - the Fed can make them swing wildly anytime it speaks.   But many geopolitical changes have occurred since 2008 - outside the control of U.S. monetary authorities.   And that is where the action is soon to begin.

Tue, 08/11/2015 - 13:06 | 6414398 mendigo
mendigo's picture

Actually, the Fed is financing the creation of bad companies which shit the bed for the good companies. Its why the rich get richer.

Tue, 08/11/2015 - 13:21 | 6414491 Clowns on Acid
Clowns on Acid's picture

Devaluations are like rats... there is never just one.

Tue, 08/11/2015 - 13:25 | 6414522 exartizo
exartizo's picture

...yo'ure preaching to the choir Guy.

ZH'ers have known this stuff for years.

Where have you been, ...on some deserted island somewhere?

Tue, 08/11/2015 - 15:54 | 6415305 Vin
Vin's picture

"The intention of Fed policy over the past 30 years has been to self-correct business cycles into a ‘steadier state’ by easing interest rates into weakness and hiking them into strength."

Are you fucking stupid??  Everything that the Fed does is to enrich the banking families and help usher in poverty to the USA.

Someone tell this guy that our current dollar is worth 4 cents compared to a pre-Fed dollar.  Jackass.

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