Yield Compression and the Federal Reserve's Conundrum

In its most recent pronouncement on March 21, 2018, the Federal Reserve stated that it was increasing the federal funds rate to its new target of 1.5 to 1.75 percent as it seeks to normalize interest rates that have been extremely low for nearly ten years.  It also stated the following:

"The Committee expects that economic conditions will evolve in a manner that will warrant further gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data." (my bold)

Economists and Fed insiders state that there could be another two to four interest rate increases in 2018 alone based largely on the "strength" of the economy.

That said, if we look at one key measure, it appears that interest rates are telling us something quite different from what the Federal Reserve is suggesting about the strength of the economy.

Here is a graphic showing the yield curves for five-, ten- and thirty-year Treasuries since the beginning of the Great Recession:

As you can see, the yields on five-, ten- and thirty-year Treasuries have compressed significantly over the past year.  Here is a look at the changes:

January 3, 2017:

Five-year yield - 1.94 percent

Ten-year yield - 2.45 percent

Thirty-year yield - 3.04 percent

On January, 3, 2017, the difference between the yields on five- and thirty-year Treasuries was 1.10 percent.

April 30, 2018:

 Five-year yield - 2.79 percent

Ten-year yield - 2.95 percent

Thirty-year yield - 3.11 percent

On April 13, 2018, the difference between the yields on five- and thirty-year Treasuries had fallen to a very small 0.32 percent, the smallest difference in yield since the depths of the Great Recession in November and December 2008.

A similar trend took place in 2006 and 2007 as you can see here:

While the yield curve didn't invert (i.e. long-term interest rates were not lower than short-term rates) as we saw at the beginning of the 2001 recession:

...the Treasury market did experience a similar compression in yields beginning in early 2005 as we are now seeing.we saw a very similar yield compression starting in early 2005.

Let's look at the most recent iteration of the FOMC's economic projections table which shows that 12 out of 15 FOMC participants believe that interest rates by 2020 will be above 3 percent as shown here:

From this posting, we can clearly see that the current level of yield compression is suggesting that the Federal Reserve is having a great deal of difficulty "unsticking" thirty-year interest rates from the 3 percent range and that the Fed is facing yet another conundrum.  If the Fed plans to continue to raise their benchmark federal funds rate over the next 12 to 18 months, they only have 1.25 percentage points or five quarter percent increases of maneuvering room before we experience a yield curve inversion, a historically accurate harbinger of an economic recession.  And, it's always important to keep in mind that central bankers never, ever see a recession until it's already in place.  

Interest Rate Reversals - A Warning from History

Updated March 21, 2018

There is no doubt that we live in "interesting times" when it comes to global interest rates.  For most of us, the post-Great Recession period of near zero interest rates has been unprecedented and the recent experiments with negative interest rates are a new reality for investors.  While all of this may appear to be a brand new phenomenon, in fact, things are even more interesting when one looks at real interest rates, rates that are corrected for inflation as shown here:

  

A recent posting by Paul Schmelzing on the Bank of England's "Bankunderground" blog looks at the really long term trends in real interest rates and how, by putting the current interest rate environment into a long-term context, we can better understand the relationship between the current low real interest rate environment and the prospect for a return to "normal" interest rates.  To assist with this relationship, the author has looked at seven centuries of data for real risk free interest rates and has produced this graphic:

For your illumination, the source of the risk-free asset data is as follows:

1.) 14th and 15th centuries - sovereign rates in the Italian city states

2.) long-term rates in Spain

3.) long-term rates in the Province of Holland

4.) long-term rates in the United Kingdom after 1703

5.) long-term rates in Germany

6.) long-term rates in the United States

From this data, the all-time real average risk-free rate stands at 4.78 percent and the 200 year average stands at 2.6 percent.  As you can see from the red line on the previous graph, the current rate environment is significantly depressed.

For those of us that have been paying attention to nominal interest rates over recent decades, we've noticed a significant downward trend as shown on this graph showing the yield on ten-year Treasuries:

The author's calculations show a similar trend in real rates over the very long-run as shown on the red line here:

On a constant time trend, the red line shows an average fall in interest rates of about 1.6 basis points per year.

