At the moment, the economic dynamic is exceedingly complicated. An understatement, I fear. The crosscurrents in the data and the markets are treacherous, and I suspect will have Fed officials scratching their heads. Hold steady with existing plans? Step up the liquidity provisions? More actively engage plans to tighten policy? The latter option seems almost inconceivable; for the moment, the debate will focus on the issue of further easing. At this point, I think the Fed will sit tight, allowing further easing to come from the already active TALF program, rather than expanding outright purchases of Treasuries.
The core issue is the steep rise in Treasury yields, which apparently were kept in check only by the expectation that the Fed would continued to gobble up the endless stream of securities issues by the US Treasury. The Fed sank that hypothesis at the last FOMC meeting, and a subsequent statement by Federal Reserve Chairman Ben Bernanke made clear that the Fed does not have a 3% target on 10 year Treasury yields. Since then, yields have climbed as high as 3.75% before prices rebounded today, bringing yields down to 3.61%. Should we be concerned with the gains?
Brad DeLong argued a few weeks ago that the Fed’s reluctance to cap rates was a policy error in the making. Indeed, it would seem that rising yields are toxic for debt heavy balance sheets, especially where housing is concerned. Officials repeatedly point to the importance of supporting housing prices, a policy that would be undermined as rising Treasury yields boost mortgage rates higher. And while we have seen some stability in recent months in existing homes sales – of which foreclosures and distressed sales are no small part – the recent Case-Shiller data makes clear that housing markets remains under severe pricing pressure:
Home prices in 20 major metropolitan areas fell in March more than forecast as foreclosures surged, threatening to extend the housing slump.
The S&P/Case-Shiller home-price index decreased 18.7 percent from March 2008, matching the drop in the year ended in February. The measure declined 19 percent in January, the most since data began in 2001.
In contrast is the view that rising yields signal an unambiguously positive environment in future months, a sentiment echoed by US Treasury Secretary Timothy Geithner:
Geithner, 47, also said that the rise in yields on Treasury securities this year “is a sign that things are improving” and that “there is a little less acute concern about the depth of the recession.”
Likewise, Alan Blinder is confused by thoughts that the Fed would attempt to control yields at all:
Blinder said he’s “more dubious” about the Treasury purchases themselves. Any reduction in long-term rates makes it more difficult for U.S. banks to generate earnings to make up for what the Fed estimated earlier this month would be $600 billion in losses under adverse economic conditions. “It makes it harder for them to earn their way out,” he said.
So we are stuck with two apparently contrasting views. On one hand, rising long rates and the related steepening of the yield curve should indicate improving economic conditions – after all, rising yields simply imply that market participants are gaining confidence to put their money to work in more risky endeavors. The steeper yield curve should boost bank earnings and, in time, encourage lending. On the other hand, higher yields may undermine support for the housing market, thus extending the downturn. The Wall Street Journal believes the Fed is choosing the positive spin:
Federal Reserve officials believe the recent sharp rise in yields on U.S. Treasury bonds could reflect a mending economy and a receding risk of financial catastrophe, suggesting the central bank won’t rush to react — even though some investors see danger in the government’s rising cost of borrowing.
The WSJ is most likely correct. Indeed, I too want to believe the first story; the steep yield curve should be a clear signal that economic activity is poised to soar. Two things are holding me back. First, the 10-2 spread went positive in mid-2007, which should have indicated that the expected Fed easing later that year would catch fire and the economy would be clear of recession territory by mid-2008. Oops – the signal was premature. Something was different (just as I had come to embrace the yield curve’s signals). My second concern is that rising yields indicate capital is fleeing the US, and the shape of the yield curve is being influenced significantly by shifts in patterns of foreign central bank purchases. And while the resulting depreciation of the Dollar will support US growth over time, the transition can be very disruptive. Interestingly, the Wall Street Journal story quoted above does not point to this possibility.
