Federal Reserve Policy - An Insight For Investors

by: WYCO Researcher

Summary

The Federal Reserve is sending mixed messages about a rate increase in December.

We are still in a liquidity trap that makes monetary policy ineffective.

The national debt is approaching $20 trillion or almost double the amount from 8 years ago.

Extremely low interest rates may actually be hurting the economy.

Sell long-term bonds now before rates increase.

You, as a U.S. citizen, are jointly and severally liable for $19,688,681,856,198.07, please pay ASAP. The total U.S. Federal government debt has grown to almost $20 trillion from "only" $8.995 trillion in early September 2007 and the M2 money supply has increased to $13.1259 trillion from $7.370 trillion during the same period. With growth like that you would think that our country's primary product was bananas and that we had exponential inflation. The inflation rate has actually been very low, which also has resulted in historically low interest rates. What happens if interest rates increase sharply? Bondholders, especially those owning long-dated bonds, could get killed.

Background

In this macro-economic analysis I am using September 4, 2007, as the start of the economic collapse. It was the Tuesday after Labor Day when I had lunch with some friends in the rag business (the fashion industry), who told me about very negative reports for back -to-school and Labor Day retail sales that they received that morning. Over the prior weekend, I also discussed with two real estate brokers in Florida about not being able to sell some condos even at much lower than the listed prices. The Federal Reserve's September 5, 2007, Beige Book confirmed my anxiety from the previous day with statements such as: "Several retailers reported that they planned to or had already heavily discounted merchandise to move inventory...Vehicle sales were described as slow or subdued in many Districts...Residential real estate and construction weakened further in most Districts."

The Federal Reserve had three programs of Quantitative Easing (l,ll,lll) over a number of years to aggressively buy debt, and thus dramatically increase the money supply assuming that this would help economic growth. According to a study (1960-2007) by the St Louis Federal Reserve Bank, annual inflation increases 0.54% for every 1.0% increase in the money supply. That did not happen this time. Actually the opposite happened - low/no inflation. There was a "liquidity-trap" and anemic economic growth. ("A liquidity trap is defined as a situation in which the short-term nominal interest rate is zero. The old Keynesian literature emphasized that increasing money supply has no effect in a liquidity trap so that monetary policy is ineffective.")

Either the Federal Reserve members flunked their second semester macro-economics class, which often spends a lot of time on the issues associated with "liquidity-traps" or they are actually very smart and created a Machiavellian plan to redistribute wealth from the rich to the poor/debtors. The "QEs" and income taxes are effectively a combined 90% tax on many high income investors. For example, the yield on a one-year U.S. Treasury note in early September 2007 was 4.39% and now it is only about 0.69%. Using an income tax rate of 35%, the after-tax yield is 0.45% or about having a 90% combined tax on a "normal" pre-tax one-year yield. Trillions of dollars have been transferred via lower yields over the last 8 years from those that have money and own bonds to those who are in debt/poor. Many investors got wise to this high effective tax and bought equities instead, which is one reason why the stock market has done so well over the last few years.

Reviewing basic macro-economics:

MV=PQ

M= money

V= velocity

P= price level

Q= quality of goods and services produced

In theory, V is a constant so that an increase in M increases P and/or Q. That did not happen during the QEs. Velocity decreased sharply.

Velocity

The velocity stayed fairly stable for decades, but then increased sharply partially because technology dramatically changed the payment methods/speed. It leveled off at a new higher "normal" only to plunge as the Fed increased the money supply too quickly.

Aggressively trying to increase money/capital is counter-productive during a "liquidity-trap" period. It is like watering a plant too much. Even if you do not kill the plant with excessive watering, it takes a long time for the plant to dry out. It is therefore, better to water in moderation. While the Fed has stopped its QE programs, it still makes open market trades to keep the Fed Funds rate at their current targeted 0.25-0.50%. (No wonder why the plant still looks like it is dying from too much watering.)

