operation twist

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They Don’t Call Them Real Interest Rates For Nothing

A reader asks:

I had a chat with a wealth management advisor from a well-known financial institution, who was bullish on short duration bond funds due to “the FED’s complete control with regards to suppressing and maintaining short-term interest rates.” I was wondering if you had any articles on what factors (other than the FED, if any) contribute to and continue to suppress short-term interest rates in the US and what potential facts could reverse this trend?

The Fed exerts a great deal of control over nominal interest rates. While the Treasury and Fed maintain the pretensions of an open and transparent market where national and international demand for government securities is generated organically, the reality is that the Fed can monetise anything that the market rejects to achieve any desired nominal interest rate. This applies equally to all securities; though the Fed allows the 10-year and 20-year to float more freely, Operation Twist shows the Fed can control the nominal yield curve if they so wish.

The Fed’s power to control nominal rates is shown quite clearly — as the economy remained in a liquidity trap following 2008, the Fed implemented policies (QE, Twist, ZIRP) to make treasuries expensive ostensibly to discourage hoarding and stimulate aggregate demand (and — so helpfully — keep the Treasury’s interest burden low):

What the Fed cannot really control is the rate of inflation, the other variable that makes the real interest rate, and the key variable in determining whether Treasuries are a winning or losing bet.

Here’s the real rate on the 2-year over the same period:

On computing the graph, my jaw almost hit the floor; real interest rates on the 2-year today are higher than they averaged during the boom years up to 2007. The Negative-Interest-Rate-Policy isn’t so new at all. All the Fed’s accommodative action has been almost meaningless — it has hardly reduced the real interest rate at all from the pre-crisis norm (although the most recent spike into positive real territory is the strongest argument for imminent quantitative easing that I have seen in a long time).

On the other hand, there are clear patterns in real rates over longer periods. Here’s the 2-year, 5-year, 10-year since 1980:


But this doesn’t prove that the Fed can really exert control over real rates. However the graph suggests very strongly that Greenspan took his eye off the ball in terms of real interest rates; as real rates continued to fall, Greenspan wasn’t raising nominal rates, as might be expected of a Fed chairman looking to prevent bubble-formation.

Simply, the idea that short-duration bond funds are a good bet due to “the FED’s complete control with regards to suppressing and maintaining short-term interest rates” is completely wrong on every level; they’ve been a losing investment in real terms for most of the last 5 years, and the Fed is determined to keep it that way. The Fed’s control over nominal interest rates is precisely the reason that I wouldn’t want to invest in treasuries; not only has it continually made bonds into a real losing proposition, the only things that would turn bonds into a winning proposition — rising interest rates, or deflation — are anathema to the Fed, and explicitly opposed by every dimension of current Fed policy.

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Identifying a Treasury Crash

Readers have asked my opinion on whether or not China and Russia’s recent treasury offloading spree amounts to the first phase of a potential Great Treasury Crash.

Here’s a reminder:

There are two very strong pieces of evidence here for dollar and treasury weakness and instability: firstly, the very real phenomenon of negative real interest rates (i.e. interest rates minus inflation) making treasury bonds a losing investment in terms of purchasing power, and secondly the fact that China (the largest real holder of Treasuries) is committed to dumping them and acquiring harder assets (and bailing out their real estate bubble). So the question is when these perceptions will be shattered.

A large sovereign treasury dumper like China with its $1+ trillion of treasury holdings throwing a significant portion of these onto the open market would very quickly outpace the institutional buyers, and force a small spike in rates (i.e. a drop in price). The small recent spike corresponds to this kind of activity. The difference between a small spike in yields and one large enough to make the market panic enough to cause a treasury crash is the pace and scope of liquidation.

Now, no sovereign seller in their right mind would fail to pace their liquidation just slowly enough to keep the market warm. After all, they want to get the most for their assets as they can, and panicking the market would mean a lower price.

But there are two (or three) foreseeable scenarios that would raise the pace to a level sufficient to panic the markets:

  1. China desperately needs to raise dollars to bail out its real estate market and paper over the cracks of its credit bubbles, and so goes into full-on liquidation mode.
  2. China retaliates to an increasingly-hostile American trade policy and — alongside other hostile foreign creditors (Russia in particular) — organise a mass bond liquidation to “teach America a lesson”.
  3. Both of the above.

Now the pace and scope of any coming treasury liquidation is still uncertain and I expect it to very much be dictated by how the Chinese real estate picture plays out — the worse the real estate crash, the more likely Chinese central-planners are to panic and liquidate faster.

