Fed Funds Rate

The Big Banks are Amateurs When It Comes to Manipulating Interest Rates


Tuesday, July 10th, 2012

The Biggest Manipulators of All

People are justifiably furious over the big banks’ manipulation of hundreds of trillions of dollars of assets. This violates the banks’ most central function: loaning money based upon the going rate.

Indeed, the Libor manipulation is so serious that even mainstream economists are starting to call for heads to roll.

The Bank of England and Federal Reserve’s encouragement of Libor manipulation is not an isolated incident. Rather than being an aberration, it is their central effort.

Indeed, the big banks are rank amateurs when it comes to manipulating interest rates. Central banks have been manipulating rates for a hundred years or more.

David Zervos – Managing Director and Chief Market Strategist for Jefferies, with $3 billion under management – points out:

Central bankers try to influence rates directly and indirectly EVERY day. That is their job. From the NYFED website this is description of the monetary policy objective –

“the directive for implementation of U.S. monetary policy from the FOMC to the Federal Reserve Bank of New York states that the trading desk should “create conditions in reserve markets” that will encourage fed funds to trade at a particular level. Fed open market operations change the supply of reserve balances in the system, and by affecting the supply of balances, the Fed can create upward or downward pressure on the fed funds rate.”

All central banks, and central bankers, are in the business of setting rates. That’s what they do for a living. That’s why we spend so much time watching them. Surely, the Fed and BoE were unhappy that Libor rates, commercial lending rates, residential mortgage rates and the like were not cooperating with their traditional rate manipulation techniques in the overnight market for unsecured funds. That is why they created a myriad of unusual and exigent programs during the 2008/2009 crisis. But for the senior management of Barclays to come out and claim the Bank of England, or any central banker, was at fault for trying to “manipulate” interest rates is absurd. Congresses and Parliaments have given central banks monopoly power in the printing of money and the management of interest rate policy.

Indeed, one of the core functions of central banks is buying or selling government bonds to keep market interest rates at a specified target value. For example as the BBC notes:

Usually, central banks try to raise the amount of lending and activity in the economy indirectly, by cutting interest rates.

Lower interest rates encourage people to spend, not save.

The Federal Reserve’s key policy lever is its “Federal Funds Rate”, which is the base interest rate that many other rates (generally including Libor, and see this and this) key off of.

As the Financial Industry Regulatory Authority – the largest independent regulator for all securities firms doing business in the United States – explains:

The Federal Reserve (or “the Fed”) sets a target for the federal funds rate and maintains that target interest rate by buying and selling U.S. Treasury securities.

The express purpose of the central banks’ emergency actions since 2007 is to effect interest rates. For example, the express purpose of quantitative easing is:

When interest rates are close to zero there is another way of affecting the price of money: Quantitative Easing (QE). The aim is still to bring down interest rates faced by companies and households and the most important step in QE is that the central bank creates new money for use in an economy.

And of operation twist:

Confronted with a stumbling U.S. recovery and a financial crisis in Europe, the Federal Reserve decided Wednesday that it would extend a program known as “Operation Twist” aimed at pushing down long-term interest rates and boosting the economy.

Indeed, central banks are now forcing private companies to buy government bonds as a way to further drive down interest rates. CNBC reports:

US and European regulators are essentially forcing banks to buy up their own government’s debt—a move that could end up making the debt crisis even worse, a Citigroup analysis says.

Regulators are allowing banks to escape counting their country’s debt against capital requirements and loosening other rules to create a steady market for government bonds, the study says.

While that helps governments issue more and more debt, the strategy could ultimately explode if the governments are unable to make the bond payments, leaving the banks with billions of toxic debt, says Citigroup strategist Hans Lorenzen.

And the Financial Times notes:

Almost exactly a year ago, the economists Carmen Reinhart and Belén Sbrancia wrote a path-breaking International Monetary Fund paper about “financial repression”. It initially caused many western investors to blink. For while such “repression” has been extensively discussed in emerging markets in recent years, not many people in America knew what this dark-sounding phrase meant. (Answer: “financial repression” occurs when governments engineer a situation in which investors feel compelled to buy bondsat unfavourable rates, ie below the prevailing level of inflation, thus helping to reduce national debt.)

How times change. A year later, the word “repression” is being bandied about at investor conferences across the western world. No wonder. In the eurozone, there are growing signs that governments in places such as Spain and Ireland are “encouraging” – if not forcing – banks and state pension funds to buy public sector bonds, at potentially unfavourable prices.

***

What is crystal clear is that Fed and Treasury officials alike are determined to keep those Treasury yields ultra low, if not negative in real terms, for the foreseeable future. And they may well succeed.

Indeed, manipulating interest rates is one of the Fed’s 3 core, express mandates:

(1) maximize employment;

(2) stabilize prices; and

(3) moderate long-term interest rates.

“Moderating” interest rates means acting on interest rates so that free market forces do not set the rates. In other words, it means manipulating those rates. So one of the Fed’s 3 primary reasons for existence is to manipulate rates.

