8/21/2013 6:00 PM ET|
Why higher rates are a good thing
The warm blanket of the Fed's easy money is about to be removed, and the free market is about to reassert itself.
The price of money is on the rise. The rate on 10-year Treasury bond has more than doubled since last summer and is closing in on 3%, a level not seen since early 2011. Much of this has come within just the last few months, as rates climb off a low of 1.7% in April.
That's a 74% gain in just four months, driven, on the surface, by indications that the Federal Reserve will pull back, or taper, "QE3" -- its ongoing $85 billion-a-month bond purchase stimulus, a program in its third iteration since the financial crisis started. It's no wonder that consumers believe interest rates will continue to rise on a scale not seen since 2005.
And as the price of lendable funds soars, it's -- to use a technical term -- pulling the rug out from under pretty much every major asset class.
Stocks are suffering; the Standard & Poor's 500 Index ($INX) has fallen below its 50-day moving average. The Dow Jones Industrial Average ($INDU) has lost the 15,000 level. Emerging market stocks are a disaster zone. And the bond market is ground zero, with the damage spreading outward, like radiation from a mushroom cloud, affecting everything from T-bonds to investment-grade corporate bonds to junk bonds.
Investors are unhappy about it. Households are worried about it. But could a dramatic increase in interest rates actually be a good thing?
Something's holding us back
First, let's establish that by the measures middle-class families care about -- and which I recently covered in this slide show -- this recovery has been underwhelming, at best. Job gains and income growth have been unacceptably slow.
Partisan warriors will fight over details and point fingers. While avoiding the mudslinging over taxes, spending and stimulus, we know a few things. We know, from survey data, that businesses are complaining about regulatory burdens. And we know from recent jobs data that the messy implementation of Obamacare is likely having a negative impact on full-time job creation, as business try to minimize their exposure to it.
But above all has been the way the credit channel -- the conduit by which the trillions of dollars of new money the Fed created in the past five years was supposed to flow into the economy-- has been badly damaged.
You can see this in the way the monetary base -- the narrowest measure of the money supply -- has swelled, from $800 billion before the crisis to nearly $3.4 trillion now; yet, total consumer loans at commercial banks have gone from around $800 billion to just $1.1 trillion in the same period. I illustrate this relationship below.
Because of this, a measure known as the "velocity of money" -- or how fast a dollar travels through the economy -- has plunged. Money is slowing down as banks pile trillions into their vaults instead of lending it out.
So while the price of money had fallen to levels not seen since World War II (before the recent surge), it wasn't readily available. Banks were worried about risks, from defaults and inflation, since low rates didn't offer them enough protection. Thus, they simply didn't lend very much.
It's the law of supply and demand at work. At low prices, businesses aren't willing to offer much supply; at higher prices, the quantity offered increases. Less-efficient resources are suddenly profitable. Old machinery is brought back to life, overtime is paid, things like that.
It's the same for banks. When rates are low, and the difference between short-term and long-term rates is even lower, the "net interest margin" that banks earn between deposit rates and lending rates is razor-thin. Thus, as the Fed pushed harder and harder on stimulus -- holding shot-term rates near 0% since 2008 while engaging in three iterations of its long-term bond-purchase stimulus -- lending activity dropped and the money velocity slowed.
The market for lendable funds was being distorted by a Fed motivated to support the economy by boosting financial-asset prices, thereby lifting home prices and confidence. Sure, officials talked up lowering the cost of credit. But everyone knew the real focus was on boosting the prices of stocks and bonds.
History will judge whether this was the right move.
Proof is in the pudding
Many, including Stanford economist John B. Taylor, warned that the Fed's actions, by usurping the market's ability to efficiently price the cost of money, was, on net, acting as a drag on the economy. He said as much in a Wall Street Journal opinion piece he penned way back in January. (You can read it here – subscription required.)
Fed policies also have encouraged retirees and other investors to take on too much duration risk -- the risk that the price of a bond will drop as its interest rate rises -- by buying low-yield bonds and bond-like stocks (which have suffered nasty losses as rates have risen in the past four months).
Not only did the Fed take the heat off of Washington to address its long-term budget problems, it also diminished the incentive for banks to take a flyer on credit risks, such as providing a mortgage loan to a young couple with a FICO score weighed down by a few missed payments.
By forcing rates down, the Fed essentially engaged in price control in the market for lendable funds. But in a free economy, executives can withhold their product or service from markets if government meddling makes such an endeavor unprofitable. It's the same when your product is money, as is the case with banks. And it's the dynamic that Ayn Rand warned of in "Atlas Shrugged."
And while other factors have played a role (tighter capital controls, new Wall Street regulations and a need to rebuild balance sheets after the housing bubble), this has been a biggie.