As Brad Setser highlights, the current dynamic is eerily similar to that of late 2007 and early 2008. In hindsight, this should have been anticipated. Financial market stability has improved dramatically as Federal Reserve Chairman Ben Bernanke and Geithner have made clear that no major US bank will be allowed to fail. It just won’t happen. That stability makes way for a reversal of the flight to safety, and the Dollar comes under pressure, and, with it, US Treasuries. The reversal must be strong – note how Treasuries sank this week despite a clear escalation in North Korean rhetoric, which should have driven some safety trades. Moreover, with the US consumer widely expected to not be a driver of growth going forward, market participants look toward the emerging markets for growth. In essence, the Fed’s ZIRP policy combined with stable financial markets once again makes the Dollar carry trade attractive. Since old habits die hard, this should “force” foreign central banks to accumulate Treasury assets – and it has.
In this scenario, stable financial markets are now pushing for further reduction in the US external deficit. To be sure, while the deficit is much smaller, it still exists . And, once again, it looks like much of the world, from the Fed to the Treasury to the emerging market central banks, are resisting the adjustment as it requires continued soft domestic demand in the US to limit imports. Eventually, that resistance will reveal itself. For example, additional US weakness will be offshored to those regions not supporting the Dollar – hence Euro and Yen strength. And commodity prices might catch a stronger bid. Indeed, this explains the gains in oil in recent weeks.
But Brad identifies an important twist on that story:
Third, the rise in central bank reserves isn’t translating into a rise in demand for longer-term US bonds. Central banks are just buying short-term bills. That presumably is one of the reasons why long-term rates are rising now – while they remained (surprisingly) low back in 2006, 2007 and 2008. Central banks weren’t willing to buy long-term notes at 2% — or even at 3%. Maybe they just didn’t want to lock in low rates. Maybe they feared a mark-to-market capital loss if rates rose. Or maybe they fear that inflation will rise, eroding the real value of longer-term claims. In some sense, it doesn’t matter. The dynamics of the market changed …
Brad has more in a subsequent post. It is almost as if foreign central banks know that the endgame of everyone’s behavior is inflation, and thus avoid longer dated securities. Not a particularly comforting thought – but one consistent with the steady rise in the 10 year Treasury-TIPS breakeven spread. Perhaps too foreign central banks realize that if the Fed is no longer willing to be a buyer of last resort of longer dated Treasuries, why should they?
How will the Fed behave in this environment? Presumably, if inflation expectations were to rise significantly, policymakers would need to respond by chasing long rates. After all, they have made clear that the target range is 1.7-2%, and want to anchor inflation expectations at those levels. With this in mind, expect policymakers to continue to emphasize their readiness to wind down their programs and raise the Fed Funds rates, when necessary, in order to combat inflation. Also, policymakers will likely turn attention toward commodity prices, particularly oil – saying something to the effect that they are keeping their attention on energy costs, but remain focused on the wide output gap, which suggests disinflation pressure in wages and core prices.
It remains difficult, however, to imagine that the Fed is truly ready to start reversing policy in the near term. Despite green shoots, US economic growth remains anemic. The green shoots really don’t look all that green. Initial jobless claims may have peaked, but they are certainly not dropping at a rate consistent with a strong rebound. Hovering just above 600,000 claims a week promises to sustain weak employment reports in the months ahead, as long as rising unemployment. Can we see a policy reversal with unemployment rates on the rise? Consistent with ongoing job market weakness, policymakers continue to commit to a sustained period of near zero rates. See Federal Reserve Vice Chair Donald Kohn last week:
In my view, the economy is only now beginning to show signs that it might be stabilizing, and the upturn, when it begins, is likely to be gradual amid the balance sheet repair of financial intermediaries and households. As a consequence, it probably will be some time before the FOMC will need to begin to raise its target for the federal funds rate. Nonetheless, to ensure confidence in our ability to sustain price stability, we need to have a framework for managing our balance sheet when it is time to move to contain inflation pressures.
Moreover, the financial stability we have seen in recent months is clearly dependent on the willingness of the Fed to commit large quantities of liquidity in various guises. Policymakers are wary that financial markets can stand on their own, and will not be eager to speed up their eventual withdrawal. Start-stop policy would certainly impose a fresh policy uncertainty that could trigger a new chapter in the crisis. No, policymakers will not change course unless a new disorderly Dollar-commodity price dynamic emerges. Even then, Bernanke kept the accelerator to the floor as such a dynamic took hold in the early part of 2008. I would imagine that the bar to policy reversal is very high at this point.
