Dear Fed, Stop with Rate Hikes and Reduce Balance Sheet
We think that the Fed should focus on steepening the yield curve. That keeping short term rates constant while focusing on balance sheet reduction would benefit the most people and the economy.
Effectively, it is time for the Federal Reserve to put balance sheet reduction on the front burner and move rate hikes to the back burner. The Fed continues to discuss rate hikes AND balance sheet reduction and that focus just seems wrong at this stage. They should shift their entire focus to balance sheet reduction for now and leave the overnight Fed Fund rates alone.
This would require a shift in their current messaging, but I think is a crucial shift for the economy and markets to thrive.
Short Term Rates Are Already Punitive
The Fed has raised rates 4 times since late December, taking the Fed Fund Effective Rate from 0.125% to 1.125%. That doesn’t seem like a lot – but it is having significant impact on costs of funds already, with little justification on the inflation front.
Overnight Fed Fund Effective Rate Since 2009
With quarterly hikes, borrowers have barely had time to digest the impact of the previous hike on their cashflow before the next hike hits.
12 Month LIBOR Has Been Hit the Hardest
The spread of 12 month LIBOR over Fed Funds has increased, in part because of expectations of future rate hikes, but also in part due to structural changes in the money market which are impacting LIBOR.
The combination of the Fed hiking short term rates while structural changes to money markets were being implemented, disproportionately hurt borrowers benchmarked to 12 month LIBOR. This really had a dramatic effect on Home Equity Lines of Credit and ARMS, which directly impacted the cash flow many American families, who rely on this form of borrowing.
This differential has decreased recently, thankfully, because money markets have been adapting to the new rules. But it will take time to undo the damage caused for borrowers who saw their rates reset higher long before the Fed’s hikes kicked in.
The bottom line is that the Fed should have been more cognizant of the risk of hiking Fed Funds while money market rules were adapting – changing the traditional relationship between Fed Funds and LIBOR – especially for the longer-term rates.
In any case, all borrowers tied to LIBOR, especially 6 and 12 month LIBOR, have been forced to overpay for loans from early 2016.
This has directly affected homeowners and student loan holders and credit card debt. These additional payments required by these types of borrowers have likely slowed spending as there is quite simply, less disposable income. Lenders received for money, but I would argue that most of the benefit of higher LIBOR accrued to the biggest financial lenders who could access capital markets or just simply didn’t raise rates on deposits by as much as rates rose on the money they lent.
Many of us question why the economy doesn’t seem as robust as the job data would suggest?
The simple answer, is that many American families, particularly middle-income families and students in the workforce (the lifeblood of the economy) have seen their ability to spend suffocated by not only the rising cost of debt – but also because of the fear of further rises in borrowing cost.
It is time to give borrowers some time to adjust to higher rates – and to take advantage of flatter yield curves – while they continue to exist.
Underwhelming Inflation Allows The Fed To Avoid Hikes
The Fed has not achieved their inflation targets. Former Fed Governor Kocherlakota was one of the first Fed Governors to point out that they should focus on averages and that after years of being below target, the rational conclusion was to run above target for long periods of time to get long run averages closer to the target.
As you can see from the following chart, the Fed has failed to achieve their inflation target, by almost any measure in the past 6 years.
PCE and CPI versus Fed Funds
The Fed’s favorite measure of inflation – the PCE deflator (the yellow line in the chart above) hasn’t been above 2% since 2012. Don’t forget, that when Yellen wanted to ‘slow play’ rate rises she discussed as ‘average target’ of 2%. I don’t mean to be overly harsh – but the only term to use for that sort of ongoing failure to achieve goals – even temporarily can only be described as failure.
Even feeling a bit generous and focusing on CPI, which has shown more signs of inflation than the PCE measure, it is still difficult to justify increasing rates at the front end of the curve.
CPI (the pink line) at least was briefly above 2%, but it has dropped and its multi-year average remains well below 2%. We could run at 2.5% inflation for multiple years without achieving a 5 year average without attaining the stated goal.