Central Banks Have Been Doing a Terrible Job of Manipulating Interest Rates

Austrian school economists have said for decades that interest rates which are too low destroy the economy. For example, Walter Block told me:

In the Austrian economic view, depressions are caused by big banks (the Fed) artificially lowering interest rates.

Hayek won the Nobel prize in 1974 partly for arguing that artificially low interest rates lead to the misallocation of capital and to bubbles, which in turn lead to busts.

But its not only Austrians. The central banks’ central bank – the Bank of International Settlements – which is the world’s most prestigious mainstream financial body, has repeatedly said that interest rates which are too low can destroy the economy.

BIS’ chief economist William White warned against overly lax monetary policy as early as 2003. As Spiegel reported:

White and his team of experts observed the real estate bubble developing in the United States. They criticized the increasingly impenetrable securitization business, vehemently pointed out the perils of risky loans and provided evidence of the lack of credibility of the rating agencies. In their view, the reason for the lack of restraint in the financial markets was that there was simply too much cheap money available on the market. [Low interest rates equal cheap money.] To give all this money somewhere to go, investment bankers invented new financial products that were increasingly sophisticated, imaginative — and hazardous….

The Telegraph noted:

“The fundamental cause of today’s emerging problems was excessive and imprudent credit growth over a long period. Policy interest rates in the advanced industrial countries have been unusually low,” [White] said.

The Fed and fellow central banks instinctively cut rates lower with each cycle to avoid facing the pain. The effect has been to put off the day of reckoning.

***

“Policymakers interpreted the quiescence in inflation to mean that there was no good reason to raise rates when growth accelerated, and no impediment to lowering them when growth faltered,” said the report.

In 2009, BIS released a paper amplifying on this point:

Easy monetary conditions are a classic ingredient of financial crises: low interest rates may contribute to an excessive expansion of credit, and hence to boom-bust type business fluctuations. In addition, some recent papers find a significant link between low interest rates and banks’ risk-taking ….

Indeed, BIS documents that interest rates which are too low are a grave risk financial to stability. See this, this and this.

The Fed’s low rate policies also reward speculators and punish savers, and quantitative easing helps the big guy at the expense of the little guy.

So the Fed – and central banks worldwide – have been manipulating interest rates, and have been doing a horrible job for the economy.

Central Banks Have Propped Up The Giant Banks’ Bad Behavior

Not only have central banks been doing a horrible job of manipulating interest rates themselves, but they have built, propped up and enabled the giant private banks to manipulate the system.

We’ve previously noted:

The corrupt, giant banks would never have gotten so big and powerful on their own. In a free market, the leaner banks with sounder business models would be growing, while the giants who made reckless speculative gambles would have gone bust. See this, this and this.

It is the Federal Reserve, Treasury and Congress who have repeatedly bailed out the big banks, ensured they make money at taxpayer expense, exempted them from standard accounting practices and the criminal and fraud laws which govern the little guy, encouraged insane amounts of leverage, and enabled the too big to fail banks – through “moral hazard” – to become even more reckless.

Indeed, the government made them big in the first place. As I noted in 2009:

As MIT economics professor and former IMF chief economist Simon Johnson points out today, the official White House position is that:

(1) The government created the mega-giants, and they are not the product of free market competition

***

(3) Giant banks are good for the economy

And given that the 12 Federal Reserve banks are private – see this, this, this and this- the giant banks have a huge amount of influence on what the Fed does. Indeed, the money-center banks in New York control the New York Fed, the most powerful Fed bank. Indeed,

Jamie Dimon – the head of JP Morgan Chase – is a Director of the New York Fed.

Any attempt by the left to say that the free market is all bad and the government is all good is naive and counter-productive.

And any attempt by the right to say that we should leave the giant banks alone because that’s the free market are wrong.

The [corrupt, captured government "regulators"] and the giant banks are part of a single malignant, symbiotic relationship.

Shah Gilani writes at Forbes, in an article entitled “It’s Not Libor Stupid, Central Banks Are The Problem”:

Central banks have done nothing to countermand the trend (nothing but encourage) leading to big banks getting bigger; so big, in fact, that now all of the big banks around the world are all too-big-to-fail.

The bigger the world’s banks are (bankers want size, because more size equals more power to price, to manipulate markets, and to pay bigger bonuses) the more important central banks become, both to the big banks, nations, and the global economy.

Central banks are the saviors of big banks that get in trouble, especially when economies and systems are leveraged for profits that backfire and they all have to be bailed out.

Central banks are supposed to be above what’s going on below their ivory towers, but, in fact, they are the puppets being manipulated by the big banks. It’s a case of the tail wagging the dog.

Why are central banks pouring money into banks, really? Why aren’t governments printing money to pour into ailing economies but aiding and abetting central banks instead?

It’s because central banks are independent supra-national bodies who have been ceded monetary power by governments almost everywhere to benefit banks and bankers the world over, who are their only constituents, and for all intents and purposes, effectively “own” legislators and governments.

They’re pouring money into banks to keep them solvent. That’s what central banks are there for. The banks aren’t lending the money (massive reserves are sitting on balance sheets to shore up appearances) because they need it to meet reserve requirements and offset the illiquidity evident in the interbank lending market…the same interbank (Libor) market that the Bank of England wanted to make look more liquid than it was viscous back in 2008.

