The Consumer Problem
First, contrary to the assumptions of most commentators, the Fed’s policy of super-low interest rates is actually reducing consumer discretionary income relative to the alternative of raising interest rates. As shown in Chart 2, as of September 30, 2012, American households had $78.2 trillion in assets, of which we estimate roughly $15.2 trillion were interest-bearing, compared to $13.4 trillion in debt1.
Based on mortgage data from the Census Bureau2, over 90% of outstanding mortgages carry a fixed rate, as well as the vast majority of auto loans, allowing us to assume that approximately 70% of liabilities are fixed rate debt.
Determining the exact amount of variable rate assets is more difficult, but given that more than one-half of deposits are comprised of time deposits, savings deposits and money market funds, it may be reasonable to assume that more than 70% of household interest-bearing assets could be considered to be variable rate. Therefore, as an approximation, a +1% increase in interest rates could increase consumer interest income by $106 billion (on 70% of assets) and interest expense on household liabilities by $40 billion (on 30% of liabilities). While definitive numbers are more difficult to calculate, what is clear is that interest income would rise more than interest expense.
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An even more serious problem is that the Fed’s policy of trying to engineer artificially low mortgage rates appears to be reducing the supply of mortgages. The problem is that, within the banking system, mortgages are long-term assets financed by short-term liabilities. Provided defaults are low, this is a profitable business in normal times, since, as can be seen in the chart below, 30–year mortgage rates are almost always substantially above short-term interest rates. However, while the current prevailing mortgage rate is 3.35%, in the long run, according to the average view of Federal Reserve officials themselves, the federal funds rate should be over 4%3. Banks issuing a 30-year fixed rate mortgage today, even allowing for a little profit in the first few years, should ultimately be saddled with a money-losing asset.
It could be argued that banks should not care about this – so long as they can package and sell these mortgages to other investors, it would no longer be their problem. However, recent history has shown a tendency for bad mortgages to return to haunt their issuers.
In the simplest terms it is akin to price-fixing, and by pushing prevailing mortgage rates down to unprofitable levels for lenders, the Federal Reserve is effectively constraining the supply of mortgages. In the oil shock of the early 1970s, the Nixon administration imposed price controls to prevent gasoline prices from rising to unreasonable levels. The good news, at that time, was that gasoline prices were kept at levels that consumers could afford. The bad news, as witnessed by the gas lines of the day, is that few wanted to sell them gas at that price. In a similar vein today, mortgage rates are an excellent deal for borrowers – the problem is finding willing lenders.
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Easy Money and Slow Recoveries
In the last 30 years, the U.S. economy has suffered three recessions – the recession of 1990, the recession of 2000-2001 and the recession of 2008-2009. The first two were relatively mild – the last was extreme. However, one trait they all have in common is that they have seen slower than normal recoveries. This is regarded as a puzzle since, in each case, the Federal Reserve had responded to the recession in a very active way. However, a careful review of the supposed effects of “monetary stimulus” suggests that this stimulus may actually have done more harm than good, as we believe it has in the current case.
Economies, like humans, have natural immune systems that should lead them to recover from shocks and illnesses. A recession, on its own, will generate pent-up demand and once the shock that caused the recession has ebbed, this pent-up demand, combined with Americans’ desire to earn more, spend more and get ahead, should lead to a recovery. Often policy makers, like medieval doctors of old, claim credit for a recovery that would have occurred anyway and perhaps earlier without their services. We believe this is true in spades today when it comes to the U.S. economy and the Fed’s over-easy policy.
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The banking system currently holds over $1.5 trillion in currency ($1.4 trillion of which is “excess reserves” that is over and above the reserves they are required to hold to meet reserve requirements). They do this because the Fed is paying them slightly more than they could get lending this money out at the federal funds rate. If the Federal Reserve raises the federal fund rate, it will have to raise this interest paid on reserves in lockstep or banks will simply lend the money on the federal funds market, defeating the attempts of the Fed to raise short-term interest rates. However this could get expensive. At an interest rate of 0.25%, the Fed is paying about $4 billion to maintain $1.5 trillion in reserves. However, at an interest rate of 4.0% (which would be about neutral given our current 2% inflation rate) it would cost the Fed $60 billion, wiping out most of the Fed’s profits.
A more serious situation would occur if the Fed felt that it needed to raise real short-term rates to a tighter than average level to combat rising inflation. At a rate of 6%, it would cost $90 billion, which, combined with the operating expenses of the Fed, could mean that the Federal Reserve would operate at a loss.
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Also, in a rising rate environment, it is unlikely that consumers and international businesses would be willing to hold anything like $1.15 trillion in non-interest earning cash and, as that cash made its way back into the vaults of the banking system, it would further boost the reserves on which the Fed had to pay interest.
The Fed’s other option would be to sell its vast security holdings back into the market, which could lead to a disorderly surge in long-term interest rates and cause it to suffer capital losses. It could also raise reserve requirements, which would help reduce the number of bonds it has to sell. Or it could make the dangerous decision to forgo necessary monetary tightening, leaving the door open to higher inflation, which would be reflected in higher interest rates.
Moreover, the newly expanded QE policy, if maintained for another year, would add almost another $1 trillion to both the Fed’s assets and excess reserves, worsening this problem. We don’t know exactly how it is going to end. However, partly because of this extraordinary balance sheet expansion, it is hard to see any long-term scenario that doesn’t involve higher inflation, higher interest rates or both, a sober prospect for investors who are overweight cash and fixed income today and still moving money in the wrong direction.
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Investment Implications
While this article only deals with two problems with the Fed’s current policy, there are others. Historically low U.S. interest rates are motivating cash flows into some emerging market economies, leading to unwelcome currency appreciation and, from time-to-time, into commodities spurring some overseas inflation. Additionally, low interest rates have affected pension plans, as driving down longer-maturity bond yields to their current levels has increased the present value of future obligations while simultaneously causing plan funding rates to deteriorate due to lower expected returns. Finally, although lower interest rates have made mortgages much more affordable for consumers, this is a double-edged sword; cheap access to credit can help Americans purchase a home today, but if they decide to move in the future, they will most likely be unable to obtain another mortgage at a similar rate, a trap that could further reduce already declining mobility.
From an investment standpoint, despite historically low interest rates, investors have continued to embrace low-yielding fixed income securities, rather than moving into riskier assets as the Federal Reserve intended. With the 10-year U.S. Treasury yielding less than inflation, holding these types of assets is a losing battle, as investors are essentially locking in a negative real return. Additionally, the system is awash with liquidity, and if inflation begins to increase, investors in high-quality fixed income stand to see their returns deteriorate even further. The FOMC has chosen two lagging indicators (unemployment and inflation) to dictate the future direction of monetary policy, but once these indicators reach levels that the Fed believes warrants a tighter monetary policy, it may be too late. That being said, when the FOMC begins to raise interest rates (likely due to stronger growth and/or higher inflation), investors could benefit from being invested in asset classes like equities and commodities, which have traditionally outperformed fixed income and cash when inflation and interest rates are rising.
Regardless of the wisdom of the Federal Reserve’s current policy, investors need to position themselves to deal with its ultimate consequences. The reality is that it is hard to see how this doesn’t end badly for bond investors, and it is becoming increasingly difficult to believe that it won’t, at some stage, also result in a bout of inflation. Given this prospect and current valuations, it makes sense for long-term investors, relative to their “normal portfolios” to be somewhat underweight bonds and overweight equities and traditional inflation hedges such as real estate.
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