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The Fed and interest rates


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https://www.cnbc.com/2018/10/18/fed-will-ultimately-push-the-us-into-recession-strategist-says.html

 

Why should we ever have an inverted yield curve?

 

I understand the desire to slowdown the economy at times to avoid rising inflation but, if you get that result isn't a clear sign that you have over-tightened?

 

Right now the Fed wants to increase short term rates but, at the same time we have both the Fed and ECB reversing their bond purchase program. How do you account for both on the yield curve and economic impact?

 

Anyway, just an anecdote. I was looking to replace my car lease with another one from the same manufacturer. Turns out that yields have gone up by 2.5% in just over 3 years. The impact is around 21% more per month than I was paying for a vehicle of similar value at original purchase. This has made me reconsider the entire leasing vs owning idea and even owning for a lot longer.

 

Also in the process of locking my mortgage for 5 years. Yields have gone up by around 0.75% since last year. While it seems like a small percentage increase, the impact on monthly interest paid is large vs what it was last year at same time since the increase in interest paid is around 22%.

 

So it seems to me that the increase in long term rates that we have seen already and reflected in the two largest expenditures of a regular family as described by my experience above is enough to cause a pause in spending behavior without any further increase in short term rates. And that is from a consumer that has a fair bit of financial flexibility. What about paycheque to paycheque folks?

 

Thoughts?

 

Cardboard 

 

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If you don't normalize interest rates when the economy is going gangbusters, you don't have any room to ease when the cycle turns.  I won't get into the debate on whether we should even be trying to soften the extremes of the cycle - but the rate environment many people got used to was not 'normal.'

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I agree that this is a short term long term question. The FED has started to reverse course but, in the overall scheme of things, would say that they are still accommodative. Wouldn't want to be in their shoes at this point. Guess also that they would easily revert to lowering interest rates at the first sign of distress which will provide other opportunities for interesting debates.

 

Thinking back of previous chairmans, what Mr. Volcker did in the early 80's was certainly not popular and an argument could be made that a recession was "triggered" but, lo and behold, in a way, it set the stage for one of the most amazing bull market.

 

There is another chairman that I admire: William McChesney Martin. Interesting to remember that when calls to have him go finally hit home, Mr. Buffett was planning on disbanding his partnership.

https://fraser.stlouisfed.org/files/docs/historical/martin/20_09_19650610.pdf

 

When somebody goes to the emergency room with a diabetic coma secondary to a sugar overdose, no questions asked, insulin is given and the life is saved. It's what happens after which is interesting as a largely preventable disease can be endured and in fact worsened by simply continuing on applying the same medicine. It's a question of perspective, different opinions are respected and maybe the point of view I describe can't stand prosperity but I think the punch bowl occasinally needs to be taken away. And IMO, this is such a time.

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I think the ECB finally concluding their quantitative easing enables the FED to raise interest rates without the USD shooting up. The latter wouldn’t be good for the US industry. I think we are leaving the Goldilocks zone where we could have economic growth , no inflation and low interest rates at the same time. Now it’s one vs the other.

 

We all know that interest rates are gravity for asset valuations , so higher interest rates will prevent bubbles from occurring. To better to deal with bubbles early on than to firefight the issue after a huge bubble has popped.

 

I think Greenspan was wrong when he stated that he does not care about asset bubbles as long as inflation is low.

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Firstly, there's nothing weird about raising rates and reversing bond buying. The way that central banks raise rates is not just by talking about it. They do it by tightening the money supply through open market operations. Namely selling bonds. So you should expect to see that.

 

Your anecdotes are really just monetary policy at work. Slowing down economic activity. That's what it is supposed to do. It is a fairly blunt instrument and it affects different people in different ways. While certain banks won't go out and say it, they don't care much who it affects as long as it has effect: i.e. if the economy slows when they want it to slow or accelerate when they want it to accelerate. But housing is big in monetary policy transmission.

 

Finally, your initial question: Should we ever have an inverted yield curve? Well, technically speaking, no. But for various reasons they've happened on occasion. And, while they're a leading indicator for a recession, the recession doesn't always come. The place where we are right now, possibly leaving a period of very low rates and entering a period of higher ones does pose a risk of an inverted curve. It's also one of those times when an inverted curve may not mean that much.

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Cardboard, my read is the 2008 financial crisis caused unprecidented easing by the Fed. Calitalism alsmost ended as we know it (there is some truth to it :-) Interest rates and QE went to extreme levels and this has created asset bubbles in Canada (not sure about Europe).