***

We need to break up all the world’s big banks so they can fail when they overleverage themselves, and entire systems, nations, economies and the global economy aren’t all brought to their knees.

If we break up all the too-big-to-fail banks we won’t need central banks. We can go back to what are supposed to be free markets dictating interest rates and creating honest, open economies and opportunities everywhere.

Central Banks Have Failed To Provide Market Stability

While central banks’ too-low interest rates have led to an unstable economy, at least – one would hope – they’ve helped the consumer in other ways.

But as the following chart of historical Dow Jones Industrial Average – courtesy of the St. Louis Federal Reserve Bank – shows, the stock market has been more volatile since the Fed was formed in 1913 than before:

Graph of Dow Jones Industrial Average

Moreover, the value of the dollar has been destroyed since 1913:

Dollar from 1913.gif A Banana Republic With No Bananas

We’re suffering more or less depression-level unemployment.

And I’m not sure the Fed has been doing a great job of stabilizing prices, either.

The Fed has also failed at its self-proclaimed counter-cyclical role of “taking the punch bowl away” when the party gets too wild.

Central banks like the Fed are also rotten with corruption and conflicts of interest. And see this.

No wonder Nobel prize winning economists think that central banks should be abolished or drastically downsized.

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The Economy and Bond Market Radar (March 19, 2012)


Saturday, March 17th, 2012

The Economy and Bond Market Radar (March 19, 2012)

The yield on the 10-Year U.S. Treasury note registered the biggest weekly advance since July 1, in response to buoyant February employment data coupled with an absence of a strong signal of further quantitative easing from the Fed meeting on Tuesday. The chart below shows the 10-Year yield broke out of its trading range, oscillating around 2 percent since November. The “risk on” trade was reinforced this week.

The Fed raised its economic growth outlook to “moderate” from “modest,” in view of the continuation of positive economic data, especially on the employment front. The Fed described recent increases in oil and gasoline prices as “temporary,” and kept its verbiage unchanged for an “exceptionally low” fed funds rate “at least through late 2014.”

Strengths

  • Three years of rising employment finally led to the first increase, albeit small, in consumer debt in the U.S. since the second quarter of 2008. U.S. household debt rose 0.3 percent in the fourth quarter of 2011, following 13 consecutive quarters of decline.
  • Despite a 6 percent increase in gasoline prices in February, headline Consumer Price Index (CPI) in the U.S. rose only 0.4 percent month-over-month and 2.9 percent year-over-year, in line with expectations, thanks to tame pricing changes in non-energy items.
  • India’s industrial production expanded by a higher than expected 6.8 percent in January from a year earlier, led by a surge in the food products and beverages category.

Weaknesses

  • U.S. industrial production was little changed month-over-month in February, lower than expected and decelerating from December and January, due to a decline in mining activity and flat output from utilities related to warm weather.
  • In January, U.S. new orders of non-defense capital goods excluding aircraft posted the first annualized decline since the second quarter of 2009.
  • Chinese exports in January and February combined grew 7 percent year-over-year, decelerating from 13.4 percent in December and 20.3 percent in the entire 2011, driven primarily by slowing shipments to Europe.

Opportunities

  • Should a growth scare resurface due to a lack of announcement of further quantitative easing from the Fed, bonds may rally again as investors flee to safety. This scenario happened in mid-2010 and mid-2011 when QE1 and QE2 programs ended.

Threats

  • Rising oil and gasoline prices combined with liquidity implications of global easing led by Europe, may raise the prospect of the reappearance of higher inflation going forward. An increasing number of Asian central banks decided to leave rates on hold after recent cuts.

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No QE3 – Yippee!


Thursday, March 15th, 2012

 

No QE3 … Yippee!

March 13, 2012

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Key Points

  • The Fed made no major changes to its policy statement and announced a continuation of Operation Twist, but did not hint at or announce further quantitative easing.
  • The Fed’s assessment of the economy did improve somewhat.
  • Richmond Fed President Lacker’s dissent and Dallas Fed President Fisher’s pronouncements ring true.

In the policy statement released at the conclusion of its latest meeting, the Federal Reserve upgraded its assessment of the economy, noting improvement in labor conditions, and did not suggest imminent additional monetary easing, while keeping the fed funds rate in the 0-0.25% range it’s been in since the end of 2008. Key in the statement released by the Federal Open Market Committee (FOMC): “Labor market conditions have improved further; the unemployment rate has declined notably in recent months but remains elevated.”

Lacker dissents … again

There was one dissenter, Richmond Fed Bank President Jeffrey Lacker, who did so for the second consecutive time and who “does not anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate through late 2014.”

As for financial conditions, “strains in global financial markets have eased, though they continue to pose significant downside risks to the economic outlook.” The Fed made no change to what’s become the key sentence in its statements, noting that conditions would probably warrant “exceptionally low” short-term interest rates at least through 2014.

The Fed also subtly upgraded its assessment of the investment environment. Business investment spending is said to have “continued to advance,” whereas in its January 25 statement the FOMC said it “has slowed.”