If we take a further look at the multi-century trends, we find that real rates have been depressed below long term averages several times in what are termed "real rate depression cycles".  Here is a graphic showing the nine historical periods of real rate depression plotted by size of interest rate depression versus the duration of that depression:

As you can see here, while the current period of real rate depression is relatively small when measured using the amount of interest rate decline, it is the second longest period of real rate depression over the 700 years in the study.

Lastly, let's look at how these real interest rate depressions reverse themselves:

As you can see, real rates rise very rapidly after they reach their trough, climbing an average of 3.15 percentage points within the first 2 years after the interest rate trough is reached.

A long look back at historical data suggests that the current depressed real interest rate environment is not unique.  While no one can predict the timing, history also shows that real interest rates are  likely to reverse themselves very quickly.  This reversal will have a significant impact on investors, particularly bond investors, who will see the value of their fixed income portfolios "readjust" in what could be a very negative way. 

Let's close with this quote from Alan Greenspan:

"By any measure, real long-term interest rates are much too low and therefore unsustainable...When they move higher they are likely to move reasonably fast. We are experiencing a bubble, not in stock prices but in bond prices. This is not discounted in the marketplace.”

Caveat emptor.

The Zero Lower Bound Problem

The lengthy and rather tepid economic recovery since the so-called end of the Great Recession in 2009 is proving to be problematic for the world's central banks, most notably, the Federal Reserve which has the unenviable position of being the world's lead central bank.  As we now know, the Fed's use of unconventional monetary policies has been only modestly successful with some key aspects of the United States economy still under significant negative pressure, particularly inflation which is below the Fed's comfort zone and the real rate of unemployment which looks something like this:

A recent speech given by Andrew Haldane, Chief Economist of the Bank of England provides us with some insight regarding the issues facing the world's central banks, in particular, the issue of ultra-low interest rates also known as the zero lower bound or ZLB.  As we are all aware, in the past, central banks have widely used interest rates to enact their monetary policies; by raising interest rates, they slow down overheated economies and by lowering interest rates, they speed up economies that are underperforming.  Unfortunately, in the age of the ZLB, this relationship no longer works since interest rates are and have been around the zero percent mark for six long years.  To give us some perspective of how critical this issue has become, here is a chart showing global real interest rates since 1980 for both advanced and emerging economies:

In this chart, the red and blue lines are calculated using the nominal yield on a ten-year sovereign bond minus the one year ahead inflation expectation.  As you can see, back in the 1990s, real interest rates averaged around 4 percent.  With an inflation target of 2 percent, nominal interest rates averaged around 6 percent giving central banks plenty of room to maneuver above the zero lower bound.  As the decades past, this interest rate "headroom" slowly disappeared, leaving central bankers with the dilemma that they face today.  Between 1970 and 1994, a typical interest rate "loosening cycle" was between 3 and 5 percentage points.  Obviously, that cannot occur today with real interest rates sitting at or just above zero.  This means that central bankers are "out of monetary policy ammunition".

Here is a chart showing international central bank policy rates since 2000 and the nations that are included:

The light blue shaded region represents the world's central banks that have a policy rate ranging from 0 to 1 percent; right now, 40 percent of the central banks of the nations that are responsible for 70 percent of the world's have interest rates that would have practically been unthinkable prior to the turn of the new millennium.  As well, some countries in Europe have short-term interest rates that are negative.  As you can see on this chart, Japan has had an official interest rate of zero for nearly two decades:

Mr. Haldane goes on to note that the Federal Reserve, European Central Bank and the Bank of England have all augmented their traditional monetary policy (i.e. setting of interest rates to the zero lower bound) with massive QE programmes, injections of liquidity into the banking system and forward guidance on monetary policies.  This has led to massive bloating of central bank balance sheets as shown here and here:

The need for unconventional monetary policies arose from a technological constraint, the inability for central bankers to set negative interest rates on currency whereas it is possible to set negative interest rates on bank reserves.  It is this inability to set negative interest rates on currency that hinders the effectiveness of monetary policy because there is an incentive for consumers and business to switch to currency when interest rates become negative.  This is the key problem of the zero lower bound and the speaker questions whether the deep roots of the ZLB constraint may be structural (i.e permanent) or, at the very least, long-lasting.