 

Interest rates need to normalize. There is a huge debate in Canada about affordable housing and nobody wants to discuss the core issue which is crazy low interest rates. As interest rates normalize we are going to have a housing price correction and this will be a good thing for Canada long term (not in the short term). There will be winners and losers (just like there has been in the past 10 years).

 

When asked if the stock market was overvalued Buffett has said repeatedly it was not with the yield on 10 year treasuries of 2% (where they were not too long ago). It makes sense that as rates normalize that the stock market averages will come under pressure. This is healthy.

 

Will the Fed tighten too much too fast? Perhaps. But 18 months ago nobody would have thought they would have been able to raise rates 7 times and for the economy to be running at 3.5% GDP growth. What the Fed has been able to accomplish against the advice of pretty mich everyone else is pretty amazing (and pretty ballsy).

 

The non-consensus view is that the 10 years rate continues higher in 2019 (to 3.5 or higher). If that happens i think the Fed will continue to tighten. (The key to both of these is US economic growth...)

 

My question is why is Europe and Japan not taking the hard medicine to get their houses in order. Both look sick and in denial. What are they going to do when the next down turn hits, especially if it is bad?

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why would fed raise short term rates before it has sold of long term QE portfolio?  seems strange.  I understand that there is no road map, but if you have an unprecedented long position in mostly long dated treasuries, shouldn't you address that first?

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why would fed raise short term rates before it has sold of long term QE portfolio?  seems strange.  I understand that there is no road map, but if you have an unprecedented long position in mostly long dated treasuries, shouldn't you address that first?

Not strange at all. The moment that they sell bonds, rates go up. It's just basic monetary economics.

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Firstly, there's nothing weird about raising rates and reversing bond buying. The way that central banks raise rates is not just by talking about it. They do it by tightening the money supply through open market operations. Namely selling bonds. So you should expect to see that.

 

 

Thank you for saying that.

 

I was wondering if my understanding of the mechanisms were right.

 

It kind of puts politicians in a tough position.

 

They scream bloody murder about debt because it rings true with voters but in order to reduce $ supply, you gotta issue debt to remove dollars.

 

Aren't higher taxes & lower spending another set of levers to pull?

 

Doesn't less money get more choosy about where it goes?

 

Short term pain for long term gain.

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Firstly, there's nothing weird about raising rates and reversing bond buying. The way that central banks raise rates is not just by talking about it. They do it by tightening the money supply through open market operations. Namely selling bonds. So you should expect to see that.

 

 

Thank you for saying that.

 

I was wondering if my understanding of the mechanisms were right.

 

It kind of puts politicians in a tough position.

 

They scream bloody murder about debt because it rings true with voters but in order to reduce $ supply, you gotta issue debt to remove dollars.

 

Aren't higher taxes & lower spending another set of levers to pull?

 

Doesn't less money get more choosy about where it goes?

 

Short term pain for long term gain.

I'd say that you have an idea but your understanding of the mechanisms is wrong.

 

You're confusing monetary policy with fiscal policy. Politicians deal with fiscal policy. Issuing debt (fiscal policy) does not shrink money supply. What shrinks money supply is when the central bank sell debt that has already been issued (monetary policy) from their holdings.

 

You're right central banks put politicians in a tough position. But I think again for the wrong reasons. Since you've touched on this let's dig a little in basic economics. I don't want this to get too political (general discussion board), but you have a good example with Donald Trump because he's so crude. It makes for a good teachable moment because it really highlights why the system is set up the way it is.

 

So Trump is trashing the Led. Logically from his position it makes total sense to do that. Because at the basic level the interests of politicians and central bankers are diametrically opposed. When you get down to incentives, politicians' goals are to get re-elected. Central bankers' jobs is to manage the economy, especially the inflation. So we the economy is doing very well their job is to take away the punch bowl and slow things down so that things don't get out of control. Politicians don't like that, because it's easier to get re-elected when times are good and the economy is rolling. When the train derails, they can leave and let someone else deal with the wreck. This dynamic gets amplified when you have a high powered political position with term limits such as the presidency of the US.

 

This is the whole basic logic and reasoning why western economies have designed the role of the central bank to be independent of politicians and political structures. That's why you hear so much about central bank independence. Politicians don't like it, but for the most part they've come to accept it. And it's really worked out quite well. Though I think we got lucky in a few spots.

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why would fed raise short term rates before it has sold of long term QE portfolio?  seems strange.  I understand that there is no road map, but if you have an unprecedented long position in mostly long dated treasuries, shouldn't you address that first?

Not strange at all. The moment that they sell bonds, rates go up. It's just basic monetary economics.