Addressing energy prices

There wasn’t much new in the Fed’s statement other than addressing the short-term inflationary implications of the recent spike in energy prices. Inflation “has been subdued in recent months although prices of crude oil and gasoline have increased lately.” The increase in oil prices “will push up inflation temporarily, but the committee anticipates that subsequently inflation will run at or below the rate that it judges most consistent with its dual mandate.”

Operation Twist continues, but no QE3

“The Committee also decided to continue its program to extend the average maturity of its holdings of securities as announced in September.” In other words, “Operation Twist” is ongoing, but there was no mention of extending it beyond its scheduled June expiration. That will likely be discussed and detailed at the next FOMC meeting in late April.

For those who’d been expecting a third round of quantitative easing (QE3)—and we were not among them—the reasoning is likely already noted above: the economy has not only picked up its pace of growth, but the unemployment rate has also begun to ease meaningfully. Remember, both price stability (inflation) and resource utilization (maximum employment) are the Fed’s mandates. With recent conflicting data on both, and the rarity of the Fed changing course amid conflicting signals, QE3 was unlikely in our opinion.

Personally, I disagree with the many who feel the only prop under this very strong market has been quantitative easing. I do believe the economy has entered the second phase of the recovery (the expansion phase) in which jobs will be more plentiful, small businesses will be greater participants, and even housing will be a positive contributor. The market’s recent strength—and importantly, its surge immediately after the Fed’s announcement into today’s close—supports this view.

Fisher speaks the truth

The subject of QE3 was likely discussed and debated, but we’ll have to wait until the minutes of the meeting are released in three weeks to get any details. I share the view of Richard Fisher, President of the Dallas Fed, who’s publicly said that economic conditions are improving and the underlying trend of inflation is “converging on the Fed’s 2% target.” Key to Fisher’s perspective is that the liquidity injected into the financial system via QE1 and QE2 hasn’t traveled into the real economy, but instead sits on banks’ balance sheets, invested in financial assets, parked in cash—or even parked at the Fed itself.

Why keep treating a recovering patient like it remains in the operating room? Fisher recently said, somewhat bluntly, that he sees “no need to administer additional doses unless the patient goes into postoperative decline.” He went on to suggest that if incoming data continues to show accelerating improvement in the economy, “the markets should begin preparing themselves for the good Dr. Fed to wean them from their dependency rather than administer further dosage.” Hear, hear.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

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The Impact of Low Rates Through 2014


Thursday, January 26th, 2012

Bloomberg details the latest from the Fed:

Chairman Ben S. Bernanke said the Federal Reserve is considering additional asset purchases to boost growth after extending its pledge to keep interest rates low through at least late 2014.

Policy makers are “prepared to provide further monetary accommodation if employment is not making sufficient progress towards our assessment of its maximum level, or if inflation shows signs of moving further below its mandate-consistent rate.”

The immediate market reaction was a risk asset rally, a huge rally in gold (per Calculated Risk: Bernanke made it clear that even if inflation moved above the target – and unemployment was still very high – the Fed would only slowly pursue policies to reduce the inflation rate), and a rally at the belly of the yield curve (the yield curve flattened out to five years… shorter rates couldn’t fall as they are already at or near zero). Why? The “late 2014″ date is much later than the June 2013 date previously projected by Bernanke last summer.
The impact of this announcement (and the previous projected rates) can be seen in the chart below that shows the Fed Funds rate curve (implied by EuroDollar futures) for March 2013 through December 2014, as of various dates over the past year.

What do we see? We see an initial drop between March and June of last year as Bernanke indicated low yields for the foreseeable future, then a huge drop (mid-summer) after Bernanke stated rates would remain zero through June 2013. Today’s announcement really did nothing through June 2013 (that was already projected), but was felt further out along the curve.
The key question is what is the Fed trying to accomplish?
In “normal” times, low yields = cheap financing = increased consumption (it creates an incentive for individuals to borrow and banks to lend), but in today’s zero-bound world the impact is minimal. Increased consumption is limited as individuals are trying to rebuild their own balance sheets and those that might benefit most from borrowing, don’t necessarily have the credit to qualify for a loan. In terms of impact on unemployment, GYSC (of Economic Disconnect fame) states:

Unemployment is a structural problem, not a cyclical one, but the FED is still stuck in the past.

In addition, there are some theories that consumption may actually be negatively impacted by zero bound rates. As I outlined over the summer, I think it is possible that negative real interest rates may actually cause individuals to save more, while Kid Dynamite outlined yesterday that low rates forecasted may cause individuals to hold off from making a loan fueled purchase:

Let me explain: right now, one appealing factor of home buying/selling decisions is that interest rates are very low – you can afford to buy more house. If I think that interest rates are going to remain low for a long period of time, I will be in no hurry to lock in this low rate on the debt I’m borrowing – I will be in no hurry to go out and buy a house.

