Sunday, February 14, 2016

Treasury Yields Keep Falling Despite Fed Rate Hike

The Federal Reserve raised its benchmark interest rate by 0.25 percentage points on December 16. It was a momentous occasion because it was the first rate hike by the US central bank since June 2006 — a 9 1/2-year span.

The US had never before experienced a period anywhere near that long without an interest rate hike.

As of February 11, the Federal Funds Rate, essentially the overnight lending rate between banks, stood at just 0.38 percent. That is still remarkably low by historical standards.

For perspective, the Fed's benchmark rate has averaged 6 percent since 1971, and soared as high as 20 percent in 1980.

Meanwhile, other central banks around the world have been cutting interest rates into negative territory. The Swedish, Swiss, Danish, European and most recently Japanese central banks have all set interest rates below zero.

Since no one wants to pay to keep their money at a bank, these actions have made US Treasuries all the more appealing than usual (Treasuries have long been considered the safest investment in the world).

Yet, with investors flocking in droves to Treasuries, this demand is driving down yields. Think supply and demand. If everyone wants in, you don’t need to entice them with higher rates. Investors are already motivated to invest.

Ten-year yields dropped almost 40 basis points during the past three weeks to 1.66 percent. The record low of 1.38 percent was set in July 2012. That record may be tested in the next couple of months.

Remember, this drop has nothing to do with the actions of the Fed. It’s due to other central banks dropping rates below zero, as well as tumbling stock markets around the world, which haven't benefitted from negative rates. Investors are seeking safety amid all the volatility.

In a normal world, the Fed’s December rate hike would be having the opposite affect — raising Treasury yields. But we no longer like in a normal world.

Last August, I wondered if the Fed might “feel empowered to raise the funds rate since the downward pressure on yields would give them some cover, and room to maneuver?”

Ultimately, the Fed did indeed feel it had the cover just a few months later to raise the funds rate.

Though the Fed would surely like to continue raising its key rate to return to some state of normalcy, the realities of the slumping global economy — and the actions of other central banks — are now dictating both actions and outcomes.

By plunging interest rates below zero, central banks around the world are trying to provoke commercial banks to lend to businesses and consumers, thereby stimulating their economies.

The Fed’s caution about further rate hikes is being driven by the actions of other central banks. Cutting interest rates below zero has created a race to the bottom in global currencies. Negative rates devalue those currencies (with the hope of boosting exports), which in turn makes the dollar stronger and more appealing to global investors.

The strong dollar has already been hurting US exporters and US companies that do business overseas, which have to convert foreign sales back into dollars.

That is making sales much weaker, and revenues are falling across the board. In fact, US companies have suffered two consecutive quarters of falling revenues, which is referred to as an “earnings recession.” It’s the first time that’s happened since the Great Recession.

In short, the Fed doesn’t want to see the dollar continue strengthening. Another rate hike would assure this.

Yet, the Fed seems helpless to control the outcome of events right now, which must be quite frustrating for these Masters of the Universe.

Treasury benchmark yields are on course to set a new all-time low in March if they keep rallying at the current pace, Bloomberg reported this week.

This clearly wasn’t the outcome the Fed had in mind when it raised the funds rate in December.

Higher interest rates have a cooling affect on an economy that is (or may be) overheating, and they consequently slow inflation. However, the US economy shows no signs of overheating, and inflation is virtually non-existent.

The inflation rate was just 0.7% through the 12 months ended in December 2015, the most recent figure published by the government.

This weak inflation has to be freaking out Fed board members. This is not how the textbooks, or history, say things should be. Extraordinarily loose monetary policy (ultra-low rates) should have long ago resulted in significant (if not rampant) inflation.

It’s a sign of how sick the global economy is, and how powerful the forces of global deflation are.

The Fed is desperate to continue raising rates so that when the next crisis inevitably arrives it will then be able to cut rates once again in response, as it always has. It’s the classic tool of central banks, but one that appears to have now been removed from the Fed’s toolkit.

That will be quite problematic when the Fed eventually comes face to face with that crisis, or recession.

Given current global conditions, that moment may not be too far off into the future.

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