 

disagree.  fed can only raise short term rates by decree.  to raise long term rates, they have to sell bonds.  by only doing former they risk inverting yield curve.  they should have done the latter first. fed is now risking recession by getting things assbackwards

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why would fed raise short term rates before it has sold of long term QE portfolio?  seems strange.  I understand that there is no road map, but if you have an unprecedented long position in mostly long dated treasuries, shouldn't you address that first?

Not strange at all. The moment that they sell bonds, rates go up. It's just basic monetary economics.

disagree.  fede can only raise short term rates by fiat.  to raise long term rates, they have to sell bonds.  by only doing former they risk inverting yield curve.  they should have done the latter first

I'm sorry, they don't raise rates by fiat. They do it by altering the money supply. To increase money supply they buy bonds, to decrease it, they sell bonds. They make the announcement and then proceed to implement it. There's really nothing to disagree with. It's just how it's done. Otherwise the free market will tell the fed to shove it - metaphorically speaking.

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The artificially, extremely low-interest rates for such a long time caused massive debts and money flow into EMs.

 

So, this situation already exists and in order for it not to get worse, interest rates have to rise.

 

The economy is fine, the market is doing good, that's the best time to do it.

 

Of course, because they rise it messes up all those EMs and debts.

 

Point is, the shit was created when they kept the interest rates too low for too long and now we have to deal with it.

 

 

 

 

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Very interesting topic indeed. Let me share some thoughts given that I spend a lot of time of my day-to-day dealing with this given I work in Fixed Income Strategy. Coincidentally, my boss spent 10 years at the Fed working on monetary policy and how it translates to financial markets so I've learned a lot from him. (Kind of ironic that as a bottoms-up guy I spend a lot of my day looking at macro stuff, but still interesting).

 

Let's define three things first. First, Short rates (think 2yrs and less) are very highly correlated with the Fed funds rate. The Fed sets an overnight interest rate at which banks lend reserve balances (at the Fed) to each other. This in turn has direct implications on the overall money market rates across markets (LIBOR, short term bank lending, Treasury bills, prime rate etc.) How does the Fed come up with this? Well, the Fed has a DUAL mandate, maximum employment (BIG checkmark here right now, there are more job openings than people to fill them) AND stable prices, this importantly includes a 2% inflation mandate and the prevention of asset bubbles (aka financial conditions). Right now inflation is (finally) at or above 2% depending at what measure you look at (they look at core PCE and economists look at core CPI). But it's going in the right direction. The second important concept is the Neutral Rate, or the rate at which the Fed is not in a restrictive or accommodative stance, thus letting the economy run naturally without giving it anything nor taking anything away. There is no way to know what exactly this is but there are various estimates, basically looking at forward inflation dynamics (10yr inflation breakevens) and potential growth. Both of these have come down due to poor demographics (think Japan as the extreme, very old population), lower productivity and technology. The estimate is the neutral rate sits at 2.75-3%. Third concept, Long rates, the most widely followed benchmark being of course the 10yr Treasury. IF we knew what the neutral rate would be for the next 10 years, the 10yr treasury should trade at the average level of the neutral rate. Of course this is not the reality and there is uncertainty tied to this, but essentially the 10yr treasury trades on whatever the market thinks inflation is going to be for the next 10 years+some compensation for growth+some compensation for uncertainty (aka term premium, right now this is negative - prob because of QE - and a whole other subject).

 

This brings us to the yield curve, the Fed will keep following its mandate and thus keep hiking interest rates as long as the data suggests it has a 2 checkmarks on the both mandates. In fact, it will probably overshoot, meaning it will go above the neutral rate in order to slowdown the economy and prevent any sort of overheating, which usually doesn't end well and is a worse alternative. On the other hand, once they overshoot, and say they are at 3.5% and the 2yr is at 3.8%, the 10yr will probably be trading below that because  it will be pricing in a probable recession as we get to the end of the cycle and an economy that over the next 10years will have low inflation and low growth, so it might be trading around 3.5% (just a little above where we are). Thus we would have an inverted yield curve, with a 2s10s curve of negative 30 basis points.

 

This has happened basically in every single cycle going back 80 years.

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why would fed raise short term rates before it has sold of long term QE portfolio?  seems strange.  I understand that there is no road map, but if you have an unprecedented long position in mostly long dated treasuries, shouldn't you address that first?

Not strange at all. The moment that they sell bonds, rates go up. It's just basic monetary economics.

disagree.  fede can only raise short term rates by fiat.  to raise long term rates, they have to sell bonds.  by only doing former they risk inverting yield curve.  they should have done the latter first

I'm sorry, they don't raise rates by fiat. They do it by altering the money supply. To increase money supply they buy bonds, to decrease it, they sell bonds. They make the announcement and then proceed to implement it. There's really nothing to disagree with. It's just how it's done. Otherwise the free market will tell the fed to shove it - metaphorically speaking.