Which brings us back to Kocherlakota, who argued strongly that to increase inflation expectations, a key element that affects consumer behavior, the Fed needs to be shown as being willing to show commitment to their long term goals – rather than becoming overly concerned about a period or two of above target inflation.
They have failed to bring inflation up to their goal consistently (whether that is a goal we should really want is another matter entirely) so they're being cautious about nipping any growth in the bud.
At its most simple, economics states that hiking rates reduces inflation. Low and behold, that theory seemed to work, as inflation measures have slowed since they raised rates!
If the Fed truly wants to raise inflation and raise inflation expectations they need to be patient on raising rates.
Flattening The Yield Curve Has Only Made Matters Worse
The idea of lending long and boring short has become increasingly unattractive of late.
10 Year Treasury Yield versus 2 Year Treasury Yield
The difference between 10 year yields and 2 year yields is the smallest it has been in 6 years.
This flat yield curve isn’t helping regional and community banks who do derive some of their Net Interest Margin from the shape of the yield curve (I don’t think the yield curve shape matters as much for big banks).
There is currently a disconnect in the borrowing and lending of money in this country for smaller and midsize banks and companies. The shape of the yield curve makes it less attractive for these banks to lend money out on a longer term basis. Many companies that would benefit from longer term borrowing at reduced costs aren’t well serviced by big banks, so they cannot easily get that benefit.
The trade-off here should be easy – a zero sum game between borrowers and lenders – but that isn’t the case right now. So many regulations have gone into effect that it constrains bank activity. That regulatory constraint, combined with risk aversion has created a dichotomy meaning that borrowing and lending is no longer a zero sum game between the two parties. It has become a negative sum game as borrowers and lenders just don’t align at all in some cases, which reduces economic activity.
All savers have been impacted by this inability to earn money for extending duration (the problem is compounded by the fact that not only are interest rates low, but credit spreads are low too).
We addressed the concern that typical households, in their prime consumption days are being hit by relatively high short term borrowing costs, there is a different and equally important group that is being hit by flat yield curves.
Long term savers – retirees and pension plans immediately come to mind, are hit by the lower levels of income. Retirees who rely on income, and made decisions possibly decades ago based on now flawed assumptions on what the risk-free rate would be, have been hardest hit. Their disposal income is lower than they expected – reducing consumption. Many, as evidenced by the jobs data, are taking on new jobs or remaining in jobs longer than they used to – quite likely making it more difficult for younger members of society to enter the workforce.
Clearly someone has benefitted. The big beneficiary has been big corporations who have been able to tap the debt market. Total corporate debt outstanding has increased. If all of the borrowing was used to fuel growth, especially domestic growth, the trade-off between savers being hurt and companies benefitting would be balanced. There is strong evidence that over the past several years, much of the borrowing has been done to fund dividends or finance share buybacks – helping shareholders. That activity might be one reason so many investors remain concerned about the stock market – as there is a surreal element of borrowing to buy back stock – but it is logical for companies to do and benefits shareholders. The problem, is that the Fed seems to have given a lot of credit to the ‘Wealth Effect’ yet it seems that the wealth effect creates less immediate consumption than expected.
The bottom line is that flat yield curves, at least partially shaped by Fed holdings and ongoing reinvestment, has helped companies. But, it has disproportionately helped the large companies, particularly those with offshore cash hoards tap the markets and hasn’t translated into more robust borrowing for smaller companies.
At the same time, savers have been hurt, particularly retirees which has in turn changed the job market and spending patterns. It has also forced ‘yield chasing’ risk decisions. In an era of low yields and low credit spreads, investors have been forced to buy longer dated instruments or lower quality instruments to meet their current income needs – at potentially the exact wrong time.
Investors not being properly rewarded for the risk they are taking can have longer term repercussions and unlike the Financial Crisis where investors were making many bad risk/reward decisions of their own accord – the risk/reward relationship here has been impacted by Central Bank policy. They cannot take their foot off the gas, but it is time to start normalizing market function – slowly but surely.
