Published January 06, 2014
“We think Janet Yellen will make Ben Bernanke look like Paul Volcker…We expect continued dollar printing no matter what as the money printers believe they are heroic.”-- Gary Kaltbaum, owner, president, Kaltbaum Capital Management.
These are just some of the comments coming out of Wall Street as Janet Yellen replaces Ben Bernanke as chairman of the Federal Reserve. The Fed’s historic amount of money printing to buy U.S. debt and mortgage-backed securities is a serious issue as its balance sheet has surpassed $4 trillion.
However, the U.S. is in a liquidity trap due to negative real interest rates, and that is a matter of serious concern.
Banks are not really profiting from making loans due to the Fed’s zero-bound rate policy, which would help small businesses grow and help bring back animal spirits into the U.S. economy. The Fed’s zero-bound rate policies arguably have put a damper on lending, as real rates (nominal interest rates minus expected inflation) stay below zero.
Certainly the Fed’s money printing has been a mood elevator on Wall Street, helping to create $5.4 trillion in market cap, notes Peter Boockvar, chief market analyst of the Lindsey Group. Investors are only slightly overpaying for stocks versus historical price-earnings ratios, though Boockvar warns investors are buying low-quality earnings “driven by lowered interest expense, stock buybacks, lower tax rates, reduced depreciation expense due to anemic levels of capital spending and stingy wage growth.”
And that means true, solid U.S. economic growth isn’t yet with us, as problems have been papered over and backfilled. Whether the bond market forces Wall Street to remove its beer goggles about stocks has also been the topic of debate, as the ten-year note trends higher than 3%.
But what is likely constricting the powerful bandwidth of the U.S economy is the zero-rate policies at the Fed itself, whereby the central bank has kept rates at zero to 0.25% since December 2008.
Yes, the Fed’s lower rates helped banks and consumer borrowers stabilize, and yes the government gave banks unprecedented bailouts. Yes a divided D.C. has put too much of the onus on the central bank to do something, anything, as the number of Americans without jobs or underemployed sit at record highs.
But now the banks are struggling to make money on loans and credit lines, restricting growth. Banks have been stingy because they can’t make a lot of money on their loans since rates are so low, with implications for banking giants Wells Fargo and U.S. Bancorp which rely on the traditional loans-deposits model for a majority of their income. Because rates are stuck near zero, banks are squeezed between paying interest on deposits and earning profits by charging higher rates on loans. Small- to mid-sized businesses have seen credit restricted, versus the large-cap companies which can borrow in debt markets.
Bank net interest margins have been squeezed since 1994, and now sit an average 3.2% (see here: http://research.stlouisfed.org/fred2/series/USNIM ), leaving bankers reaching for yield, with disastrous effect in the London Whale fiasco at JPMorgan Chase.
So where do we go from here? Watch the Fed’s reaction back in 1994, when the U.S. economy was just resurfacing from a nasty recession. The Fed began to tighten rates in response to inflation concerns as consumer borrowing picked up and the U.S. experienced tight supplies of materials and labor. The jobless rate was lower then, 6.6% versus 7% today. The Federal Reserve gradually raised rates in February 1994, starting back then with a quarter point hike and continuing through the end of that year.
Treasuries fell on the news and yields rose, as the bond market put the squeeze on the ten-year note, spiking it higher to nearly 8% from about 5.9%. That set the stock market back on its heels and earned the Fed withering headlines.
When and how will the Fed raise rates? Quarter-point increments have been the rule in the last two decades, which the Fed did starting in 1994 and then again ten years later in 2004.
Outgoing Fed chair Bernanke said last Sept. 18 that the Fed may not raise a key short-term rate—the rate banks charge each other for overnight loans—before U.S. unemployment falls “considerably below” 6.5 %.
However, the Fed’s rate policy could be hamstrung by Washington’s dramatic spending. In fiscal 2013, which ended Sept 30, 2013, the U.S. had $16.7 trillion in debt (it topped $17 trillion in October). Because of the Federal Reserve’s aggressive efforts to keep interest rates low, the U.S. government is paying record low rates on its debt. Taxpayer costs for net interest payments on U.S. debt totaled $222.75 billion or 6.23% of all federal outlays in fiscal 2013. According to the Treasury Department, the average interest rate that year on the public debt was 2.43%.
The government—with taxpayers as the backstop—is still highly dependent on free flowing and abnormally cheap money. Another point worth noting: Nearly one-third, 28.4% of U.S. debt, or $4.76 trillion, is owed to another arm of the U.S. government. The single biggest creditor, in fact, is Social Security.
Kathy A. Jones, vice president, fixed income strategist, Schwab Center for Financial Research, noted in an August report that the Fed has been here before, of course, on a smaller scale. Jones notes that: “In the 1940s, the Treasury wanted to keep government borrowing costs low to finance the war. The Federal Reserve was pressed to buy government bonds in order to hold down interest rates. In 1942, T-bill rates were formally capped at 0.38% and the discount rate was set at no more than 1.5% by the Fed.”
Jones added: “Long-term rates were also effectively capped at 2.5% by the Fed purchasing securities. The Fed's ownership of Treasuries rose from about 4% of GDP in 1929 to above 20% by 1940. Today, the Fed's holdings are about 22% of GDP; they were about 6% prior to the financial crisis.”
The trick with rate policy is forward guidance, on top of the Fed’s move toward more transparency via press conferences, publications and testimony before Congress. Jones says this:
-“Credible Fed policy and 'well-anchored' inflation expectations may be more important than the size of the Fed's balance sheet."
-“The Fed may be able to hold bonds on its balance sheet for a long time without causing inflation. It did not have to liquidate its holdings quickly in the 1950s. As a result, there weren't any sudden spikes in yields as the market tried to absorb the supply."
-“In the post-war era, the Fed continued to buy bonds as needed to maintain 'orderly conditions' in the market. It also managed duration on the balance sheet by exchanging long-term bonds for non-marketable bonds redeemable at the holder's option before maturity by conversion to a five-year marketable Treasury."