Time to Flatten the Yield Curve

Includes: BAC, C, JPM, USB, WFC
by: Matt Stewart

The Prima Facie case for a steep yield curve is to increase bank reserves so that the multiplier effect can increase the flow of credit to the economy at large.

But what should the policy response be in an environment where reserves are ample and demand for credit is actually declining?

A quick visit to the statistics section of the Federal Reserve's website shows clearly that the demand for credit is now contracting as economic agents de-lever their balance sheets.

Ergo, the argument that we need low interest rates so that banks are able to lend more is a fallacy. Bank balance sheets have ample, surplus capital to facilitate asset growth. The trouble is that demand for loans right now is inelastic....even as money is being given away.

So, instead of stimulating economic growth with a steep yield curve, all that Fed policy is accomplishing is to steal any nominal interest that might be earned on US citizens' hard-earned savings in order to fund the equity capital bases of the banking system, the bondholders of these institutions, and of course the salaries and bonuses of the employees that work there.

Now, I cannot necessarily argue that quantitative easing to help keep mortgage rates below 5% is a reckless policy, although I loathe the artificially/subsidized teaser rates that we see in the economy right now. 4.7% for a 30 year seems a tad artificial, but to try to arrest the potential for debt deflation in the housing market, the purchase of long-dated treasuries and or RMBS I suppose has its merits.

But isn't today's 30 year teaser rate just tomorrow's inevitable "price correction" in the housing market (see what happens to the price of a 30 year bond when rates move 1%) ... but we'll leave that for another day.

However, the continued policy of stealing earnings from savers/depositors with ZIRP needs to stop.

Consider for a moment the second derivative effects of this policy.

  1. Instead of individual US taxpayers allocating interest earnings in the macro-economy to help stimulate aggregate demand directly, these earnings are being used to finance the growth of bank capital when the demand for loans is contracting. This has the adverse effect of contracting aggregate demand while concurrently funding bank earnings as the offset.
  2. Investment banks and hedge funds are borrowing in dollars and buying foreign assets to take advantage of a dollar carry trade; in the process many asset values quoted in U.S. dollar are artificially inflated. This sets up the potential for a meaningful decline or capital loss for economic agents who are exposed to these asset classes either directly or indirectly.
  3. The standard of living of the average American is declining as the purchasing power of a greenback gets taken out behind the woodshed and shot. In 2002 the euro/dollar exchange rate was roughly 1:1; today, it takes 33% more dollar value to buy a euro. The erosion of purchasing power is the best way to collapse our nation's standard of living over time.
  4. Instead of trying to stimulate saving and investing as a potential source of expansionary capital flows, the bias is towards debt financing, which, as we have pointed out, is experiencing declining demand. Have we not learned the lesson that the cure for too much debt isn't more debt? Do we not need more savings, investment, balance sheet de-levering, debt to equity swaps, and or outright workouts to purge the system properly and to allow price discovery for assets to take its course?
  5. The inevitable day of reckoning when all asset prices must mean revert will become increasingly violent/disorderly, for the simple reason that market participants will look ahead of any policy shifts and discount these adjustments accordingly. For example, the price of gold took a 5% haircut on Friday as soon as the jobs data lead speculators to conclude that rate hikes might take the dollar higher...

Policy makers need to take the US economy off its morphine drip and to let the chips fall where they may. If the yield curve were to flatten, we should see a commensurate increase in individual savings while also continuing to see balance sheets de-lever, and asset prices correcting to their proper, non-subsidized, bid/ask level. Avoiding the pain is a fool's errand, which only amounts to kicking the can down the road.

The more sordid result is that every homeowner that owns their house free and clear or doesn't carry a large consumer debt load etc. ends-up subsidizing, de facto, his levered neighbor as Fed policy presently confiscates their return on savings for the "common good"...

Absent real and measurable demand for credit and solid evidence that the banking system lacks the capital ratios to fund debt demand, Fed policy has no business stealing from the Average Joe...and no defensible rationale for doing so, other than to support cronyism vs. populism.

It's time to flatten the yield curve, raise short-term interest rates, and to let free market economics sort out the mess, rather than pushing the problem down the road.

If the purchase of RMBS is still required - or liquidity facilities are needed - so be it, but let's stop allowing the Fed to confiscate or tax US savers to refinance the banking system, and to own up to the fact that we don't need more lending - because the market place is retiring its debts, not looking for more.

Disclosure: none