Diary of a Financier

Consequences of Anti-Inertial Fed Funds Rate Interventions

In Economics on Fri 3 Jun 2011 at 18:42
  • Recent decoupling of 10-year Treasury yields & SPX is reminiscent of that same action in 2006-07.
  • Historically, when the Fed unnaturally halts or reverses tightening cycles despite continued SPX/GDP strength, the 10-year cascades lower, risk runs amock, and recession rears.
  • The result is an even more accomodative Fed Funds Rate that eventually pulls SPX/GDP out of a trough.
  • With ZIRP already en force, this means the Fed will have to revisit another round of QE when the SPX/GDP flounder.
  • Given the debt ceiling, deficit issues & other deflationary matters, I still promote a HAMP-like housing solution over any semblance of QE3.

Back in April, I hit a home run in calling for the decline of long rates. In review of my outlook, I expect that we’re currently entering a period of rising front-end rates and struggling stocks. The SPX slippage has analysts already asking for QE3, so I’m starting the hunt for what macro developments are next.

I had a particular interest in examining the relationship between the 10-year Treasury rate (.TNX) and the S&P 500 (SPX), since I noticed the recent decoupling of the pair. I also noticed that today’s decoupling action resembles that of 2006-07:

TNX v SPY (2000-present)

I wanted to know what drove that relationship. What causes the decisive drop in 10-year yields so far in advance of equities? I’d reason either the market mechanism in Treasury bonds sensed pending doom (a potential epitome of the “bonds as smart money” idea), or policymakers instigated the interest rate/equities divergence with monetary policy. I’m inclined to side with the latter, since arbitrageurs would sniff out (then snuff out) the smoke signals set off by falling 10-year rates if the TNX/SPX divergence mechanism functioned so reliably.

So I started toying with some overlay charts…

First off, I charted the Fed Funds Rate (FFE) against the 10-year Treasury yield to see if policymakers prompted the plunge in rates. I noticed that the 10-year fluctuates a lot, flashing a lot of false positives which resemble those smoke signals snuffed out by arbitrageurs. However, the prolonged slides in the 10-year (recessionary periods) appear to have started as normal undulations, but they continued when the Fed decided to interrupt tightening cycles. The Fed Funds Rate displays these interruptions of [otherwise] interest rate inertia. Note the periods I’ve marked with asterisks–periods of sudden reversals from tightening cycles to flat/lower rates:

Fed Funds Effective Rate v TNX (1991-present)

Thus, I considered that the conditions in equity markets might have warranted a change in course from the Fed. Maybe the economy (as expressed via the stock market) needed the accommodative rate environment. So I added a chart of Fed Funds against SPX. Lo and behold, the stock market was already progressing at break-neck velocity, even despite rising Fed Funds Rates. But, out of nowhere, the Fed stops tightening. It halts or reverses rising rates, and SPX shifts into overdrive… into a blowoff top… irrational exuberance at the top crashes to a bottom… then the Fed needs to ease even more to nix a deep recession:

Fed Funds Effective Rate v SPX (1991-present)

That’s a rather quantitative argument. Approaching the subject qualitatively, I still cannot explain the Fed’s premature halting of its tightening cycle. After steep rate hikes between January 1994 and March 1995, the Fed started easing in anticipation of a slowing economy. They lowered rates off & on between April 1995 and May 1999. Although the Asian Crisis of 1997 and the LTCM Collapse of 1998 required a push to promote the free-flow of credit, SPX & GDP continued parabolic growth across these periods, and dovish Fed Funds rates still prevailed. The same can be said of the June 2006-September 2007 accommodative period. Look at GDP gains in those seemingly inane Fed easing segments:

GDP Constant Prices

As it occurs to me, these gratuitous periods of easing–the prolonged Anti-Inertial Fed Funds Rate Interventions–eroded the risk premium component of interest rates. That risk premium provides the holder of debentures (bonds or loans) with a buffer. For instance, a bank holding a mortgage collects these risk premia across its entire portfolio of loans, such that it mitigates the impact of one defaulted loan with the compensation from the risk premia in its other, performing loans. The risk premium similarly rewards bondholders for the risk inherent in securities markets. Expressed another way, it’s an insurance premium paid by the borrower unto the creditor for the risk borne in the extension of credit. Under this interpretation, the risk premium in interest rates makes credit too expensive for risky borrowers. (It makes the notion of PMI sound senseless. Rightfully so, because the attractiveness of “teaser rates” to subprime borrowers was truthfully offset by other loan costs in the fine print, somewhat like PMI, even before teaser rates ratcheted up upon reset.) Without the incorporation of this risk expense to borrowers, the economy accelerates in overstimulation. SPX spikes, GDP growth steepens, interest rates reflexively plunge.

This is all rather fundamental, but it helps me arrive at my key conclusion, a point I analyzed repeatedly in the first quarter: the Fed need not pursue another round of Quantitative Easing. It need not renew zero interest rate policy in the face of a 100% rally in SPX. It does need to react to the data it holds. The economy requires the restoration of risk premia via rate hikes, because the data suggest that zero-bound rates have stoked risk-taking per risk assets (e.g. HYG/SPX). Prolonged, gratuitous, accommodative policy begets crises. True to form, the interest rate risk in today’s economy is formidable; just look a the record low interest rate swap spreads, which have revisited levels of April 2010 when QE1 ended. Plus, Japan serves as an exhibit of liquidity traps resulting from ZIRP regimes. Fiscal consolidation is necessary for the US, yet we know from 1937 that we must pair it with monetary support. To accomplish the latter, I still think some pseudo-QE3 program will occur, but it should be more targeted, less broad-based. It should address housing (like a HAMP 2)–not to stimulate the residential market, but to stabilize it in an attempt to quash deflation.

–Romeo

Post Script

Fact of the matter is that I can’t prove causation within the pairs my overlays relate herein.  Even in a court of law, causal determinations are wrought from thought experiments and counterfactual hypothesis testing.  I have successfully attributed a correlation between unnecessary Fed easing and cascading crises. Nevertheless, I’ll never really be able to establish as little as a causal direction for the TNX v SPX, FFE v TNX, SPX v FFE relationships. For example, I want to determine whether a drop in 10-year rates inflated the bubbly top in SPX, or if the exuberance in SPX wore down 10-year rates. Similarly, did 10-year rates slide as a harbinger of weak growth ahead, or in mere reaction to the break in Fed Funds Rate tightening?

I’ll just have to argue like a lawyer would.  Consider, if you would, that the Fed Funds Rate is a mechanism controlled not by market forces, but by even more fallible humans. This makes me doubt the prophetic accuracy of the Fed Funds Rate (which I suppose helps me attribute some direction of causation). Throughout rising rate periods, the Fed’s policy was reaction to market conditions. Yet upon prolonged detours from its tightening course, the Fed started intervening per anticipation of future conditions (e.g. Y2K).  (I use the term “prolonged” because initial conditions often warranted Fed easing.)

I would admonish policymakers thus: given markets’ sensitivity to initial conditions, no man can continually steer an economy via continual anticipation.  When the future is uncertain (as it most often is), react to the data at hand, because acting upon anticipation is like a leveraged gambit.

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