Which Brings Us To 'Normalizing' Markets
QE3, the most recent Fed experiment in buying Treasuries and Mortgage Backed Securities ended in 2014. The Fed announced their decision to slow their monthly purchases in December 2013 and stopped adding to their balance sheet in the fall of 2014. The so-called ‘Taper Tantrum’ occurred in the spring of 2013 – when investors who had grown reliant on Fed purchases shrinking the available pool of bonds, grew concerned what tapering would mean.
The taper, by the time it was implemented went relatively smoothly. Since then the Fed has been ‘reinvesting’ the proceeds of maturing bonds to keep their balance sheet size constant.
There are theoretical discussions over which matters – the “stock” of bonds – basically the size of the Feds balance sheet, or the “flow” of bonds – whether the Fed is net buying or net selling bonds is the bigger driver.
After a decade of QE here and abroad – it is still difficult to tell what is impacted. Whether buying helps or hurts rates. Yes, even this apparently simple question can create debate.
- The argument that buying bonds lowers yields is basically that since the Fed is reducing the supply of bonds, the yields and risk premiums have to decrease as investors still have the same amount of capital to deploy
- The argument that buying bonds makes yields go higher is that this is another form of stimulus that ignites the animal spirits and increases risk taking and growth expectations which should in turn drive yields higher because expectations about future growth rise more quickly than the Fed’s purchases can offset
So, like so much in economics, there are so many moving parts and so many economic theories colliding at any given time, it is hard to sort out what is truly going on as a result of the Fed activities.
I believe that the Fed reinvestment has reduced current interest rates by only a few basis points across the curve and has contributed directly to the flattening.
The Fed is on pace to reinvest somewhere in the vicinity of $150 billion in the treasury market this year – which while large is still only just above 10% of the amount of treasuries that will be issued this year.
Based on being only 10% or so of the supply, I think that the Fed’s impact on current yields and curve shape is real, but not the sole driver.
It isn’t just Fed actions, but also their messaging that impacts markets. For several years now, they seem to rapidly shift their messaging to keep markets where they want them. This has created incredibly low volatility in the treasury market.
Treasury Volatility Remains Low – Defying the Headlines
Just as Pavlov’s dogs learned to salivate at the sound of the bell, markets have learned to be range bound as the Fed massages their messaging with every tick of the 10 year bond (or the S&P 500).
This lack of volatility is not good for me as a market strategist, but I think the problems it creates goes beyond that.
If there were no headlines coming out that should move markets, then the lack of volatility would concern me. But there are headlines, news stories, possible policy changes that should move markets more than they do – but markets have become accustomed to the Fed talking up bonds when they get too low and talking down bonds when they get too high.
The Fed’s micro-managing of markets has impacted the market’s ability to function in what its true role is – price discovery.
The normal process of price discovery has been changed, not just by the Fed’s activity in the market using its balance sheet, but also through the constant barrage of headlines designed to move markets. I would prefer to see markets allowed to drift further with less ‘jawboning” intervention.
Balance Sheet 'Normalization' Leads To Market Normalization
I firmly believe that the Fed should:
1. Back off on short term rates and focus exclusively on balance sheet reduction, with the caveat that if inflation is either extreme or significantly above target for an extended period they could hike rates
2. That balance sheet normalization should begin small and be adjusted accordingly as markets adapt – with an emphasis on steepening the curve without creating undue pressure on other bond markets (like IG corporate bonds)
A fed focused on this would help those most affected by the current rates policies in a way that should create more free cash flow that finds its way into the economy in the near term.
It would also aid Market Normalization which should increase volatility but will create the perception that investors are buying something that is ‘fairly’ priced (rather than artificially set), increasing confidence in markets and businesses.
Rather than trying to mix two forms of tightening, one of which, is uncharted territory, let’s focus the Fed’s attention and the markets attention on the new one – balance sheet reduction.
By simplifying their goal down to balance sheet reduction, away from an inflation shock, markets can price in a stable front end of the yield curve and focus on the back end.
Ultimately that should result in a yield curve that benefits short term borrowers (homeowners and student debt holders), and helps banks, pension funds, insurance companies and retirees.