Regular readers know that over the last year this blog has run several posts on this topic that came to the same conclusion (see here, here, and here). In fact, the similarities between his Investment Outlook and this blog's posts in looking at the critical assumptions behind the Fed's zero interest rate policy suggest that he too is a regular reader.
- Recent central bank behavior, including that of the U.S. Fed, provides assurances that short and intermediate yields will not change, and therefore bond prices are not likely threatened on the downside.
- Most short to intermediate Treasury yields are dangerously close to the zero-bound which imply limited potential room, if any, for price appreciation.
- We can’t put $100 trillion of credit in a system-wide mattress, but we can move in that direction by delevering and refusing to extend maturities and duration....
The transition from a levering, asset-inflating secular economy to a post bubble delevering era may be as difficult for one to imagine as our departure into the hereafter....
Yet the imagination and management of the transition ushers forth a plethora of disparate policy solutions....
Fed Chairman Ben Bernanke ... preannounced an awareness of the deleterious side effects of quantitative easing several years ago in a significant speech at Jackson Hole. Ever since, he has been open and honest about the drawbacks of a zero interest rate policy, but has plowed ahead and unleashed his “QE bowser” into the wild with the understanding that the negative consequences of not doing so would be far worse.Actually, it his belief that the negative consequences of not doing so would be far worse.
Walter Bagehot, the man who wrote the book on modern central banking, would say that this belief is not true and that the negative consequences far exceed the benefit. Mr. Bagehot said that rates should not drop below 2% and John Maynard Keynes deferred to his judgement.
My goal in this Investment Outlook is not to pick a “doggie bone” with the Chairman. He is makin’ it up as he goes along in order to softly delever a credit-based financial system which became egregiously overlevered and assumed far too much risk long before his watch began.Like Mr. Gross, I do not want to step into the Bagehot/Bernanke debate.
This blog has consistently focused on the alternative to the Fed attempting to address over-leverage in the financial system through monetary policy. The alternative is to have the banks function as a safety valve between the excesses in the financial system and the real economy.
Banks can act as a circuit breaker by absorbing the losses on the excesses in the financial system today and restoring their book capital through future retained earnings.
My intent really is to alert you, the reader, to the significant costs that may be ahead for a global economy and financial marketplace still functioning under the assumption that cheap and abundant central bank credit is always a positive dynamic. When interest rates approach the zero bound they may transition from historically stimulative to potentially destimulative/regressive influences.
Much like the laws of physics change from the world of Newtonian large objects to the world of quantum Einsteinian dynamics, so too might low interest rates at the zero-bound reorient previously held models that justified the stimulative effects of lower and lower yields on asset prices and the real economy.
It is instructive to mention that this is not necessarily PIMCO’s view alone. Chairman Bernanke and Fed staff members have been sniffin’ this trail like the good hound dogs they are for some time now. In addition, Credit Suisse, in their “2012 Global Outlook,” devoted considerable pages to specifics of zero-based money with commonsensical historical comparisons to Japan over the past decade or so. The following pages of this Outlook will do the same.
At the heart of the theory, however, is that zero-bound interest rates do not always and necessarily force investors to take more risk by purchasing stocks or real estate, to cite the classic central bank thesis.
First of all, when rational or irrational fear persuades an investor to be more concerned about the return of her money than on her money then liquidity can be trapped in a mattress, a bank account or a five basis point Treasury bill. But that commonsensical observation is well known to Fed policymakers, economic historians and certainly citizens on Main Street.
What perhaps is not so often recognized is that liquidity can be trapped by the “price” of credit, in addition to its “risk.”
Capitalism depends on risk-taking in several forms. Developers, homeowners, entrepreneurs of all shapes and sizes epitomize the riskiness of business building via equity and credit risk extension.
But modern capitalism is dependent as well on maturity extension in credit markets.
No venture, aside from one financed with 100% owners’ capital, could survive on credit or loans that matured or were callable overnight. Buildings, utilities and homes require 20- and 30-year loan commitments to smooth and justify their returns. Because this is so, lenders require a yield premium, expressed as a positively sloped yield curve, to make the extended loan.
A flat yield curve, in contrast, is a disincentive for lenders to lend unless there is sufficient downside room for yields to fall and provide bond market capital gains. This nominal or even real interest rate “margin” is why prior cyclical periods of curve flatness or even inversion have been successfully followed by economic expansions. Intermediate and long rates – even though flat and equal to a short-term policy rate – have had room to fall, and credit therefore has not been trapped by “price.”
When all yields approach the zero-bound, however, as in Japan for the past 10 years, and now in the U.S. and selected “clean dirty shirt” sovereigns, then the dynamics may change. Money can become less liquid and frozen by “price” in addition to the classic liquidity trap explained by “risk.”
Even if nodding in agreement, an observer might immediately comment that today’s yield curve is anything but flat and that might be true. Most short to intermediate Treasury yields, however, are dangerously close to the zero-bound which imply little if any room to fall: no margin, no air underneath those bond yields and therefore limited, if any, price appreciation.
What incentive does a bank have to buy two-year Treasuries at 20 basis points when they can park overnight reserves with the Fed at 25? What incentives do investment managers or even individual investors have to take price risk with a five-, 10- or 30-year Treasury when there are multiples of downside price risk compared to appreciation? At 75 basis points, a five-year Treasury can only rationally appreciate by two more points, but theoretically can go down by an unlimited amount.
Duration risk and flatness at the zero-bound, to make the simple point, can freeze and trap liquidity by convincing investors to hold cash as opposed to extend credit.
Where else can one go, however? We can’t put $100 trillion of credit in a system-wide mattress, can we? Of course not, but we can move in that direction by delevering and refusing to extend maturities and duration.
Recent central bank behavior, including that of the U.S. Fed, provides assurances that short and intermediate yields will not change, and therefore bond prices are not likely threatened on the downside. Still, zero-bound money may kill as opposed to create credit.
Developed economies where these low yields reside may suffer accordingly. It may as well, induce inflationary distortions that give a rise to commodities and gold as store of value alternatives when there is little value left in paper.
Where does credit go when it dies? It goes back to where it came from. It delevers, it slows and inhibits economic growth, and it turns economic theory upside down, ultimately challenging the wisdom of policymakers.
We’ll all be making this up as we go along for what may seem like an eternity. A 30-50 year virtuous cycle of credit expansion which has produced outsize paranormal returns for financial assets – bonds, stocks, real estate and commodities alike – is now delevering because of excessive “risk” and the “price” of money at the zero-bound. We are witnessing the death of abundance and the borning of austerity, for what may be a long, long time.