When President Obama nominated Janet Yellen to replace Ben Bernanke to take over leadership at the Federal Reserve, those of us (yes, I've been one, see my nearly five-year old article Let's Just Say It, Print More Money) who have championed monetary stimulus were relieved that someone with solid "dove" credentials would carry on the work of propping up the US economy.
But I will argue now that this nomination and certain confirmation makes it likely as ever that 10-year bond rates will rise over the next two years as Yellen follows through on the Federal Reserve's plan to taper its bond purchases. And I will also argue that she may surprise some people with her willingness to "pull the punch bowl" before the party even (ever?) starts. Please understand, this is not my wishful thinking. In a world full of American debt and increasing ability of foreign competitors to create value to attract dollars, I'm not convinced we couldn't use another $3 trillion of monetary stimulus. But this is my case for a Yellen-led Fed tapering QE and raising short term rates.
Quick historical context: the nature of political conflict has long been that compromise is often fashioned by those with the strongest base from which to compromise. Lincoln revoking Habeas Corpus, Roosevelt creating the New Deal, Nixon going to China, Reagan making peace with the Soviets, and even our current president ramping up the war in Afghanistan - there is a long history of counter-intuitive decisions at critical times in our nation's history.
And make no mistake, this is a critical time in the financial history of our country. After 60 years of global economic dominance, the US has been joined by rebuilt power economies and newly unleashed ones, with the alliances between them being especially competitive. The downturn that started in 2001 with the popping of the tech bubble and the implementation of WTO, slowed by a booming housing and credit economy, has been alleviated by reducing overnight rates to near zero and then $3.76 trillion (that's with a T) of long-term bond purchases by the Fed, currently about $85B a month. When you consider the Long Term Capital Management fiasco required only $3.6B (with a B) of backstops, the Fed has been providing over 23 LTCM bailouts every month.
And yet, core inflation remains low. Why? Because if you follow the art market or condo prices in Manhattan or London, it sure looks like the money is going to banks, and bankers, and their lawyers and consultants and shareholders (on paper, anyway) and large corporate clients and their lawyers and consultants and art dealers and other bankers and lawyers and...
And here is where we remember that Barrack Obama, ostensibly champion of all the people, has nominated Janet Yellen, who cares about unemployment more than bank profitability, to the position of Federal Reserve Chairman. And seeing as the super-low rates haven't translated to more loans for small business, and in fact it could be argued that the fear of interest rate snap-back (conventional wisdom is current Federal Reserve policy is unsustainable) is creating more risk, it's "Nixon goes to China" time. And, as we've recently seen, just the ability to speak about tapering and increasing interest rates carries as much weight in the financial markets as actually doing anything, partly because the Fed has generally carried through on their threats and trial balloons, something that an old-timer like Ms. Yellen knows.
Which is why I have little doubt that she will speak of tapering and rate increases in her confirmation hearings, which will hit the markets and make it easy for the Fed's Central Committee to act because the consequences will have largely been priced in, just as 10-year bond rates increased 35% just because Ben Bernanke spoke of tapering.
Thus, what will a Yellen-led Fed do?
First, I think a $15B/month taper has already been factored in, with 20-year rates rising from 2.43% in June to 3.45% today, and Yellen will proceed with that (OK, maybe $10B/month if unemployment data goes the wrong way). Housing could slow a bit, but housing has been booming at the urban end of the market and a 10% or 20% increase in housing payments isn't going to stop or even slow that. And 10% lower payments isn't going to help a lot of faraway suburbs and small towns much. And rates will still be well below their historical lows.
Yes, this will increase the cost of federal government borrowings. But Washington seems to have got the memo that spend and borrow government is hitting a roadblock. Dreams that Tea Partiers are going to be thrown out of office are just that - dreams - because their constituencies elected them to do just what they're doing: fight growth in federal spending. Higher bond prices will only underscore the need to shrink government, and with salaries relative to private sector being at an all time high, I believe we'll see significant wage cuts - either through re-rationalization, or more likely forced via sequester.
Second, I see a significant increase in the Fed Funds rate. It's not tightly coupled right now to short-term loan rates. There's no good reason the money center banks need to be enriched at the rate they have been, and corporations have shown little desire to spend their interest savings on hiring more employees as US headcount continues to plummet at US NYSE-listed companies.
But I also suspect the Fed has learned its lesson about inverting the yield curve. As of today, the difference between 1 month and 20 year rates is 3.3%. In 2005, when unemployment was dropping to 4.6 by 2006, it was 1.52%. By September of 2006, the difference was negative .34%- classic yield inversion, which has
caused signaled recession 20 of 21 times since the Fed was created. So if 20 year rates climb to 4%, short term rates can sit at 1% and be high enough to dampen bank profitability yet low enough to keep the risk of recession relatively low.
These higher rates will certainly bring more talk about default, which could have the odd effect of increasing the value of gold even as interest rates are rising - an interesting corollary to the past year's downward price action of gold as the printing presses have never been running harder. They will certainly affect share prices for publicly traded stocks, and I see Dow 13,000 on the horizon, led by bank stocks. But there will be cash-rich companies like Apple (NASDAQ:AAPL), Berkshire-Hathaway (NYSE:BRK.A) (NYSE:BRK.B), Microsoft (NASDAQ:MSFT) and Paychex (NASDAQ:PAYX) that could benefit from higher interest rates.
And there remains the sticky problem of America competing in a world where Chinese labor at $1.50 an hour is under pressure from Vietnamese labor at $.30 an hour. Chinese and Indian Universities are pumping out 5 times as many engineers, and far too few Americans understand the importance of the US financial services sector in our balance of payments. But the Fed can only do so much when it comes to unemployment (and $750B a year in ongoing QE is still quite a bit), and Janet Yellen knows it.
So while you'll hear a lot of talk about Yellen keeping the printing press pedal to the metal, remember Nixon and Reagan. And those like me who think $3.7 trillion might not have been enough will remind you that China and Russia are still military rivals.
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.