The Fed and US Treasury have been managing the yield curve for years
As yields on longer-dated US Treasuries continue to converge with the yields on shorter-term bills and notes, there has been rising concern in the mainstream business and alt-financial media of an impending recession or protracted economic downturn.
Much has recently been written about the tightening spread between the 10-year US Treasury and the two-year UST. In my weekly podcasts I point to it as a noted measure and under traditional circumstances converging yields could be considered a cause for concern. Indeed, the above chart illustrates a strong connection between yield inversion and imminent recession. It looks like we are getting close to another point in time that is raising red flags. Could a potential yield inversion be pointing to another recession?
The answer is “maybe” as we must consider the current set of monetary policy circumstances. What if the yield curve is managed to the point that any potential yield inversions are just red herrings? What if this has lost all significance?
The US Fed has been publicly discussing their desire to raise short-term borrowing rates, so that it can manage any nascent inflationary pressures and remain ahead of the curve. Moreover, the Fed understands that when any economic downturn does present itself it is incumbent for it to be able to lower the Fed funds rate to help stimulate credit growth and economic activity.
We must also acknowledge that it is vital that longer-dated US Treasury yields remain low, so that the US government can remain in business. I have pointed out in prior analysis that as far back as the late 1990s, the US Treasury and Fed were collaborating and conducting research towards their objective of suppressing US Treasury yields as debt levels became untenable. Some of their findings have since been implemented (e.g. quantitative easing). So, logically speaking, it may be safe to say that current yields along the curve may not accurately reflect the inflation, duration, default, and opportunity cost risks. Perhaps yield inversions may present themselves as false alarms.
What if the traditional Fed policy tools no longer work?
Since the creation of the US Fed in 1913, the Fed has used three (more recently four) tools to achieve its monetary policy goals:
- Adjustments to the Fed funds and discount rates,
- Increases or decreases to bank reserve requirements,
- The conducting of open market operations by selling or buying US government securities, and
- The crediting of interest on reserves held at the Fed to member banks.
Under traditional circumstances all four affect the amount of funds in the banking system.
Consider a set of circumstances where debt levels are unsustainable versus the size of the economy. What happens when traditional monetary policy no longer works in a centrally-managed economy like in the U.S.? What happens to the interest rate regime when zero or positive rates no longer work? How do we stay solvent in such an environment?
How do we survive in a regime of negative nominal interest rates?
Based on my observations it is evident that a primary objective of the promoters of our monetary system is to keep the national governments in business for as long as possible. Thus, we can never underestimate the ability of the central banks to keep this system together for much longer than we can anticipate.
Negative interest rates have become part of the central bank’s toolkit for responding to an economic downturn when nominal interest rates are already very low. They have worked largely as interest rate policy does in positive territory. This is a success and shows that central banks have a bit more firepower than they thought they had.
Negative interest rates: absolutely everything you need to know – World Economic Forum
Our financial well-being will depend on how we respond to the inevitable. The 90% of the population who don’t plan will lose. The 10% who are positioned correctly will benefit.
What was once novel will become more accepted. When confronted with the next prolonged economic crisis the US Fed will likely embark upon expanded quantitative easing programs. Its purchases could include businesses, land, corporate and municipal debt, residential and commercial real estate, and infrastructure. It will also institute a program of negative Fed funds rates for the first time. Moreover, as any economic downturn deepens I can see a scenario where a regime of negative intermediate interest rates becomes more likely.
In order to achieve these ends the monetary authorities will continue to conjure up new and novel programs to help manage sovereign yields and handle debt levels. The calls of economic calamity only help to accelerate this agenda.
The winners: Those with cash and underlevered assets when the downturn occurs, Real estate holders, owners of assets in which the prices are based on discounted cash flows (e.g. stocks, private businesses, rental properties, higher-yielding investment-grade bonds), and governments all win. Borrowers benefit the most from low to negative interest rates. Governments can crowd out many sectors of the economy by accessing cheap credit. As debt levels mount and social spending ostensibly becomes more painless, asset prices will continue to climb. The economic demographic disparities will continue to widen. Recall that sovereign debt securities can be considered leverageable instruments that can be used as collateral.
The losers: We all lose if the governments can continue to borrow without restraint, but some lose more than others. All wage earners, savers, overlevered investors as we enter the downturn, consumers who cannot access the credit markets, and conservative investors will lose out. Negative interest rates are toxic to these people. Though some banks may not actually debit a monthly amount based on a negative rate, they have circumvented that actual deduction by increasing fees on deposit accounts. Fees basically amount to a negative interest rate. If you pay a $60 annual fee (or $5 monthly maintenance fee) on your deposit account, and you hold an average of $2,000 in that account, it’s the equivalent of paying a negative 3% interest rate.
Those with the assets will continue to benefit at the expense of the wage earner. If inflation ebbs and we enter a period of deflation, asset prices could continue to escalate while wages fade. The social and income divides will widen. Asset owners will probably view a land of negative nominal interest rates as a good thing, while the wage earner will view a prolonged period of negative rates as the black horse of Revelation.
The economy may roll over, but the asset markets may continue to climb.