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Too Low For Too Long

With the Obama victory last week, short-term rates could be held near zero until 2016 to reach employment targets.

- Scott Minerd (@ScottMinerd)

With the Obama victory last week, Janet Yellen, Vice Chair of the Board of Governors of the Federal Reserve, appears to be a likely candidate to succeed the current Fed chairman, Dr. Ben Bernanke, when he leaves his post in January 2014. Yesterday, Dr. Yellen said that, if necessary, short-term interest rates could be held at zero until 2016 to reach employment targets. This is longer than market participants had previously been anticipating. In 1993, then Fed chairman Alan Greenspan drove interest rates down to 3%, which was the lowest level in the post-war period at that time. He held rates there for about 18 months. When he announced, in February of 1994, that the Fed funds rate would be increased by 25 basis points, the bond market went into freefall. By September 1994, the 10-year note had lost 15% of its market value. Investors were over-allocated to long duration assets at the time and the lack of incremental new demand at the long end of the curve caused prices for credit products and other fixed income assets to fall more precipitously than Treasury prices. The event proved to be the worst bond rout since 1927.

The current situation in the bond market looks similar to 1993 in many ways. By pushing interest rates to historic lows, the Federal Open Market Committee is encouraging bond investors to extend duration and take on more risk. The question now is; what would be the effects of the Fed raising interest rates after years of keeping them below their economically justified levels? We could definitely see a 1994-type scenario play out again. This time, however, it would not be because the Fed is unaware of the risk in tightening, but because it will mis-time the pace at which excess liquidity should be removed from the system. Yesterday's statements from Yellen as well as recent history indicates that the Fed is likely to err on the side of keeping monetary policy too easy for too long. This would lead to a continuation of a buildup of inflationary pressure.