As the Federal Reserve lifted short term rates in December of 2015, market participants began to believe that the Federal Reserve could actually push through a series of rate hikes. Throughout the fourth quarter in preparation for the rate hikes the yields on high quality bonds were climbing. Particularly, I'm talking about the climbing yields associated with the 2 year to 7 year range on Treasuries and LIBOR swap. However, we have seen a few weeks during which the market has taken a fairly severe beating and treasury rates are falling substantially.
One interpretation of substantially lower rates is that the market appears to believe that future rate increases will be more subdued. There are a few different theories regarding the forward path of interest rates. Most notably I would like to reference the pure expectations theory and the liquidity preference theory.
Pure Expectations and Liquidity Preference
Under the pure expectations theory we would expect that the rate on bonds across the yield curve reflect the market's best estimate at the rate that would be earned by simply holding a series of 3 month treasury bills with a new one purchased each time one expired. This is an interesting theory, but I don't believe it is quite correct.
The liquidity preference theory holds more weight in my view. This suggests that investors see longer term bonds are more volatile and view risk negatively. Therefore if an investor genuinely believes that he would earn 1% on a one year bond or precisely the same amount of money by holding 3 month notes and reinvesting every 3 months, then he would be more likely to choose the series of the 3 month notes until the one year bond offered a higher rate to compensate. To expand on this a little further, I ask investors to consider their own scenario.
The 7-year currently yields 1.79%. If your savings account was yielding 1.79%, how much interest would you have in transferring money to buy 7-year treasuries? If you would be just fine with leaving it in the savings account, then you are demonstrating liquidity preference.
There were some suggestions about flattening the yield curve in a speech given by Vice Chairman Stanley Fischer. Specifically, I'm highlighting the following section:
"Raising the Equilibrium Real Rate: An even more ambitious approach to ease the constraints posed by the zero lower bound would be to take steps aimed at raising the equilibrium real rate. For example, expansionary fiscal policy would boost the equilibrium real rate. In particular, the need for more modern infrastructure in many parts of the American economy is hard to miss. And we should not forget that additional effective investment in education also adds to the nation's capital.
As another example, numerous studies of the effects of the Federal Reserve's asset purchases suggest that these operations have reduced the level of the term premium embedded in long-term interest rates. If aggregate demand depends primarily on the level of long-term interest rates, it might be possible, in principle, to maintain a level of long-term rates consistent with full employment and stable prices by lowering term premiums while at the same time raising the level of short-term rates by a compensating amount. This result could be accomplished, for example, if the Treasury took steps to shorten the average maturity of Treasury debt outstanding or, alternatively, if the Federal Reserve maintained large holdings of long-term assets."
The Federal Reserve is struggling with conflicts created by their dual mandate. Specifically, they are struggling with the difference between supporting those mandates in the short term and the long term. They have created a ZLB (zero lower bound) for themselves by indicating that they don't see negative short term rates as a reasonable possibility. Within the context of having only positive rates (or a zero rate) their options can be limited.
This article will be fairly complex, so I want to come back to the potential flattening of the curve and tie it in after making a couple other points.
The dual mandate for the Federal Reserve is price stability and full employment. The members of the Federal Reserve have generally taken that to mean 2% inflation and 5% unemployment. At least in the short term those mandates are able to coexist reasonably in the current environment. The Federal Reserve saw unemployment hit their goal level and lifted rates while suggesting that the inflation was coming.
It can be argued quite reasonably that lower interest rates failed to generate the desired level of capital expenditures by corporations. Having greater capital expenditures is desirable from a national viewpoint because it suggests investments in productive capability to increase the output of physical goods or services that can be consumed. However, lower interest rates will not be sufficient to encourage corporations to invest capital if they do not have projects available that meet their risk and return objectives. By offering lower cost financing the return objectives may be reduced slightly, but the easy answer for corporations to low cost debt is to increase the amount of debt in their capital structure. Rather than investing in new infrastructure to support programs that may fail to generate sufficient returns, those corporations can simply use debt to repurchase shares.