What about additional easing? From Bloomberg:
“The market expects the Fed to enhance buying of Treasuries very soon,” wrote David Ader, head of U.S. government bond strategy at Greenwich, Connecticut-based primary dealer RBS Greenwich Capital, in a note to clients. “The bear market in Treasuries is having an impact on other things. Mortgages were the most notable victim.”
I was expecting more easing last month, believing the output gap would prod policymakers forward. And there is no indication that the Fed is planning to back off the TALF program (they are even expanding it too include “legacy” but possibly soon to be “toxic” assets.) But I am now wary that the Fed will increase the size of the expected Treasury bond purchases at this juncture. This is especially the case if they view rising rates as consistent with economic healing. Moreover, questions of outright monetization of the debt would intensify if the Fed appeared to be compensating for a lack of sufficient demand from the private sector, thereby driving more market participants, including central banks, out of the market.
So where does this leave us? In a environment pushed and pulled by contradictory trends:
» The wide US output gap suggests there is plenty of room for monetary and fiscal stimulus to operate without triggering higher interest rates. Yet rates have moved higher, and while I can’t say that 3.7%, or even 4.7%, or even 5.7%, would be surprising given the pace of Treasury issuance, the rapidity and direction of the move should give one pause – especially given the likelihood of prolonged US economic weakness. The rate increase should give policymakers pause, too.
» The continued existence of the current account deficit suggests the US remains dependent on capital inflows. To be sure, the need is not as great as a year ago, but significant nonetheless. Failure to attract those inflows would trigger downward pressure on bonds and Dollars.
» Greater financial stability should force market participants out of low yielding assets. But, absent a safety flight to US Dollars, there is no reason those assets have to be in the US. Low short term rates – and the Fed’s promise to keep those rates low for an extended period of time – open up opportunities for a Dollar carry trade that yields capital outflows.
» If so, we would expect downward pressure on the Dollar and upward pressure on long rates. The former supports export growth and import compression, while the latter helps prevent the decline from becoming disorderly by attracting capital into the Dollar and by further import compression (slower domestic demand).
» If foreign central banks choose to resist these trends, we would expect global reserves to rise. We are seeing this. The shift to purchasing at the shorter end of the yield curve, however, indicates that global central banks are wary of taking on additional Treasury risk. Perhaps they are finally beginning to choke on the debt.
» Downward pressure on the Dollar, in addition to the liquidity provided by central bank reserve accumulation, should put upward pressure on commodities. This is particularly evident in oil prices. This will increase headline inflation, and with it inflation expectations among the general public.
» US labor market weakness appears inconsistent with a sustainable inflation dynamic; thus, rising oil prices simply cut into domestic demand. Thus, the Fed will be inclined to hold policy steady, rather than exacerbating oil driven weakness by tightening. Tightening policy would also reverse the evolving stability in financial markets and threaten a new credit crunch. And given the Fed’s willingness to accept a benign view of the yield increase, they are not likely to increase Treasury purchases. Policy on hold. This may again have the side effect of putting relentless downward pressure on the Dollar. This is probably necessary to achieve further rebalancing of economic activity, but I suspect in the near term it will be disruptive. Alternatively, the dynamic could be reversed again by a new crisis that drove flows back to Dollars. There may be so much directionless liquidity flowing through the global financial system that it just starts constantly shifting here and there, looking for a home.
Bottom Line: I want to believe that the rapid reversal of Treasury yields is a benign, even positive, event. This is likely the Fed’s view; consequently, the will hold steady on policy. Challenging this benign view is that the reversal appears to be lock step with a return to dynamics seen in 2007 and 2008 – exceedingly low US rates encouraging Dollar outflows, stepping up the pace of foreign central bank reserve accumulation and putting upward pressure on key commodity prices. I worry that policymakers have forgotten the external dynamic that was hidden by the crisis induced flight to Dollars last fall. Indeed, capital outflows (indicated by a foreign central bank effort to reverse those flows) would signal that much work still needs to be done to curtail US consumption to bring the global economy back into balance. Policymakers are unprepared for this possibility.
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