 

The market tells the Fed to shove it when it crashes significantly, and then the Fed will stop raising rates, at least for a while.

 

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The market tells the Fed to shove it when it crashes significantly, and then the Fed will stop raising rates, at least for a while.

I meant the money market, not the stock market.

 

Edit: I don't think the equity markets will find much love from the Fed this time around if inflation is at or above target.

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Very interesting topic indeed. Let me share some thoughts given that I spend a lot of time of my day-to-day dealing with this given I work in Fixed Income Strategy. Coincidentally, my boss spent 10 years at the Fed working on monetary policy and how it translates to financial markets so I've learned a lot from him. (Kind of ironic that as a bottoms-up guy I spend a lot of my day looking at macro stuff, but still interesting).

 

Let's define three things first. First, Short rates (think 2yrs and less) are very highly correlated with the Fed funds rate. The Fed sets an overnight interest rate at which banks lend reserve balances (at the Fed) to each other. This in turn has direct implications on the overall money market rates across markets (LIBOR, short term bank lending, Treasury bills, prime rate etc.) How does the Fed come up with this? Well, the Fed has a DUAL mandate, maximum employment (BIG checkmark here right now, there are more job openings than people to fill them) AND stable prices, this importantly includes a 2% inflation mandate and the prevention of asset bubbles (aka financial conditions). Right now inflation is (finally) at or above 2% depending at what measure you look at (they look at core PCE and economists look at core CPI). But it's going in the right direction. The second important concept is the Neutral Rate, or the rate at which the Fed is not in a restrictive or accommodative stance, thus letting the economy run naturally without giving it anything nor taking anything away. There is no way to know what exactly this is but there are various estimates, basically looking at forward inflation dynamics (10yr inflation breakevens) and potential growth. Both of these have come down due to poor demographics (think Japan as the extreme, very old population), lower productivity and technology. The estimate is the neutral rate sits at 2.75-3%. Third concept, Long rates, the most widely followed benchmark being of course the 10yr Treasury. IF we knew what the neutral rate would be for the next 10 years, the 10yr treasury should trade at the average level of the neutral rate. Of course this is not the reality and there is uncertainty tied to this, but essentially the 10yr treasury trades on whatever the market thinks inflation is going to be for the next 10 years+some compensation for growth+some compensation for uncertainty (aka term premium, right now this is negative - prob because of QE - and a whole other subject).

 

This brings us to the yield curve, the Fed will keep following its mandate and thus keep hiking interest rates as long as the data suggests it has a 2 checkmarks on the both mandates. In fact, it will probably overshoot, meaning it will go above the neutral rate in order to slowdown the economy and prevent any sort of overheating, which usually doesn't end well and is a worse alternative. On the other hand, once they overshoot, and say they are at 3.5% and the 2yr is at 3.8%, the 10yr will probably be trading below that because  it will be pricing in a probable recession as we get to the end of the cycle and an economy that over the next 10years will have low inflation and low growth, so it might be trading around 3.5% (just a little above where we are). Thus we would have an inverted yield curve, with a 2s10s curve of negative 30 basis points.

 

This has happened basically in every single cycle going back 80 years.

 

agree with this, but you left something out re long rates....fed can directly affect supply and bond interest rates by selling its trillions in bonds.  usually fed cant directly tinker with long rates.  now it can...and it should to avoid an inverted yield curve

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agree with this, but you left something out re long rates....fed can directly affect supply and bond interest rates by selling its trillions in bonds.  usually fed cant directly tinker with long rates.  now it can...and it should to avoid an inverted yield curve

You seem to want to add another mandate to the FED: to avoid an inverted yield curve?

Isn't an inverting or inverted yield, if at all useful, only a symptom of an underlying problem and not a problem in itself?

 

I understand that the FED has laid out a plan to gradually decrease its balance sheet over a few years by letting bonds mature and by not reinvesting the proceeds. Are you suggesting, as they are entering the second and most delicate part of the greatest (unorthodox and aggressive) monetary experiment of all times, that they suddenly unwind the humongous position that they have built since the financial Pearl Harbour?

 

Interesting to consider the unwinding options and timeline, as tightening is being mentioned (and felt, see opening post), but the "normalization" process has only begun and lags are expected. Looking at what the Bank of the Ozarks reported today and compared to previous trend, its net interest margin has steadily decreased but not by much (even report an improving core spread) mostly because the asset side is mostly tied to variable rates but the the "tightening" is being felt as it is passed on to the borrower and aggregate loan growth has started to moderate already. Perhaps just a blip for the bank but we may already see the early manifestation of the tide going out (risk premium set too low, credit mistake) even if the "normalization" is just starting.

