Federal Reserve Is Distorting Capital Allocation Decisions

Includes: TIP, TIPZ
by: John M. Mason

Rick Rieder, an investments manager at BlackRock, accused the Federal Reserve of distorting the economy in discussions with the Financial Times.

"Fed policy has had a distorting effect on capital allocation decisions of all kinds at virtually every level of the economy. It is a very large and dull hammer for markets."

In other words, the policy followed at the Federal Reserve under the guidance of Ben Bernanke has basically been that of throwing "stuff" against the wall and seeing what sticks. Quantitative easing, if it is anything, is target-less in the sense that it is not aimed at anything but the economy, as a whole. Whatever is stimulated is stimulated…and whatever stimulus the Fed gets is some form of stimulation...hopefully of real output.

Mr. Bernanke's policy has one goal in mind: Don't get caught not forcing enough reserves into the banking system. He does not want to ever be accused of doing "too little". Mr. Rieder claims that the Fed's buying actions have "distorted markets and risk stoking inflation."

"BlackRock estimates that interest rates on 10-year Treasuries are about 100 basis points below where they would be normally."

On Monday afternoon the 10-year Treasury note was trading to yield about 1.75 percent. So, that would put the yield on this security around 2.75 percent, not too different from what I have been saying over the past month or two.

I, too, believe that there are distortions to "capital allocation decisions" and these distortions are not always what the policy-makers want over the longer run. The distortion in interest rates are allowing hedge funds and other wealthy groups to buy into assets and creating windfalls that the middle-class and others cannot participate in. Mr. Bernanke looks like he is creating opportunities for the wealthy in a bet that if the wealthy buy into these assets, this will help stimulate the overall economy.

But, this is where the distortion comes in. For example, artificially stimulating housing to attract "owners" that will rent out the properties is not really stimulating the economy. And, what about the boom in subprime auto asset based securities?

Is the quantitative easing really spurring on economic growth? Or, are the economic growth problems structural, as Mr. Rieder suggests:

"These structural problems include: the costs of healthcare and pensions, which encourage the hiring of part-time workers; skill shortages-'people are not fit for the jobs available'; and demographics-'as the population ages, more and more people are staying in the workforce'.

But, Mr. Rieder doesn't consider that the yield on 10-year Treasury Inflation Protected Securities (OTC:TIPS) is negative. Monday afternoon this yield was a negative 0.75 percent. My argument has been that this yield is negative because of the "haven" effect created by international flows of money into United States Treasury issues (and German bunds) seeking a haven from riskier global investments.

Interestingly enough, over the past few months the yield on the 10-year Treasury note was trading about 250 to 260 basis points above the 10-year TIPS. One often uses the difference between the yield on the 10-year note and the 10-year TIPS as an estimate of inflationary inflation. If this is the case, then for a fairly long time now, international investors have felt that the expected rate of inflation over the next ten years is somewhere around 2.50 percent.

This has meant that even though the TIPS security has traded between a negative 0.50 percent and negative 0.80 percent over the past few months, the yields on both the 10-year Treasury note and the 10-year TIPS have moved in parallel. Interesting fact.

Thus, if the yield on 10-year TIPS drops by 15 basis points, the yield on the 10-year Treasury note also seems to drop by 15 basis points. And, the changes seem to come whenever there is a buildup of concern in international financial markets, like when the situation in Cyprus deteriorated, or when the concern subsided, like when the tension in Cyprus seemed to ease.

If international financial considerations were to ease and the yield on the 10-year TIPS were to rise by 100 basis points, we would have a positive yield on this security of 25 basis points, and if inflationary expectations do not change, then the 10-year Treasury note should rise to yield 2.75 percent.

"Mr. Rieder said that as such interest rates normalize, "losses that occur to fixed-income portfolios will be more and more acute."

I just don't see these interest rates rising 100 basis points until the international funds decide to leave their "haven" in the United States…and Germany…interest rates in the United States…and Germany…return to more normal levels.

As long as the "haven" effect is still present, any pressure for United States interest rates to rise due to the Federal Reserve backing off its quantitative easing stance, I believe, will be met by more inflows into the United States financial markets. As long as the "haven" effect is working, the 10-year Treasury note will still hang around in the 1.75 percent to 2.00 percent range.

Still, I agree with Mr. Rieder, I just don't see why the Federal Reserve needs to purchase $85 billion of Treasury securities and mortgage-backed securities every month. According to the Financial Times article, this amount is about two-thirds of the net issuance of such bonds. This is definitely distorting allocation decisions. I can't see how it doesn't distort allocation decisions.

And, when allocation decisions are distorted, usually the law of unintended consequences comes into play. All one can say is that there will be repercussions for these distortions later on. We just don't know where they will be. However, unintended consequences generally result in an opportunity for people to invest and make a good return on their investment, if they get in early enough.

From the point of society as a whole, the problem of unintended consequences is that we don't know what the cost of dealing with the repercussions will be. I am sure Mr. Rieder of BlackRock is keeping his eye on what the Federal Reserve will do concerning its quantitative easing, and if it continues, I am sure he will be looking for "unintended consequences" where he can put the $763 billion he manages to work. And, the rich get richer!

Disclosure: I 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.

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