Tuesday, December 22, 2015

The rate increase

So far, it looks like we have dodged a bullet.  Since the zero lower bound probably causes distortions even in forward rates, I thought there was a chance that when the rate hike was implemented, pulling forward rate expectations up off the zero lower bound, it would be associated with a relative decline in forward rates.  So, either there was no distortion as I had speculated that there might be, or the change in the distortion had been priced in before the hike announcement, or forward expectations are strong enough to counter it.

I think the next concern to watch for is the discovery process as credit markets react to the higher interest rate on reserves.  If the rate hike has created a contractionary response in currency, bank credit, or excess reserve levels, we will learn this over time, and I would expect forward rates at the terminal end of the yield curve to decline.  Trends in mortgage lending are probably more important than any of this.

In this graph, we can see that when the Fed backed off its rate hike plans in the first half of 2015 and the economy looked reasonably strong, the rising portion of the yield curve moved forward in time, in conjunction with expectations, and the monetary accommodation led to a general rise in the terminal end of the yield curve.  I would have liked to have seen the rate hike moved back to March or June.  I would hope that continued patience from the Fed would have pulled the long end of the curve up to 4% or 5%.  That would be normalization, if that's what we are going for.

But, as the Fed held firm on a 2015 rate hike, the long end of the yield curve fell back to the 3% range.  The confirmation of a hike pulled the short portion of the curve up slightly, but the terminal value at the long end remained around 3%.  The top end hasn't moved much since early October.  I think this is probably the thing to watch now, but I don't have any opinion about the direction it will go.  If the Fed starts pulling in more reserves and the long end of the curve begins to fall, then that seems like a strong sign that the Fed needs to reverse the hike.

If mortgage credit expands and the long end of the curve moves up, then I think we may have recovery for an indefinite period of time.


  1. "I would hope that continued patience from the Fed would have pulled the long end of the curve up to 4% or 5%. That would be normalization, if that's what we are going for."

    I guess it is possible for the long end of the curve to get back to 5%, but hard to see now. The globe is in disinflation, and possibly deflation. There are global capital gluts. Money is hunting for a home.

    Capital formation is strong, due to demographics, sovereign wealth funds, public pension plans, insurance company regulations, and cultural traits in the Far East. Possibly also huge thug-state accumulations of wealth (Nigeria, Russia etc), and internationalization of tax evasion.

    I doubt a quarter-point hike means much, and for that a matter, even negative rates may not matter.

    The big story is the Fed ceasing QE (the stock market flattened out about the same time, notice). IOER is notable, but maybe not that important. Banks won't lend unless they think it is a good loan. Yes, with IOER they get money for nothing....

    The mortgage market looks good, as we are in that phase when lenders like real estate. This is a self-reinforcing cycle. The longer the track record, the better the collateral looks (to a bank). Obviously, trees do not grow to the sky, but one can hope for healthy property markets for a while.

    I think the macro-macro story is global central bank QE. With global capital gluts, the central banks should probably conduct QE as conventional policy, ala the Bank of Japan. The PBoC may doing QE, but we don't know. The ECB is for now, but daintily.

    Frankly, I can't understand the reluctance to monetize sovereign debts. So far. little sign of inflation, and we relief taxpayer debts. Unless I am mistaken, the Swiss have missed a chance to monetize away national debts. And why not? The Bank of Japan may be on course to do much the same thing.

    The US monetized $3 trillion in federal IOUs, and the PCE core is sinking, not rising. The dollar is rising now too. The price of a new car has not changed in 20 years.

    I cannot fathom this aversion to monetizing debt at a time of sinking inflation and sluggish growth.

    It must be some sort of conflation of personal morals (indeed, one should honor debts, and not print counterfeits to pay off) and national debts (which can be paid off in fresh cash, if there are no excessive inflationary consequences).

    One note, maybe not important: Banks make money borrowing short to lend long. Short rates are up, but if anything that will bring down long rates. Banks will make less money, possibly lend less....

    But...there is so much capital sloshing around I think any good idea or business prospect or real estate deal will get financed....

    The weakness is on the demand side, and obviously so.

    1. I don't think we have dodged anything. Hoarding of long bonds is massive. Hell will freeze over, IMO, before long bond rates go up significantly. Too much demand for bonds as collateral has been created. See this article: http://m.treasuryandrisk.com/2013/06/11/demand-for-swaps-collateral-could-bolster-bonds

    2. Maybe when rates go up, the quantity demanded for collateral will go down. Maybe the derivatives market is so bloated because the opportunity cost of collateral is so low.

      I think most of your comments begin with reasoning from a price change and end with a conspiracy theory. I'm not sure there is much else for me to respond to.

    3. But Kevin, look at it this way, this bond demand is not a conspiracy, it is a fact. Well, it was a conspiracy before it came to practice. But think of this, if price goes down for these hundreds of billions of dollars of collateral, what are the counterparties going to use for the massive margin calls? You guessed it, a lot more bonds. Firms can't get enough treasury bonds. They just can't. And the weaker the bonds get, as you want, the more they will have to buy. Now tell me it isn't a conspiracy, Kevin. :)

    4. And, by the way, Kevin, I would like to see a natural market for long bonds as well. But it isnt' going to happen.

    5. Sorry. Maybe it's just above my head. But it's just not something I'm going to spend time on.

    6. But, Kevin, please, it is about supply and demand, ie, the supply and demand for the long bonds. It is a topic economists need to study, because it is affecting other tried and true measurements. I don't want to over stay my welcome here, but this is crucial stuff. The Fed has a real dual mandate. 1. save and protect the banks 2. create markets for treasury bonds.