With Labor Day upon us, we look into the fall to see what awaits us.
The Federal Reserve is still maintaining that the Federal Funds rate will remain within the zero to 25 basis point range through the fall (and into the distant future).
The effective Fed Funds rate, as presented by the Federal Reserve, rose from around 8 basis points around the start of the year, to about 18 basis points by the end of July. It has retreated to the 13 basis point level through most of August.
These variations took place during the year without any evidence on the Federal Reserve's balance sheet that there were pressures building up in the market that needed to be relieved by Federal Reserve action. Excess reserves were higher during the early part of the year, reaching a peak around $1.560 billion, and then dropped off through August, with a trough of about $1.460 billion.
This certainly doesn't match the profile of the movement in the effective Fed Funds rate. So, there seems to have been no "demand" pressure in the Fed Funds market requiring the Federal Reserve to increase "supply" so as to keep the rate within the Fed's target range.
Yields on 3-month Treasury bills were consistent with the conditions in the Fed Funds market trading in a range of 8- to 12-basis points.
The only thing that really seemed to have any impact on the Treasury yields was the economic and financial events taking place in Europe that led to international flows of funds seeking a "safe haven. The yield on the 10-year Treasury bond dropped below 2.00 percent in April and has traded as low as 1.41 percent in July and substantial funds flowed into the United States. Currently, its yield is in the 1.60 to 1.70 percent range.
The economy recovery has seemingly had almost no impact on longer-term interest rates. This reflects the "tepid" pace of economic expansion going on in the United States with the year-over-year rate of growth of the economy remaining below its long-term average. The revised number for real GDP growth, recently released, is 2.3 percent.
While all this was happening yields on both investment grade corporate bonds and high-yield corporate bonds have fallen to record low levels.
Although United States financial markets have been impacted by the turmoil going on in Europe and European financial markets, United States markets have been relatively peaceful and smooth. This is something, of course, that people at the Federal Reserve and other official agencies have been very happy about. There have been no economic shocks or blows to the markets that might have disrupted the banking system, which is still fragile, and the economic recovery, which is still modest. Fed officials would like the economic growth to be greater, but an economy recovering without disruptions is good!
It is my belief that this is what the Fed would like to continue throughout the rest of the year.
Economic growth is expected to be modest throughout the rest of the year. I am expecting that real GDP growth will be in the 1.5 percent to 2.0 percent, year-over-year, for the remainder of 2012. This will not put a lot of loan demand pressure on the commercial banks and the financial markets.
The estimate of Wall Street is that "investment grade debt sales (will be) in the vicinity of $60 billion to $100 billion after Labor Day." This should be handled without any trouble. If there is any problem with debt absorption it will come with higher-yielding corporate bonds.
We await the words of Fed Chairman Ben Bernanke from Jackson Hole at the annual Kansas City Fed "get-away.'' And, my guess is that nothing much will be promised … or delivered … in the way of a further easing of interest rates. Bernanke will in all probability stick to the tone of the minutes from the last meeting of the Fed's Open Market Committee and give voice to the need to continue to watch for problems in the economy and financial markets but will not commit the Fed to anything specific with regards to another round of quantitative easing.
As mentioned above, although the Fed would like the economy to grow more rapidly, there is little more it can achieve right now in the way for additional economy growth. And, the Fed can be content with everything quiet and moving along smoothly in the banking system and in the financial markets. Financial healing is continuing to take place while all is quiet and peaceful.
What about Europe?
"Signs that we are moving towards fiscal co-ordination in Europe will create a better tone on markets overall," says Rick Rieder, chief investment officer for fixed income at BlackRock. The European Union seems to be heading not only toward a fiscal union but also toward a unified banking system. If there is continued movement toward such an outcome, European financial markets would be greatly soothed and become much calmer.
Of course, if European financial markets settle then funds will once again flow out of the United States and US interest rates will begin to rise. My feeling is that the yield on10-year Treasury securities could eventually rise to around 3.5 percent where they were before the international movement of money took place, but would not move that high in the rest of 2012.
The EU still has a lot to do in order to complete a new banking union and a fiscal union and there are going to be a lot of bumps along the way. September is a particularly crucial month.
However, if discussions in Europe do proceed this fall and there are not any major breakdowns in talks, I could see the 10-year Treasury rising toward a 2.50 percent yield before the end of the year. Investment grade corporate bonds and high-yield corporate bonds would rise accordingly.
Beyond the end of the year? Interest rates must rise. Even if the economy grows at a rate below its long-term average, yields on the longer Treasury issues will rise to the 4.00 percent range over the next two to three years. Demand to support growing inflationary pressure will cause bank lending to rise along with more bond issues, both of investment grade and above. Furthermore, as credit inflation continues to unfold, more financial innovation will be forthcoming.
The open question is timing. That is why we must stay alert. And, we must stay alert to possible shocks and disruptions that will negate everything said above.