So what is it then? Corporations!
There is one sector that I think will be positively impacted by the latest announcement…. corporations. Don’t let their record profits as a percent of GDP (while personal income is at record lows) fool you into thinking they don’t need help at the populations expense. Seriously though… my initial reaction upon hearing that rates would be held down near zero through 2014… buy credit… WITH duration out to around ten years (the secondary impact is positive for equities, as explained below).
While Treasury yields are at all-time lows, corporate spreads remain at elevated levels (when yields fell during the summer when we had to deal with the US downgrade and Europe, spreads widened significantly).

In “normal” times, when markets calm these spreads would be expected to narrow, which I still believe is the case. One would also “normally” expect Treasury yields to rise as investors shift out of Treasuries, causing the hard interest rate component of corporate yields (rate + spread = yield) to rise, but this risk has been removed for the foreseeable future out to around ten years. The result is that corporate bonds seem like a very safe investment. This decreased risk should mean even cheaper financing for longer dated maturity corporate bond issuance.
So will this finally set off a round of corporate fueled expansion? If they don’t see aggregate demand improving, then I don’t see how this will impact the underlying economy. But, with the cost of equity high (i.e. what I perceive as fair to cheap equity valuations) and cost of debt low (i.e. these lower yielding corporate bonds), we may see significant change in capital structures (perhaps via private equity).
Source: Barclays Capital

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The Economy and Bond Market Radar (January 23, 2012)


Sunday, January 22nd, 2012

The Economy and Bond Market Radar (January 23, 2012)

Long-term treasury yields rose sharply as once again the schizophrenic market gyrates up one week and down the next, which is what we have experienced since mid-November.

Yields rose throughout the week as we appear to be in another “risk on” mode where risky assets rise and safe assets fall.

Economic data generally met expectations this week as inflation continued to slow on a year-over-year basis and housing data was generally in line with forecasts. The big surprise of the week was initial jobless claims, which hit the lowest levels since 2008. This number is often viewed as a leading indicator, which bodes well for the economy going forward.

Initial Jobless Claims

Strengths

  • The weekly initial jobless claims are indicating the economy is picking up steam.
  • Both the Producer Price Index (PPI) and Consumer Price Index (CPI) came in below expectations, giving the Fed plenty of room to maneuver if it were to decide additional stimulus is needed.
  • China reported fourth quarter GDP which rose 8.9 percent and beat expectations. The Chinese hard landing many pundits were worried about has yet to materialize and government policy has already shifted to an easing bias, likely resulting in a reacceleration in the second half of 2012.

Weaknesses

  • Overnight deposits with the ECB hit another record high at roughly $685 billion as banks are still unwilling to lend to each other in the overnight interbank market. This indicates significant lack of confidence in the European banking sector and is at odds with the equity performance of many European banks of late.
  • Greece has yet to come to an agreement with private creditors on the level of haircut that will be taken. This remains an overhang on the financial markets.
  • Industrial production rose 0.4 percent but came in shy of expectations.

Opportunities

  • The Fed is expected to release its Fed funds rate forecast at the conclusion of the Wednesday Federal Open Market Committee (FOMC) meeting. This new openness is welcome but depending on the detail and how well the information is explained, will ultimately determine how the market takes this new news.

Threats

  • The situation in Europe remains extremely fluid and negative news is almost expected at this point. Unfortunately it is politically driven and difficult to predict outcomes and ramifications.

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Fixed Income in 2011: The Year of Opposites (Tucker)


Wednesday, December 21st, 2011

by Matt Tucker, Fixed Income,  iShares

Expectations of rising interest rates. Fears of massive municipal bond defaults. Heading in to 2011, those were the two strong trends that investors expected would shape the fixed income market. But as we know now, 2011 turned out to be almost the opposite of expectations.

At the end of 2010, investors were positioning their portfolios to respond to rising interest rates. To hedge rising interest rates in the first three quarters of the year, investors turned to fixed income ETFs, moving into short duration funds or investing in leveraged and inverse funds. Leveraged and inverse fixed income funds almost doubled in size by September1.

But contrary to expectations, rising interest rates never materialized. The Federal Reserve kept its benchmark Funds rate near 0% and in August communicated for the first time that it intended to keep rates between 0% and 0.25% until 2013.

This was an unprecedented move on the part of the Fed. Previously they had communicated changes in the Fed Funds rate, as well as their view on the economic outlook and the likely path the Fed Funds rate would take in the future. Never before had they indicated to the market that they would maintain a target Rate for a specific period of time.

In September, the Fed once again took action to keep interest rates low, unveiling “Operation Twist.” The Fed said it would sell shorter-term Treasuries from its own portfolio and use proceeds from the sales to buy long-term Treasuries – a move designed to lower long-term interest rates.

The net result of these actions, illustrated in the chart below, was that US Treasury rates actually declined over the course of year. Short end Treasury rates remained low because they are primarily driven by the Federal Funds rate, which remained at 0%. Longer maturity Treasuries actually moved lower in yield, driven by the Fed actions as well as by increased investor concern over European sovereign default risk.

At the start of 2011, there was also a great deal of fear about the health of the US municipal bond market. Numerous states were facing budget deficits and cities were grappling with everything from falling tax revenue to rising pension costs. Wall Street analysts meanwhile were predicting that municipal defaults would be large in both size and quantity, with some fringe analysts even predicting that defaults could total hundreds of billions of dollars.

