The big news wasn't yesterday, it was not the non-announcement by the Federal Reserve about another quarter point increase in interest rates. Uncle Alan has been telegraphing this for quite sometime, and there was no surprise, in fact, some in the financial press are calling the statement made
"all but meaningless". Nor was the ECB's announcement to hold rates steady particularly a surprise.
Instead the big news is today, that the treasury is considering bringing back the long bond. The price of the long bonds in circulation dropped downward - increasing their interest rate, or yield, though they rapidly adjusted leaving only a smaller jump - from 4.48% to 4.59%.
This really ought to be Hale's territory, but fools go where angels fear to tread...
[Stirling Newberry is Chief Economist for Langner & co. Sign up for our new monthly econ newsletter focused on small cap stocks.]
What this is about is
"the yield curve". What the curve is is simple, it plots the yield, the interest rate, on the left hand side, and the length of time the bond takes to pay back all of the amount loaned on the bottom.
A "normal" yield curve is a "lazy U" shape, with a bit of a stem at the bottom. That's because people who can get their money back more quickly are taking less risk. An urban legend of wall street is that bond traders are right all the time, and so changes to the yield curve are often explained in the language of rational expectations - or "rashex". The reality is different, the market doesn't care what people expect, but what they do. When there is more supply of long term bonds, the buyers can pay lower prices, and, therefore, get higher interest rates. When there are more buyers than supply, bond prices are bid up, and interest rates are sent down.
One of the worst decisions of the Treasury Department this economic cycle was to stop selling the 30 year long bond in October 2001. This has acted, effectively, as a tax on the ordinary individual, and a subsidy to those borrowing money long term. Great for the big corporation selling 30 year paper, since it has to pay a higher interest rate than the government, but lousy for the taxpayer, who was not able to lock in low interest rates for a long term proposition while long term interest rates were at generational lows. In effect, a subsidy for big bond sellers at the expense of the American public. Two consecutive Treasury Secretaries were the only people in the world not to realize that this was a great time to take out a 30 year mortgage.
By announcing that they may bring the 30 year back, the executive is admitting that the "spread" between the top and the bottom of the yield curve is getting dangerously small - because if the yield curve "inverts" it is usually regarded as a sure fire sign of a recession coming. Now this isn't a cause effect link, but it is such a well known indicator, that it might well be self-fulfilling. Those who know act on it, and that starts a self-perpetuating downward spiral.
Back in February Alan Greenspan noted that there was a "conundrum" of long term rates staying low, even as he had been doing everything but taking out bill boards in Time Square saying he was going to raise rates and that investors should leave interest rate investments. Part of the reason was that there was no new supply of long bonds, and therefore those people who needed 30 year Federal bonds - often because of financing arrangements - had to buy what was available. No new supply, with some continuing demand, meant that buyers had to pay more, and this kept rates down.
However it also meant that the yield curve started to flatten as the interest rate campaign continued. Part of the point was to avoid the situation in 2000 where the yield curve inverted and a recession occured, and it was not doing its job. Clearly yesterday's semi-announcement means only one thing: that the powers that be are looking at the yield curve, and they do not feel comfortable with the amount of ammunition they had to raise interest rates.
The recent announcement that oil prices are to stay high for the forseeable future are to be looked at in this context: that is, the Federal Reserve may need more ammunition to fight inflation, and while they are fairly sure that long term inflation risks are contained - the mere omission of this sentence was enough to roil markets yesterday - they realized that the intersection of the probable top of Federal Funds, at 4%, and the long yield - yesterday at 4.48% before the treasury announcement, was uncomfortably close.
Now what does all of this actually mean? Will it work?
Work is a relative question. It isn't clear that this kind of manipulation of the bond market will do anything - it may well be that the inverted yield curve, like so many other indicators, only worked when it wasn't being gamed. It may well be, and I think this likely, that such manipulation, while it can change the distribution of credit in the economy by providing incentives, won't do anything for the macro-equilibrium. Basically, if we are going to have a recession, we are going to have one, and a last minute shot of long bonds isn't going to stop an 11 Trillion dollar GDP economy from going where ever it is it is going to go.
But it is interesting, because it is a sign that the balance of incentives is about to change. It means that long borrowing is about to get more expensive - depending on the credibility of the statement on the long bond. What will likely happen is that long bond rates will fall again when the long bond is actually introduced, as people who have been buying 10 year bonds and wanted 30 year bonds stop buying 10 years and start buying 30 years. This will raise the demand again, and bring the top end of the yield curve back down. It is for this reason that it is very likely that the announcement does nothing to change the macro-picture in the longer term. The timing of the announcement buttresses this theory of why it is being reintroduced - on the same day as the Fed raising rates a quarter point - and timed for February, the very month, if quarter point raises continued, that the yield curve would have been in danger of going flat.
Summary:
The reintroduction of the long bond was the most important interest related announcement yesterday - it was the only "news". The reason for its reintroduction is probably related to the "conundrum" of the yield curve, in fears that the yield curve would invert, sending an recessionary signal. The announcement eases this fear. Whether this actually does anything is another question, the overwhelming likelihood is that if macro trends are headed to a recession or a hard landing, that changing the mix of bonds at this late date is not going to change that in any significant way.
It does mean that the relative incentives within the economy - the micro-economic picture - are likely to change. It means that mortgage rates will probably start to rise, as buyers seeking long exposure have another area to move to. It is likely that it is an admission that the US government is going to continue to run large deficits, and is seeking a way to fund them at more favorable rates, and it is a way to attract buyers back to the dollar and dollar based bonds, given the continued diversification away from dollars by many central banks.
In short, the meaning of this move is much more important to the micro picture, even though it is very probably driven by macro- considerations. It is important because it is a sign that the current shift from a "wimp dollar" policy to merely a "weak dollar policy" is accelerating.