Interest Rate Behavior and Misbehavior Post-Financial Crisis

Joe El Rady

FED TAPERING WILL NOT RAISE INTEREST RATES

QE has raised rates while tapering has lowered them

Source: STA Wealth

QE and ZIRP by design support risk taking

• QE and ZIRP redirect capital from bond markets to risk markets.

• Conversely, recent tapers have reversed capital flows from risk assets to the safety of the bond market, raising bond prices, which lowers bond yields.

• Therefore, further Fed tightening will likely lower interest rates again as investors flee to safety, increasing demand for bonds, which raises their prices and lowers their yields.

TAPERING MAY LEAD TO ECONOMIC WEAKNESS

Without Fed support the economy has weakened

Source: STA Wealth

Economic weakness in the absence of Fed support has lowered interest rates

• Each time the Fed has withdrawn financial accommodation, the economy has flagged pushing interest rates lower.

• Without Fed support, continuation of an already long economic expansion will prove difficult given the lack of underlying drivers that contribute to growth.

US economy already has enjoyed 7th longest expansion since 1879

The end of QE / ZIRP may end this already long expansion

• The Federal Reserve’s programs have effectively and successfully pulled forward future consumption to support current GDP.

• The end of these programs may reveal the void.

• Even small increases in interest rates can immediately dampen interest rate sensitive economic activities such as business lending and real estate purchasing.

The expansion, though long, has been frail

• US economy has not grown as robustly as it should during the first few years of a post-recession recovery.

• Reduced average household incomes (which have actually fallen every year for the past 5 years on an inflation-adjusted basis) have restrained the recovery.

Real GDP growth lagged over the past several years compared to other cycles

Inventory buildup has lagged and productivity growth has been weak

Personal consumption growth has been dismal

Retail sales collapsed during recession…

… and continue to underperform their long term trend…

…especially when adjusted for inflation and population growth

Comparison to other recessions demonstrates the weakness in retail…

…arrested by low personal income levels starving the economy of fuel…

…and hindering personal credit growth…

…lagging confidence…

…due to low job growth feeding a cycle leading to lower job growth

The growth that has occurred in jobs is not only anemic, but also sub-standard

• Almost 70% of jobs created in Q2 2013 and 60% of all jobs in the first half of 2013 were created in the three lowest-wage sub-sectors:– Walmart, McDonalds, Janitorial etc.– These jobs pay an average of only $15.80/hour– Half of these jobs are part-time

THE LIQUIDITY TRAP RENDERS MONETARY POLICY INEFFECTIVE

The Fed may also be caught in a Japan style liquidity trap

• Cheaper credit through monetary easing doesn’t yield much when cheap capital is already abundant.

• For example…

Twenty years of low interest rates in Japan has failed to sustain growth

MARKET DYNAMICS MAY CONTINUE TO COMPRESS RATES

As long as the world remains awash in liquidity, Treasuries will rally

• Higher propensity to save in emerging economies, coupled with investor preference for safety, has increased worldwide demand for bonds.

• Foreign central banks, such as China’s, are buying US Treasuries in order to gather dollars, thereby weakening their own currencies in order to boost exports.

• Financial institutions are also increasing Treasury purchases to satisfy bolstered regulatory capital requirements.

Supply and demand dynamics also contribute to the rally

• Higher levels of treasury purchases are occurring while the supply of you US government debt continues to shrink due to a lower budget deficit.

• The US government has enjoyed increased tax receipts due to higher tax rates, leading to lower levels of Treasury offerings.

PRICE AND WAGE DISINFLATION WILL KEEP RATES LOW

With inflation below target, rates will not rise

Labor costs remain essentially flat

Inflation is a rise in the price level

• Prices = Supply of Money * Velocity of Money• Regardless of how much the Fed increases the

supply of money, the lack of movement (velocity) of that money, will offset the supply, preventing an increase in the price level.

Money hoarding has offset money supply

PREDICTIONS AND CAUTIONS

Predictions

• Expect the size of the Fed’s balance sheet to remain above 2011 levels until 2020.– The Fed has stated that it has some tolerance for a

period of inflation in excess of its long-term targets.

• Expect policy rates close to zero until about 2016.

Cautions

• The aging demographic will continue to strain the financial system, increasing levels of indebtedness and poor fiscal policy to combat the issues restraining economic growth.

• Therefore, continued monetary interventions may create the next boom/bust cycle in financial assets.

• A potential for phantom inflation caused by bubble in asset prices remains a serious risk.