Let’s Twist Again!
At its meeting last week, the Fed expanded Operation Twist by $267 billion through the end of this year; its latest attempt to take a sledgehammer to the long-end of the yield curve. Policy makers also stated that economic conditions will likely warrant “exceptionally low” rates through late 2014 and that they are “prepared to take further action to promote a stronger economic recovery and sustain improvement in labor market conditions in a context of price stability.” In other words, the environment is bad enough that they don’t expect to increase the Fed Funds target from its current 0-25bps for more than two years and they are willing to take on additional QE should the situation deteriorate further. So much for the talk of economic acceleration that was all the rage early this year!
Using month-end data from the end of 1979 through March of this year, the two-10-year spread averaged about 95bps with a median level of 89bps (Chart 1). The curve was inverted in March of 1980, when both short and long-term yields were double-digits and the two-year yielded 200bps more than the 10-year. The maximum spread of 282bps occurred just this past January. With the two-year Treasury currently about 25bps and the yield on the 10-year about 1.60%, the current spread of 135bps is a good bit wider than the norm of the last 30-plus years. The banking business is a spread business, with banks borrowing short-term and lending longer-term. With spreads well above historical norms, banks theoretically can make an attractive return above their short-term borrowing cost.
But here is the rub. Spreads have been well above historical norms for four and a half years (Chart 2), but this has not resulted in an economic boom. Since the end of 2007, the median spread has been 227bps, well above the long-term median of 88bps. The lack of economic growth in the face of historically wide interest rate spreads is likely due to a number of issues: delevering of consumer and bank balance sheets, a lack of confidence in the sustainability of the recovery, and the low absolute level of interest rates across the entire yield curve.
While consumer and bank delevering appears well underway, the government has taken up most, if not all, of this leverage. As such, total leverage in the US economy is similar to what it was at the inception of the credit crunch. With leverage still elevated and growth weak, we now face a fiscal cliff that further threatens US economic growth. A fiscal contraction of 3-4% of GDP is currently scheduled to take place in 2013 due to the sun-setting of tax breaks and mandated spending cuts. While we expect Congress and the Administration to act to reduce the impact of fiscal contraction, the issue is unlikely to be addressed prior to November’s election, a likelihood that instills anything but confidence in lenders and borrowers alike.
Additionally, the overall level of rates is an impediment to lending. Why? Because while spreads are wide, the overall structure of the curve is such that a rapid adjustment in short-term rates, while unlikely in the near future, could rather easily and quickly swamp the value of long-dated fixed rate assets.
As such, taking a hammer to the long-end of the curve is unlikely to result in incremental lending. With the current spread 92bps below the median level of the last four and a half years, if the Fed succeeds in lowering spreads further, they may also succeed in reducing lending.
Finally, the chart below from Morgan Stanley makes the conversation even more interesting. It indicates that the onset of each of the Fed’s QE programs has actually seen a rise in rates while yields have fallen upon the conclusion of these programs. So much for the theory that without Fed buying there is no one willing to buy Treasuries, or conversely, that it is Fed buying that has resulted in lower yields. Why is this occurring? We believe that the Fed’s bond buying programs have been the primary mover and shaker in the risk-on, risk-off trade. When the Fed stimulates, investors sell Treasuries and increase risk exposures within their portfolios. When Fed bond buying programs end, investors buy Treasuries, reducing the risk in their portfolios.
At some point, though it is hard to know when, markets are likely to take up the old adage “Fool me once, shame on you. Fool me twice, shame on me.” Of course, by that time, markets will have been fooled far more than twice! The point is, at some point the Fed’s QE programs will no longer stimulate the demand for risky assets and the game will end, likely badly. It has become abundantly clear that the Fed’s QE programs are neither lowering interest rates nor stimulating the US economy. Its just as clear that these programs have been a leading force in the risk-on, risk-off trade. But there are limits to how often this game is likely to work and it would appear that the end-game is near, likely to be brought on by the crisis in Europe and/or slowing global growth. The Fed is the proverbial emperor with no clothes, but interestingly, most investment professionals have been unwilling to point this out. The same of course holds true for the situation in Europe. Most investment professionals have professed faith in Europe’s ability to fix its problems, paying little attention to its Ponzi–like financing schemes. Spanish banks have borrowed from the ECB to lend to the Spanish government, which in turn, has borrowed from its neighbors to shore up its insolvent banks. Note too that as the fourth largest economy in the Euro-zone, Spain guarantees approximately 12% of the money raised by the bailout funds, and therefore, of the funds being used to bailout its banks. If all of this sounds wildly absurd, well, it is. And it isn’t going to end well.
Past performance is no guarantee of future results. Opinions contained herein are those of Blue Water Capital Management as of the date of this publication and are subject to change without prior notification. All market, economic, and other data and information are obtained from sources deemed reliable. However, there is no warranty, express or implied, as to the accuracy of such information. Nothing contained herein constitutes an offer or solicitation to purchase or sell securities. This publication may not be reproduced, in any part or in its entirety, in any form, without the express written consent of Blue Water Capital Management, LLC. ©