Submitted by John Aziz of Azizonomics [11]
They Don’t Call Them Real Interest Rates For Nothing
A reader asks:
I had a chat with a wealth management advisor from a well-known financial institution, who was bullish on short duration bond funds due to ”the FED’s complete control with regards to suppressing and maintaining short-term interest rates.” I was wondering if you had any articles on what factors (other than the FED, if any) contribute to and continue to suppress short-term interest rates in the US and what potential facts could reverse this trend?
The Fed exerts a great deal of control over nominal interest rates. While the Treasury and Fed maintain the pretensions of an open and transparent market where national and international demand for government securities is generated organically, the reality is that the Fed can monetise anything that the market rejects to achieve any desired nominal interest rate. This applies equally to all securities; though the Fed allows the 10-year and 20-year to float more freely, Operation Twist shows the Fed can control the nominal yield curve if they so wish.
The Fed’s power to control nominal rates is shown quite clearly — as the economy remained in a liquidity trap following 2008, the Fed implemented policies (QE, Twist, ZIRP) to make treasuries expensive ostensibly to discourage hoarding and stimulate aggregate demand (and — so helpfully — keep the Treasury’s interest burden low):
[12]
What the Fed cannot really control is the rate of inflation, the other variable that makes the real interest rate, and the key variable in determining whether Treasuries are a winning or losing bet.
Here’s the real rate on the 2-year over the same period:
[13]
On computing the graph, my jaw almost hit the floor; real interest rates on the 2-year today are higher than they averaged during the boom years up to 2007. The Negative-Interest-Rate-Policy [14] isn’t so new at all. All the Fed’s accommodative action has been almost meaningless — it has hardly reduced the real interest rate at all from the pre-crisis norm (although the most recent spike into positive real territory is the strongest argument for imminent quantitative easing that I have seen in a long time — Krugman, Avent, DeLong, Yglesias, take note).
On the other hand, there are clear patterns in real rates over longer periods. Here’s the 2-year, 5-year, 10-year since 1980:
[15]
But this doesn’t prove that the Fed can really exert control over real rates. However the graph suggests very strongly that Greenspan took his eye off the ball in terms of real interest rates; as real rates continued to fall, Greenspan wasn’t raising nominal rates [16], as might be expected of a Fed chairman looking to prevent bubble-formation.
Simply, the idea that short-duration bond funds are a good bet due to “the FED’s complete control with regards to suppressing and maintaining short-term interest rates” is completely wrong on every level; they’ve been a losing investment in real terms for most of the last 5 years, and the Fed is determined to keep it that way. The Fed’s control over nominal interest rates is precisely the reason that I wouldn’t want to invest in treasuries; not only has it consistently made bonds into a real losing proposition, but it also creates a good deal of systemic currency risk. Simply, the Fed will — in the pursuit of low-rates — monetise to the point of endangering the dollar’s already-under-threat [17] reserve currency status. The only things that would turn bonds into a winning proposition — rising interest rates, or deflation — are anathema to the Fed, and explicitly opposed by every dimension of current Fed policy.
Of course, creating artificial demand for treasuries to control nominal rates has blowback; if the buyers are not there, the Fed must inflate the currency. Hiding inflation is hard [18], so it is preferable to a central bank that old money is used; this is why Japan has mandated that financial institutions buy treasuries, and why I fear that if we continue on this trajectory, that the United States and other Western economies may do the same thing [19].