Economic observers and money managers have faced a confusing environment since last summer, when then-Chairman Ben Bernanke shook the complacency of the market and signaled a tightening.
Markets are made at the margin, and in this case the tightening, in the form of a very small tapering, impacted the margin through a signaling effect.
Hindsight is a beautiful thing, and it’s clear that negative real yields (which reached their most negative in December 2012) weren’t forever. The Treasury curve steepened with 5-year yields rising from 60 bps to nearly 175 and the 10-year from 1.60% to almost 3.00%.
Wednesday’s Fed decision and press conference from Chairwoman Yellen didn’t make things any clearer. She commented that “policy intentions were unchanged” despite the median end 2016 Fed funds forecast jumping 50bps from 1.75% to 2.25%. Moreover, she then defined “a considerable amount of time” as potentially as short as “six months”.
The market unnecessarily obsessed over the timing and verbiage of the Fed’s taper, while the actual economy gave coincident clues of an acceleration. But improvement was largely mediocre, leaving the United States with the proud claim of being the world’s “tallest midget” in economic terms. The Fed has done extraordinary things, and it’s hard to blame the Fed, given the challenges from the financial crisis and deleveraging.
It’s worth remembering that economic data and Fed statements are followed so carefully because market participants are eager to anticipate marginal changes in monetary policy, including changes to interest rates. Despite having a poor track record of predicting both economic growth and inflation, the Fed provided thresholds to help the market better anticipate a Fed exit and eventual rate hikes. As the U-3 unemployment rate steadily fell toward the Fed’s 6.5% threshold, cries began to emerge from various corners of the market that a rate hike was closer than some thought.
I believe market participants have largely gotten off track, as they have arguably forgotten the actual purpose of a rate hike. What is the purpose of the Fed raising interest rates? Do rates necessarily need to be hiked because the unemployment rate has fallen to a certain percentage?
My answer is no, and I believe many are placing too much weight on factors such as this and missing the actual reasons why the Fed would need to hike.
What’s the Federal Funds rate?
The federal funds rate is the overnight rate at which banks lend to each other. At the current time, there is a near-zero demand for overnight money. We know this because the Fed has flooded the system with trillions of excess reserves and banks are flush with liquidity. Actual trading in the fed funds market has largely evaporated with the effective fed funds rate trading significantly under IOER (interest on excess reserves), which at this point is just a GSE arbitrage.
General collateral repo is done more as a favor than anything else between banks. Who wants to give up precious US Treasury collateral when you have enough overnight liquidity as it is? Nobody.
Now astute readers would stop me here and say, “The quantity of money injected into the system IS the reason there’s no overnight demand.”
Inflation needs to happen before rates rise
Signs of monetarist inflation are necessary before the Fed hikes rates. Although the Fed has increased the monetary base through QE, broader forms of money supply are driven by credit creation. We know that corporations have wisely taken advantage of the favorable issuance conditions and unquenchable demand for yield by issuing large amounts of debt.
Even cash-rich companies, such as Apple and Google, have joined in. That being said, households still haven’t begun to leverage again (Editor’s note: see this article for an in-depth analysis of where we’ve been and where we are). The recent Z1 report showed a slight deleveraging within households for 4Q13 after an increase in the prior quarter.
All else being equal, the Fed needs to see signs that broader forms of money supply are growing too rapidly before thinking a hike is necessary. This is what’s important — not necessarily a 6.5% unemployment figure, which doesn’t tell you enough on its own.
The Fed’s commencement of the taper is important because it’s slowing down the creation of new reserves in the system. Now this is just the tip of the iceberg in terms of what needs to be done before a rate hike could ever occur.
Once the taper ends, the Fed will be left with its existing securities portfolio, which means it would be on target to reinvest runoff, hence a flat balance sheet. The trillions of dollars of reserves sloshing around in the system create a problem because there’s not a “true fed funds rate.” This is why the reverse repo program (aka “Death Star,” by Kevin Ferry) has been created and tested.
With this, the Fed would remove reserves from the system and pledge collateral (US Treasuries and/or agency mortgage-backed securities). Many reputable sell-side analysts have estimated that $2 trillion needs to be drained before federal funds might be at a more natural rate. This is a significant task, and the current size of the reverse repo test program is just a drop in the bucket compared with this projected $2 trillion need. Draining enough reserves should close the gap between effective fed funds and IOER. Some rules of thumb of a “normal” market include effective federal funds 15 bps under IOER and 12-month bills at 35 bps.
What might happen, and what should we be looking at?
A good question is whether there will be strong overnight demand for money before indicators, such as wages and loans, have accelerated. My initial response would be “not necessarily.” We are seeing signs of an increase in bank lending as measured by the weekly Fed H8 report. Much of this growth has come in commercial and industrial (C&I), while consumer lending has been flattish.
Nonetheless, there is some evidence that broader forms of credit creation are accelerating. On the wage front, hourly wage growth appeared to spike, but that jump appeared to be fueled more by a reduction of weekly hours for a similar weekly wage. Wage growth, however, is an important thing to monitor, and very strong arguments are being made that we could see pressure on wages going forward.
Taken together, everyone keeps looking for an inflection point, and it hasn’t arrived. We began the year with the 10-year at 3.00%, and EDZ5/EDZ6 (the spread between December 15 eurodollars and December 16 eurodollars) at 125 bps. Today, that spread is 10 bps to 115 bps while 10s are down to roughly 2.75%. The spread of 5s30s has fallen to only 193bps, down from 253bps in November showing less pessimism at the long end of the curve with the majority of the concern shifting to the timing of a rate hike.
The jury is still out on whether economic growth has decelerated or if the weather really did throw a wrench in things. In the meantime, it is essential that the Fed continues to taper. It has been buying an increasing percentage of agency mortgage-backed securities with prepayments falling from higher rates and hence lower issuance.
If the Fed is going to be ready to hike rates when it needs to, the taper needs to end, and it needs to prove it can drain a significant amount of reserves through the reverse repo program. This all needs to happen at the same time as we continue to dissect economic data and search for an inflection point. Investors would do well to move past U-3 figures alone and consider exactly why the Fed would hike rates, what the signs of monetarist inflation are, and what are the mechanical roadblocks the Fed faces before a hike is feasible. As my friend Kevin Ferry says, moving back to a rates regime means that policy traction is a function of the rate relative to the current “neutral” rate.