First published at Minyanville.com http://www.minyanville.com/business-news/the-economy/articles/Awash-in-Liquidity-Part-I-Why/5/27/2014/id/55107
And why, in the short-term, increased market volatility will result.
Despite a generally stronger economic outlook for the US economy, interest rates in May moved significantly lower, as if expectations were for an oncoming recession. This has confounded many macroeconomists. In this first installment of a two-part series, I will discuss why interest rates are now falling, and why, in the short-term, increased market volatility will result. Tomorrow, in the second installment, I will discuss the implications of the Fed’s future use of non-traditional and unproven policy tools with which it is experimenting, and how existing policies have exacerbated the income gap.
Falling Interest Rates
At the beginning of 2014, the US 10-year Treasury yield was 3.0%. As I write this in late May, they are near 2.5%, a huge move in any man’s bond market. There are several reasons for this, all of them revolving around policy and central bank activities.
- Evolving Fed Policy: The Janet Yellen Fed has now made it clear that interest rates will stay low for a longer period of time than the markets had anticipated, especially after her initial faux pas in suggesting a six-month time frame for rates to rise after the taper had ended. Markets adjust to this kind of anticipation rather rapidly. Furthermore, this Fed appears to be interjecting social issues into its policies, especially having to do with the unemployment rate. The latest is some policy sensitivity to “disadvantaged” workers (the long-term unemployed, and those working part-time for economic reasons). If the issue is structural (e.g., lack of employable skills), then monetary policy is powerless to help, and relying on these indicators as proof of slack in the labor market may result in a monetary policy that does more harm than good. There is also an unconfirmed rumor in the blogosphere involving former Fed chair Ben Bernanke. Most of the time, such rumors aren’t worth talking about, but this one is quite interesting. In a private meeting, the former chair is rumored to have said that the Fed funds rate is unlikely to reach its 4% long-term “neutral” state in his lifetime. Mr. Bernanke is 60 years old, so the implication is that rates will remain abnormally low for at least the next 20-25 years. Let’s take such rumored remarks with a grain of salt — this is the same person who assured us that the sub-prime meltdown had been “contained.”
- The Fed’s Backroom Operations: In March, one of the world’s major holders of US Treasury securities dumped $100 billion onto the markets (Russia is the usual suspect). One would expect interest rates to rise to accommodate such a large and sudden increase in supply; but there was none. Strangely, the central bank of Belgium ended up with $100 billion of such securities on its balance sheet. That particular central bank cannot print money, as it is part of the European Union ( EU) where only the European Central Bank (ECB) can print. So, it had to borrow funds to buy such bonds. No banker in his/her right mind would do this without a guarantee; so it is rumored that the Fed made a low- or no-interest rate loan. In effect, this then became a no-brainer: a matched term where the borrower pays 0% but gets 2.5% in return. (The losers are the US taxpayers to the tune of about $2.5 billion per year.) This transaction also created 100 billion of new dollars (which occurs whenever the Fed increases the assets (loans) on its balance sheet). If this is anywhere near the truth, along with its regular QE program, the Fed created about $150 billion of new money in March, which the markets have had to absorb. In addition, the US federal deficit is shrinking, so even with tapering, the Fed is still purchasing the lion’s share of newly issued US Treasury debt, thus limiting supply to a market that is clearly awash in liquidity.
- ECB Easing: Mario Draghi & Co. have let it be known that, at its June 5 meeting, the ECB will be announcing new easing initiatives in the wake of disappointing economic growth in the EU, especially in Spain and Italy. (By contrast, the UK is doing quite well with signs that its economy is performing better than it has for the past two decades.) With the world awash in liquidity and every major central bank signaling further ease, the 10-year paper of Italy and even that of Spain (which cried “uncle” less than three years ago) is trading at yields of less than 3%. German 10-year bund rates are at 1.30% and are at record spreads to their US counterparts. French 10-year yields are at 1.80%. When one considers that that the French socialist economy hasn’t had robust growth for years, US 10-year paper, even at 2.50%, looks like the buy of the century.
Under such conditions, it wouldn’t be a surprise if 10-year Treasury yields fell further. Jeffrey Gundlach (Doubleline Funds) has indicated that there is a good chance (30%) that US Treasury 10-year yields could retest their 2012 lows (about1.45%).
The major short-term consequence of a world awash in liquidity is an increase in risk (volatility) in the bond market, which has spillover effects on equities. I don’t expect another dumping of $100 billion of Treasury securities, so, once that excess liquidity is mopped up, downward pressures on interest rates may begin to subside. The same is true if tapering continues and QE3 is ended in a few more months. Finally, if the expected June 5 ECB meeting produces a package that disappoints the markets, which are now priced for an ECB asset purchase program (that looks iffy), then there could be some retreat in European yields, which would have similar repercussions on the US Treasury yield curve.
There are also long-term consequences of the continuing ultra-easy monetary policies of the Fed and the world’s other major central banks. I will discuss these in the second part of this series tomorrow.
Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value Advisors (UVA), Reno, NV, a Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee. Robert is available to discuss client investment needs. Call him at (775) 284-7778.
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