The Two Faces of the FED:
The Greatest Transfer of Risk and
Resulting Wealth Loss in US History is Here Now
Roger Arnold
I believe that treasury yields will continue to fall from here, regardless of what the stock market does, regardless of geo-political concerns over Iraq, Terrorism and North Korea, and regardless of geo-economic concerns in Europe and Asia.
Although each of these plays a significant role on a cyclical basis and can certainly lengthen or shorten the secular trend toward deflation / recession in the US, the economic reality of the US is the primary consideration and must be viewed in that context.
The US is in its fourth year of contracting stock and bond markets even after substantial monetary, mortgage and fiscal stimulus. I can not overstate from an anecdotal point of view how important this to understanding the rest of the economic cycle and where the US is most probably headed.
In the words of Dr. Greenspan of a few days ago:
"Policies intended to improve the flexibility of the economy seem to fall outside the sphere of traditional monetary and fiscal policy."
This is really stating nothing more than what the empirical evidence has proven since the FED began its stimulus measures. As of yesterday the 10 year treasury fell to 3.90% and the 30 year fixed rate mortgage posted another record low rate.
Although the recent low for the 10 year treasury as set back in October of about 3.52% on an intra-day basis has not yet been broken to the downside I believe it will be this year and by a substantial margin. It may even break 3%.
Why do I believe this?
The FED as an institution has an obligation to operate in a counter-cyclical fashion. What this means is that by congressional mandate they must add liquidity and lower over night lending rates as the economy slows and the risks of loan defaults rise.
The goal of course is to counter the slow down with cheap and readily available money.
They have been doing this but the economy continues to slow.
Although the FED still has additional room to move rates lower, as I believe they will, we are quickly approaching zero real rates now. This is exactly the situation the Japanese have found themselves in over the course of the past 13 years with most of their downside movement coming within the last 5 years.
Japans debt to GDP ratio has grown to levels no mature economy has before experienced without collapsing. This means that the government has issued enormous amounts of debt and is running huge deficits. And yet their long term interest rates are well below 2%, with their overnight rates at zero and even recently moved into negative territory for the first time in the countries history.
I will not get into a discussion of US versus Japan but merely point this out for those whom believe that when a government issues debt it must drive rates higher. It simply doesn't. There is no correlation between budget deficits and debt issuance to interest rates in this respect, contrary to what a lot of the pundits are stating.
Rising government debt issuance does not drive rates higher.
That is not to say that that is not one of the goals for having done so, and this where it gets tricky but critical to understanding where the US Economy is.
In the early phases of monetary and fiscal stimulus, including mortgages, the goal is to stimulate the economy. By that I mean increase economic activity. Increasing economic activity mandates a greater demand for investment versus consumption debt financing; i.e. capital borrowing versus consumer borrowing.
The goal then is to entice companies to borrow. Dragging consumption borrowing along is a band-aid on the economy until the corporations begin to borrow and expand.
If the stimulus is successful it is reflected in rising rates as demand for cheap money outstrips supply on a marginal basis allowing lenders to increase borrowing costs to borrowers; i.e. inflation.
But, why isn't that working now?
It is not working now because of the massive debt hangover incurred by companies during the late 1990's. In other words the enormous inefficient use of capital resources during that period of time. Much of the money that was deployed through capital borrowing spending and investing during this time period was not invested, it was actually consumed. Consumed money has no compensating investment for which it's existence can then be justified.
This inefficient deployment of resources during the 1990's is what caused the stock market to bubble. Investors, shareholders, bond holders, investment banks, banks, and companies had confused investment borrowing with consumption borrowing.
This led to irrational expectations as to the investment potential or future returns achievable with this borrowed money. The money was spent rather than invested; i.e. there is no return over time on consumed capital.
As this became apparent the equity bubble collapsed but in its wake left behind all of the debt that had been incurred which no longer had any asset or income stream validating its existence. And this is where we are today.
Over the course of the past few years the FED has been relatively successful at affording investment grade companies the opportunity to restructure some of their debt into lower rates and payments but has been unsuccessful at helping to lower rates and costs to speculative grade companies or to be the impetus for new investment borrowing by companies.
All of corporate America is laboring under current debt burdens and is focusing on how to get rid of the debt that was incurred in the 1990's in some way other than having to incur new debt to expand.
Additionally, after 12 rate cuts by the FED and massive additions of liquidity the FED is now approaching zero real rates. As we approach this juncture companies are becoming increasingly averse to borrowing and more pessimistic about the prospects for monetary stimulus to work.
Critical
When the FED lowers rates, prints money and removes treasuries from the market place two fundamental things occur.
First, and what every pundit focuses on is that the borrowing costs are lowered across the board. This leads to a marginal shift in optimism that this time it will work. Stocks typically take a technical jump up, bonds typically fall, and long term rates rise. This is all a technical reaction to stimulus and indicative of nothing more than a technical reaction. It is not indicative of any fundamental belief that economic stimulus will drive economic activity and be the cause of a new bull market in equities.
Second, and MOST IMPORTANTLY, it is indicative of a flight to safety by the FED itself. When the FED prints money and uses that money to buy treasuries away from the market it is actually parking its own assets in the only "risk" free paper asset available in the world. By so doing they are moving to protect their asset base at the expense of other investors. As rates are dragged down in the process other investors must find alternatives to treasuries in which to invest for a desired return. In other words the FED is transferring risk to the market place and away from themselves.
To date however this balance has been that the FED's primary function has been to stimulate the economy with protection of their own asset base being secondary.
As we move toward zero real rates however I believe this function will shift to protection of their own asset base versus that of stimulus. As a result they will increase their buying of US treasuries and will drive the yields down to the levels I wrote about above.
Everything pivots on economic activity.
The FED, reserve bankers and member banks are willing to incur a reduction in the value of their own asset base caused by the inflation they induce only if it causes an increase in economic activity. In the event that monetary stimulus fails to cause an increase in economic activity, the FED, reserve bankers and member banks will have NO ALTERNATIVE than to move to protect their own asset base ahead of the recessionary, deflationary effects of falling economic activity.
Once the FED and associated members make the decision that protection of their asset base is paramount to stimulus measures the yield on the 10 year treasury will begin to fall rapidly.
As this occurs those not understanding this will assume the FED is still attempting to stimulate and make the tragic mistake of attempting to buy stocks and bonds expecting a rebound.
What is actually happening is that the FED is capitulating to an economic crash themselves and moving to protect themselves at the expense of everyone else.
Also, please be mindful of the fact that the FED will NEVER tell us that this is what they are doing.
February 21, 2003
Roger Arnold is the President of www.myhomelender.com , host of the nationally syndicated talk show "The Roger Arnold Show" and publisher of "Daily Observations" Roger can be reached at roger@myhomelender.com
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