So, what are the speaker's recommended solutions to solving the zero lower bound conundrum?  

1.) Allow the inflation target to float upwards.  For instance, by raising the inflation target from 2 percent to 4 percent would allow 2 extra percentage points of interest rate headroom.  The problem with this solution is that the world's economy over the past three decades has become accustomed to a falling inflation rate scenario.  By deliberately allowing inflation to rise, unforeseen risks could occur.  It may be difficult for the world's central bankers to reign in inflation once it begins to rise.

2.) Allow unconventional monetary policy to become conventional.  Under this scenario, QE and its fellow "Twist" would become "a monetary policy instrument for all seasons".  Unfortunately, as shown in the case of Japan, a lengthy period of QE has proven to be completely ineffective at prodding the moribund Japanese economy back to life.  As well, putting QE on a permanent monetary policy footing would risk the boundaries between monetary and fiscal policy which is controlled by governments.  If a central bank executes its QE program by purchasing government debt, this has an impact on the cost of servicing that debt (which it is supposed to do).  If that purchase is permanent, it has implications for how much debt the government can issue.  Obviously, this scenario would have an impact on "central bank independence".

3.) Allow negative interest rates on currency.  This scenario involves finding a means to levy a negative interest rate on currency through a stamp tax which could include randomly invalidating banknotes with certain serial numbers.  It could also be undertaken by abolishing paper currency or by setting an explicit exchange rate between paper currency and electronic or bank money.  In the last scenario, paper currency would steadily depreciate relative to digital money, acting as a negative interest rate on currency.  Whether any of these options would be accepted by consumers is up for debate.  The speaker notes that Bitcoin is a prime example of a digital currency that has worked and that it could form the template for a new central bank-issued digital currency, doing away with the need for those nasty old fashioned bank notes.

To switch gears for a moment, here is an excerpt from Janet Yellen's speech on September 24, 2015:

"Inflation that is persistently very low can also be costly, and it is such costs that have been particularly relevant to monetary policymakers in recent years. The most important cost is that very low inflation constrains a central bank's ability to combat recessions. Normally, the FOMC fights economic downturns by reducing the nominal federal funds rate, the rate charged by banks to lend to each other overnight. These reductions, current and expected, stimulate spending and hiring by lowering longer-term real interest rates--that is, nominal rates adjusted for inflation--and improving financial conditions more broadly. But the federal funds rate and other nominal interest rates cannot go much below zero, since holding cash is always an alternative to investing in securities.  Thus, the lowest the FOMC can feasibly push the real federal funds rate is essentially the negative value of the inflation rate. As a result, the Federal Reserve has less room to ease monetary policy when inflation is very low. This limitation is a potentially serious problem because severe downturns such as the Great Recession may require pushing real interest rates far below zero for an extended period to restore full employment at a satisfactory pace.  For this reason, pursuing too low an inflation objective or otherwise tolerating persistently very low inflation would be inconsistent with the other leg of the FOMC's mandate, to promote maximum employment." (my bold) 

As we can see from both of these speeches, the world's central banks have backed themselves into a monetary policy corner.  With the world's bond and stock markets dreading the impact of a minute increase of 0.25 percent in the Federal Reserve's federal funds rate and with the mathematical likelihood of the next recession looming, the zero lower bound will prove to be increasingly problematic for the Federal Reserve, the European Central Bank, the Bank of England, the Bank of Japan, the Deutsche Bundesbank and their sister central banks around the world.

After all of this, it certainly appears that the Fed (among others) is simply going to raise rates just so that they can lower them again in the future, suggesting that they are concerned about the effectiveness of their experimental policies over the past seven years.