The bond market is a different animal, by the way, and it did very well as interest rates fell, giving companies such as Apple (AAPL) the ability to raise cheap cash by issuing debt securities. But that was an end-run around the traditional bank lending channel. It arguably resulted in capital misallocation, as the "reach for yield" shoveled cash into companies that didn't need it at "prices" (that is, interest rates) that were too low. Households were shut out. And the results, via relatively tepid job growth, recent bond market losses and a collapse in money velocity, speak for themselves. I wrote about the risks in the bond market back in June.
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ABOLISH THE FED!!!
It is true that higher interest rates would benefit the private sector economy by increasing the amount of aggregate savings in the U.S., which means there would be more funds to be loaned out.
What Anthony M. is missing is that 6% interest on the 10 year Treasury bond would KILL THE FEDERAL GOVERNMENT! They planned their budget expecting the 10 year yield to be around 2.0%, if not 1.7%. The funds in the Treasury to pay for 6% or even 4% on the 10 year may very well have been spent already! 6% will cause a partial government shutdown!
The fact that the 10 year yield is heading for 3.0% while the Federal Funds Rate is stubbornly at 0% shows the Fed is LOSING CONTROL of interest rates. Recent help from China, which may have been as much as $200B in Treasury bond purchases, drove the 10 year yield from 2.6% to 2.4%. Well, it is back up to over 2.8% today, so the Chinese didn't get much for their sacrifice. The Chinese government may be through propping up the U.S. dollar and the Treasuries.
The Fed probably WILL NOT TAPER the QE! It is the lender of last resort. Once the 10 year yield gets above 3.0%, the Fed will have to purchase massive amounts of Treasuries. It'll stop only when the dollar falls sharply in the Forex market. The consequence will be that the DOLLAR WILL LOSE ITS WORLD RESERVE CURRENCY STATUS. Our lives are going to change a lot.
Come on, Anthony! Can't you see there is a huge gorge to be crossed before we can enjoy the benefits of higher interest rates?
Panic will erupt in Obamaville - first a reduction in food stamps and then higher interest rates on top of it all.
Good news bad news, right? Higher rates will be good for those with savings, but HORRID for the Government which cannot service its enormous debt as it is; the US is essentially insolvent now. Higher rates will ensure that the debt can NEVER be serviced and creditors will begin pulling the plug on US Treasuries; already occurring as countries like Japan begin selling them off. Soo...we are screwed blued and tattooed no matter what we do.
Another blog this morning says 'stocks are headed higher'. I almost peed myself laughing. Good luck with that one, you market shill!!!
Does Anthony M. really believe that banks just store huge amounts of cash in vaults or the electronic equivalent? Usually, when an organization controlling large amounts of dollars is "sitting on the money," it is actually holding Treasury bonds.
This means the money that is not being loaned to private customers is being loaned to the government, which puts the money into circulation and drives up the cost of living for ordinary Americans.
Remember that most national governments in the world, every state and local government, every public and private pension fund, every corporation including banks and insurance companies, the Social Security Trust fund, rich people within and outside of the U.S. ... own Treasury bonds and/or bills!
If the Federal Reserve Bank tries hard to suppress the bond yields by buying up the bonds, the bond market shall CRASH. All of the above-mentioned categories of organizations shall be taken down at the same time! And the U.S. government shall barely be able to function!
"The market for lendable funds was being distorted by a Fed motivated to support the economy by boosting financial-asset prices, thereby lifting home prices and confidence. Sure, officials talked up lowering the cost of credit. But everyone knew the real focus was on boosting the prices of stocks and bonds."
I don't think everyone knew. I don't think anybody knew exactly what to expect with QE/cheap money. Things just went they way they went, and the fed was content to ride it out until signs of economic growth, inflation, or both. Money sought returns where it could, and it did.
If rising rates stimulate the banks to lend, I say great.
is anyone else comparing the S&P chart for the last three months AND the 10-year treasury chart AND the daily market volume chart with the same charts for the three months leading up to "black monday" in october 1987??
lions, and tigers, and BEARS .... oh my!
so, how did UVPIX shares fare today?
Higher interest rates are really a disaster waiting to happen. When the FED "tapers" QE and interest rates go up that will be very, very bad for the interest rate derivative market. If the interbank loan lending rate even goes up slightly it's game over for the big banks. If that happens you'll see bank liquidity go to zero within less than 24 hours; you'll see major banks going insolvent in weeks because of trillions of dollars of bad interest rate derivative market bets on their books; you'll see the collapse of currencies throughout the world; you'll see the price of gold and silver sky rocket; and you'll probably see massive social unrest on a global scale. I hope Mirhaydari is right and I'm wrong, but given his track record versus mine I doubt it.
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