Well, it’s nearly one year later. While a few high-profile defaults and bankruptcies were announced — like the Jefferson County bankruptcy — wide-scale defaults never materialized.

According to S&P, municipal defaults in 2011 are down 69% compared to the same period in 2010. Year-to-date monetary defaults in the S&P Municipal Index total roughly $750 million, representing less than 0.5% of the index. This compares with 2010 defaults of $2.4 billion.

Despite the dire predictions, most municipalities have a number of tools at their disposal – like raising taxes, cutting spending or laying off government workers — to help them make timely payments on their debt and to avoid defaults.

What’s the lesson learned from 2011? Diversification and liquidity are key, especially in volatile markets. All markets rise and fall, and the fixed income markets are no exception. Having a diversified portfolio can help to insulate your holdings, while being in liquid investment vehicles allow you to make timely, tactical investment decisions based on changing market environments.

Footnotes: 1 Source: Investment Company Institute: Estimated Long-Term Mutual Fund Flows report data as of 11/22/2011

Diversification may not protect against market risk. Liquidity of investments is not guaranteed.

Bonds and bond funds will decrease in value as interest rates rise.

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Bill Gross says QE3 Unlikely Even as Job Growth Slows; Gross Still Shuns Treasuries, Likes Dividend Yielding Equities


Monday, June 6th, 2011

Bill Gross says QE3 Unlikely Even as Job Growth Slows

Pacific Investment Management Co.’s Bill Gross, manager of the world’s biggest bond fund, said the Federal Reserve is unlikely to do a third round of quantitative easing even with the economy adding fewer jobs than forecast.

Central bankers are likely to “extend the extended period” language for longer in their policy statements, Gross said in a radio interview on “Bloomberg Surveillance” with Tom Keene. The less-than-projected pace of jobs growth in May that the Labor Department reported today shows that “there is a persistency here. It’s back to our old new normal,” he said.

“We don’t see a QE3. There has been too much discussion and dissent within the Fed to permit that type of program,” Gross said in the interview from Pimco’s headquarters in Newport Beach, California. Given the current pace of growth and inflation “they will speak to a fed funds rate that persists for an extended period of time, which in effect caps interest rates in the process.”

Investors could seek higher real returns than those now offered from government debt through investing in shares of “conservative” companies such as Procter & Gamble Co. (PG), Merck & Co. or those of utilities, according to Gross.

“The Treasury market up to seven or eight years is negative in terms of real interest rates, and that’s not a positive for savers,” Gross said. “But if they took that money and invested it in a conservative stock, such as a Proctor or a Merck or a utility yielding 4 percent; then that’s 3.5 to 4 percent real yield in comparison to those negative real yields in the Treasury side. So you have to take a little bit of a chance in order to avoid getting your pocket picked here.”

Video

I concur with Gross about the likelihood of QE3 in the near-term horizon and suggested the same thing in a recent interview on Market Ticker with Aaron Task. The key to that sentence is the phrase “near-term”.

Right now, the Fed does not want more froth in junk bonds, nor does it want higher commodity prices or $150 crude, especially since QE2 was a miserable failure in producing jobs or reviving housing.

However, should the economy enter a sustained downturn, and if commodity prices plunge (giving the Fed some breathing room), it’s a given the Fed will try something. Whatever the Fed tries will likely be good for gold.

Please see Why I Continue to Like Gold for a video discussion.

The problem with Gross’s dividend stock play is that it is likely all stocks get hit in another sustained downturn. A 4% yield may be nice, but not if it comes at the expense of a 25% haircut in equity prices.

With valuations stretched everywhere one looks, there is a lot to be said for waiting on the sidelines for better opportunities.

Mike “Mish” Shedlock

http://globaleconomicanalysis.blogspot.com

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Prepare for a Fed Hike… in 2018. So Says Goldman Sachs?


Friday, May 20th, 2011

by Trader Mark, Fund My Mutual Fund
About this time last year – or perhaps 14 months ago as QE1 ended – the talk was about the Fed tightening that was to come by the end of 2010.   With the tsunami of spending out of the federal government still going full blast, one could assume the economy could handle a few less steroids from the central bank.  Instead economic activity drooped, and the stock market (after flash crashing), had an awful summer.  By late August, QE2 was hinted at strongly and it’s been all (mostly) “good times” since.  (I say that with sarcasm)
 

As I look around we are in Groundhog Day.  I hear the Fed and the financial infotainment industry believing that tightening will happen by the end of this year or early next.  Now “tightening” is all relative – even if the Fed began selling inventory off their balance sheet, the Fed funds rate is at its lowest in history and the Fed still holds trillions of product.  So we’re simply talking from going from”ultra ultra ultra ultra easy” to “ultra ultra ultra easy”.

Call me an outlier.  I don’t think it will happen.  My belief is the structural economy is so dependent on easy money from the federal government spigot, plus super easy monetary policy [Nov 18, 2009: Our Economy is on Steroids] any true reversal of policies will lead to the same type of weakness (economic) we saw last summer, and the Fed will immediately panic.  QE3 will be here.  Indeed I expect it by next winter.  Just about the time everyone believes The Bernank will “tighten”.