So here’s the relevant data:


Clearly, what we would expect to see in the nascent phases of a crash is that blue line to spike while the other lines all decline significantly.

Does this look like that to you? Well, frankly, no. China’s holdings have merely declined to 2010 levels — hardly a nosedive, but certainly signifying China’s lukewarmness toward the Obama-Bernanke administrations. Right now they are just testing the water.

Significantly, rates have risen in the past few days, signalling that even in spite of all the QE and Twisting, Bernanke’s task remains volatile.

So — while it is all very easy and attention-grabbing to spew fear-mongering projections of an imminent crash — I have to be realistic. 2013 or 2014 or even later seems a much likelier timeframe for this momentous and historic eventuality. And of course, black swans can derail any projection. Humans will always be fallible, no matter how much processing power we put behind our prognostications.

So there is really no timeframe to my prediction. Certainly, Bernanke has proven himself to be a proficient can-kicker. Too many economists have scuppered their reputations by making timed predictions which fail to play out.

And my prediction is not an economic prediction, so much as a geopolitical one, and political science is an oxymoron; politics (like any other market — yes, it’s a market to be bought and sold) can swerve and tilt in any direction in the time-being, even while its broader historical trends are clear and evident. (In this case, the rise of China, the end of American primacy, and the death of the dollar as a reserve currency).

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No QE3 (Yet)

So Bernanke announced a twist operation, shifting the weight of bonds toward the long-end of the maturity spectrum, and a program to roll maturing mortgage backed securities. This means that the Fed’s balance sheet will remain largely unchanged — in other words, very bloated.

But in the immediate term there will be no QE3, no drop on interest in excess reserves, no purchases of equities, commercial paper, foreign debt or any of the wackier theories about Bernanke surprising the economy into recovery. What does this mean for projections on the US economy? Very little — without an artificial updraft of stimulus, and with the ongoing global pressures, it seems inevitable that equities — Bernanke’s metric of choice — will sooner or later end up in the ditch by the wayside.

From the Guardian:

The Fed said the economy faced “significant downside risks”; one of those risks being the volatility in financial markets around the world. US stock markets reacted badly to the move. The Dow Jones Industrial Average closed down 283.82 points, or 2.49%, at 1124.84. The Dow has fallen two of the last three trading days following fears that Europe’s financial woes will spread to the US.

As I wrote last month:

Bernanke’s policy since 2007 as Governor of the Federal Reserve has been to pump money to reflate the rest of the economy to catch up with swollen debts acquired during the bubble — debts, especially in real estate, that would otherwise be defaulted upon as post-crash deflation took hold, leading to bank failures, credit retraction and a huge deflationary spiral to the bottom. That was his thesis in 1983 in regard to the 1930s, and he has been particularly lucky (or unlucky) to be able to test his thesis through policy. The real question is — what is supporting asset prices now? Is it real, new organic growth in America? No — growth is low, stagnant, and led by corporate profits, not small business or industrial output. Is it a booming real estate sector? No — confidence and prices are as low as 2009. Is it lower dependence on foreign oil, and a booming energy sector? No — America is more dependent on Arab oil than at any time in history, and the Arabs are wealthier than ever. Is it deeper, wider and burgeoning consumer demand? No — consumer demand for all but the rich is stagnant, burnt out by crippling food and fuel inflation, and rampant unemployment especially among the young.

He will print eventually — perhaps not this week or month, but he will — no matter how clear Wen Jiabao has been that QE3 should not happen.

Some interesting commentary comes from Peter Tchir of TF Market Advisors

Disappointment With The Fed

There are lots of things out there that once they have been done, can never be undone. Ben just disappointed the market for the first time. Whether he knew it or not he failed to beat expectations. He has been so good at managing expectations and using that as a policy tool he lost sight of how far ahead of itself the market had gotten. Everyone expected twist and seriously, what’s a 100 billion in size between friends in this crazy market.

He downgraded the economy but didn’t use that as an excuse to do more. There was no new, ingenious idea. If anything they tried to clarify the commitment to hold rates low til 2013 is dependent on economic conditions remaining weak.  Yet there were still 3 dissenters.

Ben has been a fan of making markets dance to his tune based on expectations. By disappointing some people I expect his ability to keep the market up by talking will be reduced as investors will need to see action rather than being told vaguely that there could be action. That will take time to play out and even I have to admit he gave us something today, just not enough.

The conclusion is very simple: intervention breeds expectation of more intervention, which breeds dependency.