The Fed Didn't See This Type of Bond Conundrum Coming
There is something peculiar happening in the yield curve these days. Short-term debt maturities are acting as if the economy is very strong and inflation is already at target. Longer-term maturities are trading as if inflation may not reach the Federal Reserve's 2 percent target anytime in the next 30 years. This is creating a repeat of the “conundrum” that then-Fed Chairman Alan Greenspan complained about in 2004, where the central bank hikes interest rates and short-term yields follow, but long maturity bond yields fall because inflation is under control, causing financial conditions to loosen which, in turn, allows for more rate increases.
There is a new type of conundrum brewing, one driven by efforts in the wake of the financial crisis to make the financial system safer. The byproduct of those endeavors is that the potential exists for higher short-term rates to actually stimulate the economy. Current conditions would allow the Fed, which raised its target for the federal funds rate last week by a quarter percentage point to a range of 1 percent to 1.25 percent, to push rates all the way to its long-term target of 3 percent without causing disruption or volatility in markets.
To see how this would work, it's important to first understand that U.S. money-market reforms, the Basel Committee on Banking Supervision’s global bank capital adequacy and liquidity ratio requirements, and central bank purchases have contributed to excessive demand for safe assets. So much so that even as the Fed continues to raise rates and begins to reduce its $4.48 trillion balance sheet -- which essentially means it will hold fewer bonds -- prices of fixed-income assets perceived as safe, such as Treasury bills and notes, will remain high.
Then consider that the Greenspan conundrum of falling long-term rates had something to do with low term premiums, or the excess return investors demand to hold long maturity bonds. Short-term notes have term premiums, too, because there is always a risk the Fed may hike more than expected, and that can impose capital losses on noteholders. The premium in short-term notes is currently low despite 2-year yields having been on the rise, suggesting that investors don't appear to be concerned about the path of rates envisioned by the Fed.
More recently, a new variable has entered the equation. The U.S. Treasury Department released a report this month with recommendations for revisions to financial regulation, and suggests banks’ holdings of Treasuries, cash on deposit with central banks and initial margin requirements for centrally cleared derivatives should be excluded from the supplemental leverage ratio (SLR) calculation. This means that the cost of funding for U.S. Treasuries could fall significantly and the balance sheet capacity of primary dealers and banks may increase. That, in turn, could help revive the repo market and underpin demand for short maturity Treasuries as collateral despite a rise in repo rates rise in response to a higher fed funds rate.
Finally, there is the U.S. debt ceiling, which was reached on March 15. The Treasury has been able to borrow using “extraordinary measures” on a remaining estimated borrowing capacity of $200 billion that may run out by Aug. 31. Historically, the short end of the Treasury bill curve has been sensitive to squabbles in Washington over whether to raise the debt ceiling because not doing so could lead to a potential default by the U.S. government. Credit-default swaps tied to U.S. sovereign debt, though, have been declining despite the risk that another hostile debt-ceiling debate could be looming. Treasury bill rates, therefore, are rising for reasons other than potential default risk.
Putting this all together, it's not hard to see how the “conundrum” at the short-end of the yield curve may cause financial conditions to loosen -- ironically, higher short-term rates could stimulate the economy. In that scenario, the fed funds rate is likely to overshoot the long run neutral rate and the yield curve could invert more than during the previous two economic downturns. Bond and equity markets are so far comfortable with the scenario because it's fine for higher short-term rates to lead to looser financial conditions as long as the dollar remains weak and inflation is controlled.
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