We’re running at a 10% annual federal deficit simply to push out paltry 2-2.5% GDP growth.  It’s pathetic.  If the government goes back to 3% type deficits (which I don’t foresee but even a drop to 5-6% will be a blow to the economy) the US goes back into recession immediately.  No one wants to take the ‘medicine’, so QE infinity it is.  Some say it is politically impossible – I say, I disagree.  More dollar weakness and commodity speculation?  Yes.  Is the Fed trapped in a box?  Yes.  But to appear to be useful the Fed has to do ‘something’.  They can’t sit on their hands.  And the only ‘something’ they have left is the same thing.

Yes, the Fed policies will blow up the US again down the road – I expect Bernanke to be viewed like Greenspan now is in due time – I wrote that 2+ years ago. If the stock market corrects 12-15% I expect an immediate QE hint in a speech.   We’ll see, perhaps I am wrong.  But according to this story on CNNMoney, some of the sharp minds at Goldman Sachs agree with my outlier view on no ‘tightening’ anytime soon.   Indeed they don’t believe the Fed will tighten until near the end of the decade.  With a cyclical recession surely to hit sometime mid decade, I don’t necessarily disagree with them on that count either.   Where Goldman disagrees with me, is they believe no more QE….

From the story:

  • A report issued by economists at Goldman Sachs argues that a coming wave of government belt tightening, hailed by hawks everywhere, will actually keep central bank doves in control for a long stretch — perhaps well into the second half of this decade.
  • The yawning U.S. deficit and the fear that tighter policy could derail a weak recovery could keep the fed funds rate near zero for perhaps six years, the Goldman research suggests.  “The best the Fed can do is keep monetary policy on hold to cushion the growth drag from the fiscal consolidation,” writes Goldman economist Sven Jari Stehn. “As a result, the looming fiscal adjustment should reasonably be expected to see policy rates — and probably longer-term rates too — at lower than normal levels for an extended period.”
  • With all the frothing about inflation, how on earth will Bernanke & Co. be able to justify staying on the sidelines? The answer lies in the unhappy math of a profligate nation out of control for so long that its excesses can’t be trimmed all at once, no matter what the Paul Ryans of the world might claim.
  • Even if our political leaders quickly agree on a package of spending cuts and tax increases – an outcome that doesn’t look terribly likely right now, on debt ceiling day – it will take years to bring that massive deficit under control. Goldman cites an IMF survey of fiscal consolidations in rich countries that puts the average length of the successful government belt-tightenings at six years.
  • That is a daunting enough statistic. But most of these successes – ranging from Ireland in the mid-1980s toFinland, Italy and Sweden in the mid-1990s – shared one notable characteristic: A cut in short-term interest rates that averaged 5 and a half percentage points.  Pulling that lever isn’t an option for the Fed, which cut its fed funds rate to its current level just above zero in December 2008.
  • “With the funds rate close to the zero lower bound,” Stehn writes, “a spending based adjustment could not be accompanied by monetary easing unless the Fed decided to adopt another asset purchase program (which we think is highly unlikely).“
  • That means that even a successful U.S. consolidation could feature a Fed on hold for, all things considered, a decade. (just remember, we are not Japan) If you start back in 2008 and figure it will take our solons in Washington the rest of the year to put together a plan for meaningful reforms, a six-year timeline means we could still be consolidating in 2018. And that assumes something gets done before next year’s presidential election.
  • It will also mean more trials for the dollar, which has fallen 10% against major currencies since Bernanke said in August that the Fed would do anything to boost domestic demand.

Copyright © Trader Mark, Fund My Mutual Fund

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The QE2 Trade is Over; Can We Start Dumping Risk Assets Now?


Sunday, April 10th, 2011

By Edward Harrison, March 28, 2011

“The Fed could announce a federal funds target of 3% but the tsunami of excess reserves now out there swamps any conceivable demand, so the Fed funds rate would be guaranteed to remain stuck at zero. The target would be meaningless.”
~ Ryan Avent as quoted in Why the Federal Reserve wants to drain excess reserves, Dec 2009.

This is the problem for the US Federal Reserve. And now that people are talking seriously about exit strategies for the Fed, it makes sense to discuss these mechanics. Yes, I know some people are still talking about QE3, but let’s deal with that if and when the economy swoons after QE2 is over.

What got me to thinking about this was a Bloomberg article about James “Seven Faces of The Peril” Bullard. Remember, Bullard is the Fed official which got us started on the road to QE2 when he said:

“Under current policy in the U.S., the reaction to a negative shock is perceived to be a promise to stay low for longer, which may be counterproductive because it may encourage a permanent, low nominal interest rate outcome. A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities.”

When Bullard said those words, everyone knew the Fed was going to start buying up Treasuries. So, Bullard’s most recent statements bear remembering. These are very important words.

“If the economy is as strong as I think it is then I think it may be reasonable to send a signal to markets that we’re going to start withdrawing our stimulus, and I’d start by pulling up a little bit short on the QE2 program.”

