Tuesday, March 12, 2013

The Fed - Caught Between a Rock and a Very Hard Place

A recent speech by Ben Bernanke provides us with a look at the double-edged sword of his low interest rate policy from his perspective.

Let's open by looking at the yields on 10 year bonds for Germany, Canada, the United States, the United Kingdom and Japan:

With the notable exception of deflation-plagued Japan, the yields on 10 year government bonds are at 13 year lows according to Mr. Bernanke's chart.  This attests to the global nature of today's economy and how central bankers (aka policy makers) have acted in concert to breathe life back into the world's economy after its near collapse in 2008 rather unsuccessfully.

Mr. Bernanke goes on to answer two questions:

1.) Why are yields so low?

2.) What are the risks associated with pushing yields back up to normal levels?

Rates are low for three reasons:

1.) The expectation of inflation is low over the term of the bonds involved.

2.) The expectation that short-term real interest rates will continue to remain low.

3.) The expectation that the term premium for longer bonds is lower than normal (i.e. investors do not expect much of an interest premium when they invest their money for longer periods of time).

This chart shows how changes in each of the above components has affected current and historic yields for 10 year Treasuries :

Much of the recent decline in yields is due to a drop in the term premium (in green), however, since investors expect the direction of short term rates to continue to drop, this has pushed that component down as well (in black).  In both 2012 and 2013, the FOMC set the inflation target at 2 percent (it's actually a bit below that now) meaning that inflationary pressures on bond yields are minimal.  It also means that real returns on 10 year bonds approximate zero percent after correcting for inflation.  In fact, real interest rates are negative for 5 to 10 year inflation indexed bonds for all five preceding nations as shown here:

While the Fed likes to toot their horn and suggest that the current interest rate environment for Treasuries is of their own making, such is not entirely the case.  Let's look back at the concept of "term premium".  Over the past few years, as European sovereign debt has looked increasingly shaky, investors have been fleeing to the few "safe haven" bond issuers that still remain.  As demand for U.S. Treasuries rises, prices rise and yields drop.  If this "safe haven" perception should change, this is what could happen to yields:

I bet that Italy's Central Bank wasn't expecting 10 year yields in excess of 7 percent back in 2012!

There is a significant downside to the ultra-low yields on long Treasuries; low yields suggest that bond market participants believe that even over the long-term, economic growth will be slow at best.  That's not a great thing, is it?

With all of this in mind, where does Mr. Bernanke think that interest rates are headed over the coming years?  Here is a summary of several prognostications in graph form:

Over the next five years, yields on 10 year Treasuries are expected to rise between 2.25 and 3 percentage points back to the 4.25 percent to 5 percent range.

Now, let's look at an interesting quote from Mr. Bernanke:

"To oversimplify, the first risk is that rates will remain low, and the second is that they will not."

Yup, that's a perfect Catch-22.  If rates remain persistently low, investors tend to engage in risky investing in a desperate search for yield (and yes, that includes investing in very long bonds which tend to be more volatile to the downside as interest rates rise!).  If rates rise, capital losses will occur for long-bond holders.  Kind of a "damned if you do, damned if you don't scenario, isn't it?

The Fed claims that they have a multi-pronged approach to beating the odds:

1.) The Fed is now more closely monitoring systemic vulnerabilities, paying "special attention to developments at the largest, most complex financial firms, looking for factors that leave the system vulnerable to the "fire sale" dynamic where declining asset values could force leveraged investors to sell assets which results in a further decline in prices.

2.) Stress testing of large banks, ensuring that they have sufficient capital to weather a downturn.

3.) New-found transparency from the Fed will mitigate the risk of rising interest rates since there is no more "surprise" aspect to their policies.

4.) The Fed could use its now bloated balance sheet to reduce the risk of rapidly rising interest rates by adjusting the pace of selling its ample inventory of Treasuries, keeping uncontrolled price changes in check.

In closing, here's a final quote from Ben:

"On the one hand, the Fed's dual mandate has led us to provide strong support for the recovery, both to promote maximum employment and to keep inflation from falling below our price stability objective. One purpose of this support is to prompt a return to the productive risk-taking that is essential to robust growth and to getting the unemployed back to work. On the other hand, we must be mindful of the possibility that sustained periods of low interest rates and highly accommodative policy could lead to excessive risk-taking in some financial markets. The balance here is not an easy one to strike. While the recent crisis is vivid testament to the costs of ill-judged risk-taking, we must also be aware of constraints posed by the present state of the economy. In light of the moderate pace of the recovery and the continued high level of economic slack, dialing back accommodation with the goal of deterring excessive risk-taking in some areas poses its own risks to growth, price stability, and, ultimately, financial stability. Indeed, as I noted, a premature removal of accommodation could, by slowing the economy, perversely serve to extend the period of low long-term rates." (my bold)

There's the rock and the very hard place.

1 comment:

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