 

Just to add, versus another part of the thread above, monetary and fiscal policy are two different animals but, for a while, the FED was, in a way, buying debt issued by the government (indirectly in the secondary market) and this paradigm will change as the FED will no longer be a net buyer of government debt at a time when the Treasury Department will need to offer an increasing amount of debt to the market. I wonder if they will go to the short or long end of the curve.

 

 

 

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The bonds/QE were a liquidity program from my understanding. I'm not aware of the fed showing they had any affect on LT rates (or even immediate rates). They could affect LT rates for a short period, but that would be an expensive mistake.

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The bonds/QE were a liquidity program from my understanding. I'm not aware of the fed showing they had any affect on LT rates (or even immediate rates). They could affect LT rates for a short period, but that would be an expensive mistake.

 

there was a huge demand for money after FC, and fed satisfied that demand by buying bonds and letting banks hold excess reserves that, for the first time, bore interest.  I am not saying that QE was wrong.  just that a coordinated unwind makes more sense than hiking short term rates and sitting on a long portfolio....and it is mostly long dated (lots of agency and t bonds)

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The bonds/QE were a liquidity program from my understanding. I'm not aware of the fed showing they had any affect on LT rates (or even immediate rates). They could affect LT rates for a short period, but that would be an expensive mistake.

 

there was a huge demand for money after FC, and fed satisfied that demand by buying bonds and letting banks hold excess reserves that, for the first time, bore interest.  I am not saying that QE was wrong.  just that a coordinated unwind makes more sense than hiking short term rates and sitting on a long portfolio....and it is mostly long dated (lots of agency and t bonds)

 

Ya, I'm not second guessing the merit of QE, but it was a liquidity program. It had no long-run effect on LT rates. Unwinding will decrease liquidity. We are in the midst of that. If they go any faster we will see sporadic shocks. LT rates are primarily inflation expectations plus some other risk factors. ST rates are a completely separate issue from LT rates from a central bank perspective.

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The bonds/QE were a liquidity program from my understanding. I'm not aware of the fed showing they had any affect on LT rates (or even immediate rates). They could affect LT rates for a short period, but that would be an expensive mistake.

 

there was a huge demand for money after FC, and fed satisfied that demand by buying bonds and letting banks hold excess reserves that, for the first time, bore interest.  I am not saying that QE was wrong.  just that a coordinated unwind makes more sense than hiking short term rates and sitting on a long portfolio....and it is mostly long dated (lots of agency and t bonds)

 

Ya, I'm not second guessing the merit of QE, but it was a liquidity program. It had no long-run effect on LT rates. Unwinding will decrease liquidity. We are in the midst of that. If they go any faster we will see sporadic shocks. LT rates are primarily inflation expectations plus some other risk factors. ST rates are a completely separate issue from LT rates from a central bank perspective.

 

disagree.  this time, there is no short term and long term disconnect for fed; fed can directly raise long term rates by selling its massive QE bond portfolio. that's why this time is different, and fed is botching the term structure by not selling its bonds back into the market

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The bonds/QE were a liquidity program from my understanding. I'm not aware of the fed showing they had any affect on LT rates (or even immediate rates). They could affect LT rates for a short period, but that would be an expensive mistake.

 

The fed can certainly affect LT rates.  What would happen to LT rates if $100T was printed tomorrow?  What would happen to LT rates if fed shrunk MB by 99% tomorrow? (extreme examples, but they are helpful thought experiments)

 

All of this gets confusing, but the effect is usually the opposite of what most people think.  Most think that low interest rates are a sign of easy money when in fact, as Milton Friedman said, low interest rates are a sign of TIGHT money.

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The bonds/QE were a liquidity program from my understanding. I'm not aware of the fed showing they had any affect on LT rates (or even immediate rates). They could affect LT rates for a short period, but that would be an expensive mistake.

 

The fed can certainly affect LT rates.  What would happen to LT rates if $100T was printed tomorrow?  What would happen to LT rates if fed shrunk MB by 99% tomorrow? (extreme examples, but they are helpful thought experiments)

 

All of this gets confusing, but the effect is usually the opposite of what most people think.  Most think that low interest rates are a sign of easy money when in fact, as Milton Friedman said, low interest rates are a sign of TIGHT money.

 

No, it's important thought experiments! If they bought $100T the USD would tank and vice versa. You can't view rates in isolation.

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