Over the past couple of months the long-term borrowing costs for the US treasury have been pushing down again, concurrent with increased pessimism about the economy and when the US will emerge from recession/slow growth. In the past few days, the prices of 10 and 30 year treasury bonds have positively surged. At the same time, equity markets have remained fairly stable. What does the divergence between treasury yields and equity prices say about the near future of our economy? One possibility is that the market is now anticipating and pricing in quantitative easing from the Federal Reserve – and so prices of both equities and bonds are rising. Another possibility is that expectations of future inflation are falling, which would lower bond rates, all else equal. A final possibility is that the bond market is signaling another leg down in the economy, and that equity markets are behind the curve.
Under more normal circumstances, a flattening spread between short and long rates is caused at least in part by the short term rate rising. This, in turn, is usually the result of increased economic activity, forcing the cost of short-term funds to rise as opportunity costs grow and inflation expectations rise. As has been commented by the San Francisco Fed recently, it is difficult to compare the current curve flattening with historical examples because the Fed Funds rate is pegged at zero. However, while most previous periods don’t yield a useful comparison, the period of November/December 2008 does have similarities to the current environment.
By November 2008, Fed Funds had dropped interest rates to exceptionally low levels. During December 2008, there was also a substantial rally in the long end of the bond curve as market participants priced in the possibility of quantitative easing. The rally in the long bonds caused the yield differential between the ten year and Fed Funds rate to narrow by 1.5% between the beginning of November and the end of December (Figure 1).
Similarly, since April of this year the yield differential between the Fed Funds and the 10 year yield has narrowed by 1.3% (Figure 2).
The unique feature of both of these periods is that the yield differential narrowed exclusively because of a falling ten year yield, and that the Fed Funds rate was already pegged at an ultra-low rate. The parallel between these two periods leads to interesting questions about quantitative easing. December 2008 was a time when quantitative easing (QE) had been announced but not formally initiated. A parallel between the two periods could be that the narrowing of the interest rate spread is in anticipation of a large QE announcement to be made some time in the future.
Given how weak the economy has been over the past few months, focusing on the Fed Funds rate is barking up the wrong tree. This is primarily because consumer credit is contracting even with zero percent interest rates. If banks aren’t lending and consumers aren’t borrowing, it implies that the real expected rate of return in the economy is below zero. Banks have the same old concern of Mark Twain–they are more interested in the return of their money than the return on their money. Since the Fed Funds rate can’t go below zero, the interesting numbers have become the interest rate spread in government bonds and the "quantity" in quantitative easing (QE). As noted above, the interest rate spread is a way for the market to signal that all is not well. QE, in turn, can be seen as a way for the Federal Reserve to lower the real Fed Funds rate below zero and get "ahead of the curve".
An extreme example of QE will make this concept clear: if the Federal Reserve were to print enough money to create 20% inflation (for example by directly buying sufficient treasury bonds which were in turn used to fund tax cuts and transfer payments) then a bank receiving a nominal interest rate of 0.25% would be receiving a real interest rate of -19.75%! Banks might be worried about lending under current conditions, but it is unlikely that the real negative interest rate in the economy is lower than -20%! Obviously, banks would be incentivized to get their cash out in the system in the form of loans and money velocity would increase.1 Likewise, consumers and business owners would quickly see the benefit of borrowing with cash flooding the system.
This potential sudden shift in credit, however, is what has guys like Thomas Hoenig so worried. Quantitative easing, once it works will work suddenly and have a non-linear effect – partly from the increase in the money supply, and partly from a sudden shift in money velocity. It could be argued that the same occurs after every cycle bottom (and that is what ultimately inspires monetary tightening). In this case, however, the shift could come more violently and be more difficult to get a handle on.
In spite of these worries, it is pretty safe to say that the Fed has gotten behind the curve again in terms of their policy. They are always fighting to keep a balance between inflation and deflation, and deflation (or fear of it) has been ruling the roost for 2 years now2. The money printing announced in March 2009 was intended to provide a boost to the economy that would get banks lending again and money velocity to increase. It is becoming clear that that effort has failed. Calling this a failure is not meant as a criticism – at the time, it certainly seemed there was sufficient stimulus and QE to get banks lending again. But the current state of the economy makes it fairly clear that we did not achieve critical velocity to clear the gravitational pull of a deflationary debt collapse3. If the bottom line is that the monetary and fiscal authorities are hell-bent on clearing the pull of a deflationary debt collapse, then the rocket needs an additional booster. Evidence for this need includes the following:
- At this point consumer demand is down considerably – a fact borne out by both the ECRI and final consumer demand indicators such as what is found at Consumer Metrics Institute.
- Consumer credit continues to decline.
- Year over year comparisons are going to be more difficult for companies in the third and fourth quarter, as they will be compared to a time in the previous year when stimuli was hitting its stride (think Cash for Clunkers and the first time home owner tax benefit.)
- Finally, since consumer confidence and economic performance are dependent on one another – it is likely that deteriorating economic numbers will be a self-fulfilling prophecy in a downward spiral of bad economic numbers and consumer fears.
The guys at the Fed aren’t dumb, and in spite of protestations from Hoenig, we can expect them to roll out ever larger artillery if economic conditions deteriorate; and the rally in the long bond seems to be saying that conditions have deteriorated. Shields up!
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1 The possibility exists that a debt deflation could get bad enough that a real return of less than -20%
2 June 2008 sticks out in my mind as a date when the Fed started to be too hawkish. Their tough words on inflation in that FOMC meeting, marked the beginning of a yield curve flattening and the commodity complex started to collapse around the same time. Within 4 months, we had entered the full blown stage of the credit crisis of 2008.
3 Note that a deflationary debt collapse is a valid option for clearing the decks of economic detritus!
