Too Low for Too Long
By Scott Minerd
November 15, 2012
The Federal Reserve faces the risk of inducing a sell-off in bonds similar to that which occurred in 1994 when Dr. Greenspan tightened credit conditions after maintaining an artificially low interest rate environment for an extended period.
“With the Obama victory last week, Janet Yellen, Vice Chair of the Board of Governors of the Federal Reserve, appears to be a likely candidate to succeed the current Fed chairman, Dr. Ben Bernanke, when he leaves his post in January 2014. Yesterday, Dr. Yellen said that, if necessary, short-term interest rates could be held at zero until 2016 to reach employment targets. This is longer than market participants had previously been anticipating. In 1993, then Fed chairman Alan Greenspan drove interest rates down to 3%, which was the lowest level in the post-war period at that time. He held rates there for about 18 months. When he announced, in February of 1994, that the Fed funds rate would be increased by 25 basis points, the bond market went into freefall. By September 1994, the 10-year note had lost 15% of its market value. Investors were over-allocated to long duration assets at the time and the lack of incremental new demand at the long end of the curve caused prices for credit products and other fixed income assets to fall more precipitously than Treasury prices. The event proved to be the worst bond rout since 1927.
The current situation in the bond market looks similar to 1993 in many ways. By pushing interest rates to historic lows, the Federal Open Market Committee is encouraging bond investors to extend duration and take on more risk. The question now is; what would be the effects of the Fed raising interest rates after years of keeping them below their economically justified levels? We could definitely see a 1994-type scenario play out again. This time, however, it would not be because the Fed is unaware of the risk in tightening, but because it will mis-time the pace at which excess liquidity should be removed from the system. Yesterday's statements from Yellen as well as recent history indicates that the Fed is likely to err on the side of keeping monetary policy too easy for too long. This would lead to a continuation of a buildup of inflationary pressure.”
Economic Data Releases
U.S. Trade Deficits Narrow as Exports Rebound, Both Consumer and Business Confidence Continue to Advance
The University of Michigan U.S. Consumer Confidence Index rose to 84.9 in November, the highest level since July 2007. The NFIB Small Business Optimism Index also rose to a five-month high of 93.1 in October. The labor market continues to improve, with initial jobless claims falling to a four-week low of 355,000 last week. In September, U.S. trade deficits narrowed to their lowest level since December 2010, with exports growing 3.1% from August, the fastest pace in 14 months. October retail sales were likely to have been affected by the Hurricane Sandy, with a 0.3% MoM decline from September, the first decline in four months.
Weakness Shown in the German Economy While October Data Shows Signs of a Rebound in China
Economic releases last week raised concerns over the growth outlook for the German economy. Germany’s ZEW survey showed that the economic outlook worsened in November and the assessment of current conditions fell to the lowest level since June 2010. In September, German industrial production fell 1.8%, the largest monthly decline in five months. Meanwhile, German exports fell 2.5% in September, the largest monthly decline in nine months. Data for other eurozone countries also worsened. Industrial production in France, Italy and Spain posted substantial declines in September. Eurozone retail sales fell at the fastest pace in five months in September. In Asia, October data showed signs of a rebound in the Chinese economy, with retail sales rising at the fastest pace in seven months. Additionally, both industrial production and exports from China grew at the fastest pace in five months, and the 12-month rise in the consumer price index was slower than any month since January 2010. In Japan, the economy contracted at an annualized rate of 3.5% in 3Q, the largest quarterly drop in six quarters. On the policy side, both the Bank of England and the European Central Bank kept their interest rates and bond purchase plans unchanged.
Chart of the Week
Taylor Rule Estimate vs. Fed Funds Target Rate
The Taylor Rule has been widely used to measure the optimal interest rate that a central bank should target. In 1994, the Federal Reserve tightened the rate more aggressively than the Taylor Rule suggested was appropriate, thereby inducing a bond market rout. Following the recent improvement in the U.S. labor market, the Taylor Rule suggests that the current optimal interest rate should be 0.65% instead of the current target of 0.25%. Based on the Federal Reserve Open Market Committee (FOMC) members’ projections on inflation and unemployment through 2015, the Taylor Rule implied optimal rate by 2015 should be around 3.0%, materially higher than what the FOMC has pledged to maintain.
Source: Federal Reserve, Bloomberg, Guggenheim Investments. Data as of 10/31/12.
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