As the Fed raises its targeted Fed Funds rate, there will be less buying by the Fed's trading desk and if velocity increases with the same level of money, the price level and/or production will increase. That could also mean higher interest rates. So what would cause an increase in velocity? Actually velocity is just a reflection of a change, you can't force velocity to increase.

Economists often assert that when there is a dramatic increase in the money supply without an corresponding increase in prices or production, that the money is being horded. I would also add that how the money/capital is being used has a significant impact production. There is a large impact difference on the economy when money/capital is just used to replace cracked sidewalks versus a new factory. The sidewalks only have a short-term static impact, while the new factory has a continuous impact on the economy. The "shovel ready" projects used cash without long-term impact on economic activity. This also helps to explain the current low velocity. In addition, the Federal government borrowing and the Fed buying the debt, "crowds out" the private sector from borrowing for more productive uses of capital.

So how does all this economic theory impact investors?

Besides the Fed, other buyers helped keep interest rates unrealistically low, such as local governments that can only hold U.S. treasuries under local statutes. These are captive buyers of treasuries. In addition, many banks, both domestic and foreign, hold U.S. treasuries to meet reserve requirements. Some individual investors who were hurt by the plunge in stock prices from 2007 to early 2009 now fear the equity market and do not want to assume the risk of losing money, especially seniors who are not able to earn money to replace any losses. Some are also chasing the yields by going further out on the yield curve or buying lower rated securities, but they are forgetting that when interest rates increase, the bond prices drop. Low coupon long-dated bonds dropped sharply as rates increase. While U.S. treasuries do not have default risks, they do have price change risks if sold before maturity.

Interest rates and debt prices are not stable as seen from these charts.

2-Year Note Yields

10-Year Note Yields

When trying to push a car, it takes an extra effort - initial inertia - to get the car rolling, but after it starts to move it is easy to push. I think the same will happen with interest rates. It will take the Fed some time to adjust its Feds fund's targets higher, but once the rates move higher, the credit market will have a dramatic shift towards more normal interest levels. Because the current rates are so low, this adjustment to normal levels will seem like a "melt-down" in bond prices. Prices may drop more than few years' worth of interest income in a very short period of time.

Prices and interest rates could move higher as the excess money created by the Fed's actions finally gets put to a more productive use by entrepreneurs creating new private businesses. The change in attitude by those currently holding the "sacks of money" to invest in or lend to new/expand businesses could be caused by a change in presidents. What is really needed is some type of catalyst such as a reduction in business regulations or a major new invention (Back to economic theory, this would cause V to increase.)

Current Federal Reserve Statements

The release of the minutes of the latest Fed meeting seems to indicate a possible increase in the Fed Funds target rate at the December meeting, but that still will not be enough force to get the "car rolling." A speech on Oct.14, by Chairman Yellen, however, hinted that they would let the economy and inflation strengthen before raising rates. Some economists take the view that if the Fed is too lax, then inflation will creep up causing long-term interest rates to increase. This could explain why long-dated treasuries rose after Yellen's speech. (Editorial: Personally I have the opinion that the Fed members are inept and incompetent. Their policies are counter-productive and are hurting the economy: 1. Keeping rates artificially low is an indicator to entrepreneurs that the forecast for the economy is weak, which discourages them from creating or expanding businesses. 2. Low rates take money from investors who depend upon fixed income, such as seniors, who have had to cut expenditures. Higher rates could actually stimulate the economy as seniors have more money to spend.)

Conclusion

We are still caught in a liquidity trap and need a catalyst to get velocity of money to increase. While forecasting for exactly when interest rates will increase, the increase could be slow at first but then move quickly higher. These higher rates may cause a "melt-down" in the bond market with few years of interest income wiped out by plunging bond prices. U.S. treasuries are not risk-free investments. In theory, investors could buy higher coupon and shorter maturity bonds because they are less price sensitive to interest increases, but for risk-adverse investors I would recommend owning only short-term debt and sell long-term debt.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am only long bonds that are associated with restructuring and bankruptcies.