Can we start dumping risk assets now? Seriously. The QE2 trade is now officially over. Remember guys like David Tepper telling us last September that they were going to run with the Bernanke put? Well now there’s the Bullard call instead of the Bernanke put. Bullard is telling us the jig is up. QE2 is finished.

Here’s the part I want to highlight though. The Bloomberg piece reads:

“If the Fed opts to start withdrawing stimulus and tighten policy, it should start with the “balance sheet” by selling bonds first, then changing its wording about keeping interest rates near zero for an “extended period” and then raising interest rates, Bullard said.”

If you go back to the Ryan Avent quote you will know why that’s the sequence of events. There’s no way the Fed can tighten with trillions of dollars of excess reserves in the system unless it raises the interest it pays on reserves in concert with its rate hikes. That’s a lot of interest payments. The Fed doesn’t want to make those payments. It would prefer to drain the excess reserves first and then start hiking rates later. That tells me that the fed funds rate will be effectively zero for some time to come.

So, the Fed has basically just announced it will stop QE2. It will then start selling Treasuries. And remember, this is at the same time the Treasury is selling $10 billion a month in mortgage securities. Only after this will rates be hiked. That doesn’t sound like a bullish scenario for risk assets. Could bond yields fall even though the Fed is selling if the economy swoons as a consequence?

About The Author – Edward Harrison is the founder of Credit Writedowns and a former strategy and finance executive with 20 years of business experience.  Edward holds an MBA in Finance from Columbia University, and a BA in Economics from Dartmouth College.  He started his career as a diplomat and speaks six languages.

This article is originally published on Credit Writedowns on March 28, 2011.

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Fed to Start Tightening in Third Quarter


Friday, February 25th, 2011

The general consensus agrees with the minutes of the FOMC of January 26 that the highly accommodative monetary policy will be maintained owing to the expectation that the weakness in the labour market will persist for a long time and inflation is still below target. The FOMC expected to keep the fed funds rate near zero “for an extended” period. But will they?

I had a look at what triggered the Fed in the past to change direction in their monetary policy and especially the fed funds rate. No, it was not inflation nor was it employment as they profess. It was consumer sentiment! Over the past 22 years it is evident that the Fed changed policy a quarter after the Conference Board’s Consumer Sentiment Index crossed its 5-quarter weighted moving average. The only exception was in the third quarter of 2005 when consumer sentiment briefly fell below the weighted moving average.  Yes, they are chartists just like us!

Sources: Conference Board; I-Net; Plexus Asset Management.

The reason for the Fed’s behaviour probably lies in the fact that consumer sentiment normally leads core inflation by approximately ten months. A strong and sustained rise in consumer sentiment is therefore likely to lead to a higher core inflation rate ten months hence. In the current cycle, however, the core inflation rate kept on falling despite continued improved consumer sentiment. That can largely be ascribed to the continued weakness in the housing market and shelter in particular.

I am therefore of the opinion that a sustained improvement in consumer sentiment in the next few months will again see some hawks raising their heads in the FOMC as headline inflation is also turning for the worst. I would certainly start to bet on the Fed raising the fed funds rate in the third quarter of this year.

With consumer sentiment a major factor in the Fed’s monetary policy it is no wonder that the bond market slavishly follows the Conference Board’s Consumer Sentiment Index. The bond market obviously sees a stronger economy and higher inflation ahead.

It brings me to another point – where is the yield on the 10-year Treasury note heading? From the historical relationship between the 10-year yield and consumer sentiment over the past 12 years it is evident that the 10-year note at 3.62% is aptly priced given the current level (60.6) of the Consumer Sentiment Index.

A sustained rise (as I expect) in this index in the coming months is likely to take the yield on the 10-year note higher. Where it will top out I do not know but an improvement in consumer sentiment to 80 could see the yield rising to in excess of 4.1%. Obviously, bonds will rally if consumer sentiment surprises on the downside.

What about U.S. equities?

As in the case of U.S. bonds the U.S. market sentiment is significantly influenced by consumer sentiment. For market sentiment I used Robert Shiller’s Cyclically Adjusted Price Earnings Ratio (CAPE) or PE10 for the S&P 500. It is similar to the standard price-earnings ratio but instead of dividing the current index by the past year’s earnings, it uses the average earnings of the past ten years. It is apparent that the equity market players are keen followers of consumer sentiment as it is obviously a major factor in their valuation models.

In light of the relationship between the Consumer Sentiment Index and the S&P 500’s CAPE the current CAPE of 23.7 indicates to me that a level of about 77 for consumer sentiment is priced in by the U.S. equity market. That compares with the current 60.6 (January).

If consumer sentiment comes in weaker than the 77, I doubt whether it will result in a major train smash as long as the number is much stronger than January’s. But what about inflation? Higher inflation was the reason why the S&P 500’s CAPE went sideways from 2004 to 2007 despite consumer sentiment rising further. I expect the same to happen when consumer sentiment hits the 85 level. A level of 85 transpires to an S&P 500 CAPE level of 26, though ’ up approximately 10% from the current levels.

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