Many people have been quick to discount the significance of the Fed’s recent pledge to keep the Fed Funds rate at near 0% for two years. So unimpressed have investors been with this initiative that many have been crying out loudly for QE3 as soon as the minutes of the last Fed meeting were announced and there was no mention of further QE.
But investors should not be so quick to dismiss the medium-term economic and financial significance of this pledge to keep the Fed Funds rate near zero. In this article, I will lay out five reasons.
CERTAIN TYPES OF BANK LENDING MAY PICK UP
Many people think that the only reason that banks have not been lending is because they can’t find credit-worthy customers. Wrong!
In large part, banks have not been lending – especially of the longer-term variety – because they have been projecting rises in their funding costs in the future.
Bank managements are not dumb. They know that the current low rates of funding will not last forever. If they made long-term loans now a low interest rates calculating a spread based on 0% funding, this would be foolish since they know that funding costs will rise very significantly in the future. Many banks have been projecting funding cost rises of 2% or more over a two-year period.
In many lines of business, a gross margin contraction of 2% or more makes certain lines of credit unprofitable on a projected basis. And in certain lines of business, raising the interest rate offered by 2% (to compensate for the projected rise in funding costs) will kill demand for the credit.
Thus with guaranteed funding of near 0% for two years, a few lines of business will open up. Certain lines of business credit with two-year terms will benefit.
In particular, banks such as Bank of America (BAC), Citibank (C), JPMorgan Chase (JPM) and Wells Fargo (WFC) and others may start aggressively pushing credit cards. The average duration on credit card debt is in the two-year region.
IMPACT ON LONG-TERM YIELDS
Providing guaranteed funding for banks at 0%-25% means that the yields on all U.S. government securities with maturities of less than two years will be only a few basis point above that range, at most. This means that many investors seeking any yield at all will essentially be forced out further onto the yield curve. On the margin, this puts downward pressure on yields all the way out on the curve – e.g. 5Y, 10Y and 30Y (see TLT).
In turn, since the rates on long-term U.S. Treasury securities essentially serve as benchmark rates, the interest rates on many types of credit will tend to be pressured downwards.
IMPACT ON MORTGAGE RATES AND OTHER LONG-TERM CREDIT
It would seem that in principle, the two-year pledge should not really affect long-term interest rates for private sector credit in areas such as mortgage lending. Not so.
Asides from the “benchmark effect” described above, the Fed pledge can affect long-term interest rates to the private sector for a very important reason. Banks can lend to private clients further out on the curve and hedge their interest rate risk on the funding side by shorting U.S. Treasury Bonds.
Hedging allows banks to perfectly match their duration on the funding and lending side, thus mitigating risk. Hedging has a cost, of course. But that cost can be passed on to the borrower while the bank limits its downside risk. Furthermore, with yields on the long end of the curve so low, and short-term interest rates so low, the cost of such hedging operations is at historically low levels.
FUNDING OF U.S. FISCAL DEFICIT
The Fed’s two-year pledge essentially guarantees the U.S. government unlimited cheap funding for two years. Why? Because U.S. banks have almost $2 trillion dollars in excess reserves earning 0.25%. With funding guaranteed at 0%-0.25%, banks will buy as much U.S. Treasury debt as is offered at a rate of over 0.25%.
This is extremely important for two reasons. First, it very much takes out of play the possibility of a spike in short-term interest rates. Second, it keeps interest costs for the U.S. government extremely low. Third, it eliminates all risk of a funding shortage for the U.S. government. In particular, it takes out of play any possibility of “blackmail” by foreign creditors and/or any fear of such blackmail on the part of investors.
SUPPORT FOR U.S. BANKS
Guaranteed low funding for banks essentially equals guaranteed profitability. The importance of this is not that bank shareholders are getting rich, but that health be restored to the financial system. Since the government is restricting bank dividend payments, virtually all bank profits will be retained. In turn, this means that banks will be building up their capital bases and systemic risks in the U.S. banking system will be reduced.
The Fed’s pledge to keep funding rates at 0%-0.25% is economically and financially significant for the economy and the stock market (SPY).
The potential importance of this initiative will certainly be muted if investor, business and consumer confidence does not improve, since risk-aversion tends to depress credit activity. Improving systemic confidence is an issue that policy-makers must urgently address.
Having said that, the significance of the Fed initiative in terms of securing low-cost funding for the U.S. fiscal deficit and supporting the U.S. banking system is still very important.
NOTE TO READERS
I welcome thoughtful and considerate comments -- whether they be critiques or compliments of the arguments I put forth, or exposition of entirely different views. I encourage intelligent and cordial dialogue.Disclosure:
I am short TLT and long TBT and SBND. Long SPX puts.