Scotiabank On Treasuries & The Fed: "You Got Some 'Splaining To Do"

Via Scotiabank's Guy Haselmann,

There’s Something About Treasuries

Treasuries are still cheap.

The FOMC statement says that “even after employment and inflation are near mandate-consistent levels” the committee may keep “the target federal funds rate below levels” viewed as normal in the longer run.  Whenever I read this, I think of Desi Arnaz screaming, “Lucy! You got some ‘splainin’ to do!”  If the Fed has achieved its mandated goals, then why would it still need to have a less than normal policy rate level? Yellen has not attempted to answer this question, but thinking about the potential reasons unveils some interesting possibilities.

At the moment, the median forecast for the long-run neutral rate (in the Fed’s Central Tendency Forecasts) is 4%.  I wonder if the FOMC is warning that it will be lowered at some point soon.  Such a move would surely cause a swoon in Treasuries.  The 4% level has been the median forecast, because it’s widely believed that ‘normal’ policy rates veer toward nominal GDP (typically near 4%, i.e., 2% real GDP plus 2% inflation).


However, it is possible that a new world order requires a neutral policy rate that is much lower.  If this is true, then Treasuries do not look nearly as expensive as pundits claim.

The combination of high debt, globalization, aging demographics, and technological advancements, should continue to act as structural headwinds for the foreseeable future conspiring to suppress growth and inflation (and thus require low rates).

Lower expected inflation means the burden of repayment is greater in real terms.


Moreover, governments and corporations have taken advantage of the Fed’s ZIRP to significantly expand their total amount of outstanding debt.   Borrowing to consume today means debt repayments and interest charges will reduce future consumption.  (Debt servicing becomes a problem when loans cannot be rolled over, or if payments are hindered by a decline in a debtor’s revenue.)

There have been numerous studies by Fed research departments and academics that try to determine the long-run neutral Fed Funds rate.  Due to such high levels of ZIRP-induced outstanding debt, the price of money and servicing costs of that leverage will be critically important going forward to financial markets as well as being vital for a healthy economy.

Therefore, the extraordinary measures that have been taken, and that will need to be taken, by the Fed are partially a function of trying to prevent an Irving Fisher-type of debt deflation.  He theorized that, when over-indebtedness exists, debtors and/or creditors will ultimately become concerned and trigger a chain of consequences.

Debt Deflation


At the April press conference, Yellen indicated that the FOMC expects the economy to return to full output.  However, she also said that “headwinds from the crisis have taken a long time to dissipate and are likely to continue”.  Which is it?  She talked about other headwinds such as tight credit for many families, tight fiscal policy, and weakness in the global economy.  Is she opening up the possibility that interest rates will have to stay at permanently low levels to have any shot of getting the economy (and keeping the economy) at full output?

Job creation has also been a central focus of the Fed.  The 2008 crisis exacerbated longer-term challenges in labor markets: particularly, globalization, technological change, and international trade.  Failure to invest enough in skill re-training is reflected in elevated long-term unemployment and declining wages.

Falling wages and inflationary expectations worsens economic performance by encouraging consumers and investors to delay spending, and by redistributing income and wealth from higher-spending debtors to lower-spending creditors.  It might be worth re-visiting Larry Summer’s remarks about secular stagnation.

Treasury prices do not care if Q4 is around 4%.  Economic data matters little for the time being.  Prices are being driven more by positions, relative value, and future Fed policy.  Markets know the Fed is ending QE.  What it really wants to know is the terminal Fed Funds level in the new ‘world order’.  In the meantime, stay long.

As mentioned recently by Pimco, “if the neutral policy rate was 2% instead of 4%, then bonds, instead of being artificially priced, would be attractively priced”.  I agree.   Admittedly, there are enormous costs to such financial repression, but a discussion of those costs is a topic for another day.

“And the sand-castle virtues are all swept away in the tidal destruction, the moral melee.”  -Jethro Tull