If the corporations choose to repurchase shares rather than expand productive capacity, there is little need for additional labor. The result is stubbornly high unemployment and a lack of inflation. The Federal Reserve argues that inflation will come due to pressure from wage growth and that may finally be true since Wal-Mart (NYSE:WMT), Target (NYSE:TGT), and McDonald's (NYSE:MCD) were lowering wages at the bottom of the pyramid.
One sector of the economy that has seen capital expenditures is the harvesting of commodities. For instance, the mining sector stubbornly invested more money on capital expenditures to increase supply while focusing only on their average cost of production. Supply kept increasing and demand projections are coming down leading to massive reductions in the values of the company within the sector.
Inflated Asset Prices
Members of the Federal Reserve have occasionally referenced asset prices being "high". They have also been discussing financial stability which gives at least the appearance that they are considering the impact on the stock market from movements in rates. While their dual mandate does not specifically include maintaining stock market valuations, there are some important aspects to consider here. If the stock market were to suffer a major setback right now (say another 30%), it would severely handicap the portfolios of retirees which would be reducing demand and therefore decreasing the amount of output the companies need to produce. The logical response to that would be layoffs.
When stock prices are relatively high, as measured by a low earnings yield (inverse of the P/E ratio), it would be logical for companies to be looking for new investment opportunities rather than repurchasing their own shares. It made sense for the market to focus on repurchasing shares rather than building out productivity capacity until the share prices were high enough to reduce the attraction to repurchasing them.
Houses Are Also Assets
It isn't just share prices that have moved up materially. Housing prices have recovered in many parts of the country. This creates a difficult situation for the Federal Reserve because the majority of MBS (mortgage backed securities) have agency guarantees. The government saw what happened in 2008 when the housing market collapsed. While having homes be prohibitively expensive is a bad thing, a sharp reduction in home values creates another problem since home owners still have the option to allow foreclosure. This is a negative sum game since labor must be poured into resolving the situation and no real wealth is created.
In short an increase in the interest rates would encourage lower valuations on the market and result in lower demand by retirees leading to lower employment and lower inflation. The problem would be compounded by damaging the value for houses since higher rates on mortgages would make housing materially less affordable from a simple analysis of cash flows. If the monthly cost of interest is higher, the purchase price must come down. This fairly simple chain makes raising rates dangerous.
The Federal Reserve is left considering a flattening of the yield curve by selling off the short term securities they hold (driving prices down and yields up) and buying more long term securities. That would allow them to flatten and perhaps even invert the yield curve. The logic of pushing down the longer end of the yield curve may be reasonable if they assume that capital expenditures would increase when the companies have access to long term debt financing on attractive rates. However, I don't foresee that as a realistic possibility.
The fundamental argument for repurchasing shares relative to capital expenditures still relies on attractive investment opportunities. Low rates on the longer end of the yield curve don't create those opportunities. It is not the role of the Federal Reserve to create those opportunities. Flattening the yield curve simply gives investors a reason to favor short term bonds over equity investments. If their ability to press long term rates created even lower rates on MBS, it would encourage the creation of another housing bubble. The ideal outcome in the housing market is slow and steady appreciation. Anything else is either fueling towards a bubble or encouraging a negative sum game.
I believe the most prudent option for the Federal Reserve is to simply commit to leaving rates lower for longer. Flattening the yield curve is only useful if the goal is to reduce the valuation of the stock market. Such a goal makes sense initially if we assume the Federal Reserve is trying to prevent valuations from getting higher and repeating the scenario from the start of the century. However the risk of pushing share values down is the reduction in demand for services that could trigger weaker GDP.
If the Federal Reserve is not going to factor the stock market into their analysis, then there is no logical basis for trying to shove short term interest rates higher when the rest of the world is pushing rates lower.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in WMT over 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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