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Wednesday, January 25, 2012

The Impact of Low Rates Through 2014

Bloomberg details the latest from the Fed:

Chairman Ben S. Bernanke said the Federal Reserve is considering additional asset purchases to boost growth after extending its pledge to keep interest rates low through at least late 2014.
Policy makers are “prepared to provide further monetary accommodation if employment is not making sufficient progress towards our assessment of its maximum level, or if inflation shows signs of moving further below its mandate-consistent rate."
The immediate market reaction was a risk asset rally, a huge rally in gold (per Calculated Risk: Bernanke made it clear that even if inflation moved above the target - and unemployment was still very high - the Fed would only slowly pursue policies to reduce the inflation rate), and a rally at the belly of the yield curve (the yield curve flattened out to five years... shorter rates couldn't fall as they are already at or near zero). Why? The "late 2014" date is much later than the June 2013 date previously projected by Bernanke last summer.

The impact of this announcement (and the previous projected rates) can be seen in the chart below that shows the Fed Funds rate curve (implied by EuroDollar futures) for March 2013 through December 2014, as of various dates over the past year.

What do we see? We see an initial drop between March and June of last year as Bernanke indicated low yields for the foreseeable future, then a huge drop (mid-summer) after Bernanke stated rates would remain zero through June 2013. Today's announcement really did nothing through June 2013 (that was already projected), but was felt further out along the curve.

The key question is what is the Fed trying to accomplish?

In "normal" times, low yields = cheap financing = increased consumption (it creates an incentive for individuals to borrow and banks to lend), but in today's zero-bound world the impact is minimal. Increased consumption is limited as individuals are trying to rebuild their own balance sheets and those that might benefit most from borrowing, don't necessarily have the credit to qualify for a loan. In terms of impact on unemployment, GYSC (of Economic Disconnect fame) states:
Unemployment is a structural problem, not a cyclical one, but the FED is still stuck in the past.
In addition, there are some theories that consumption may actually be negatively impacted by zero bound rates. As I outlined over the summer, I think it is possible that negative real interest rates may actually cause individuals to save more, while Kid Dynamite outlined yesterday that low rates forecasted may cause individuals to hold off from making a loan fueled purchase:
Let me explain: right now, one appealing factor of home buying/selling decisions is that interest rates are very low – you can afford to buy more house. If I think that interest rates are going to remain low for a long period of time, I will be in no hurry to lock in this low rate on the debt I’m borrowing – I will be in no hurry to go out and buy a house.
So what is it then? Corporations!

There is one sector that I think will be positively impacted by the latest announcement.... corporations. Don't let their record profits as a percent of GDP (while personal income is at record lows) fool you into thinking they don't need help at the populations expense. Seriously though... my initial reaction upon hearing that rates would be held down near zero through 2014... buy credit... WITH duration out to around ten years (the secondary impact is positive for equities, as explained below).

While Treasury yields are at all-time lows, corporate spreads remain at elevated levels (when yields fell during the summer when we had to deal with the US downgrade and Europe, spreads widened significantly).

In "normal" times, when markets calm these spreads would be expected to narrow, which I still believe is the case. One would also "normally" expect Treasury yields to rise as investors shift out of Treasuries, causing the hard interest rate component of corporate yields (rate + spread = yield) to rise, but this risk has been removed for the foreseeable future out to around ten years. The result is that corporate bonds seem like a very safe investment. This decreased risk should mean even cheaper financing for longer dated maturity corporate bond issuance.

So will this finally set off a round of corporate fueled expansion? If they don't see aggregate demand improving, then I don't see how this will impact the underlying economy. But, with the cost of equity high (i.e. what I perceive as fair to cheap equity valuations) and cost of debt low (i.e. these lower yielding corporate bonds), we may see significant change in capital structures (perhaps via private equity).

Source: Barclays Capital