The Damage Caused By the Fed's Zero Interest Rate Policy (ZIRP)

Accounting for various inflation measures, the target and daily effective Fed Funds interest rate has been negative since 2009. The Fed has reiterated this so-called "zero interest rate policy" or ZIRP, indefinitely, and additionally has tied further monetary easing measures via bond and asset purchases not only to inflation, but to unemployment, regardless of the lack of evidence that such monetary measures positively affect growth leading to less unemployment. Rates on Treasury Inflation Protected Securities (TIPS) recently hit a record low yield to maturity of -1.496% on 4-year, 4-month issues, forcing the obvious question: Who would buy these things? Evidently, investors are willing to accept getting paid back less than the principal loan at maturity on the expectation that regular payments tied to the government's understated consumer price index (CPI) inflation measure will make up for the negative yield to maturity over the life of the loan - the auction was relatively strong, with a 2.7 bid-to-cover. The likely outcome is that investors will barely break even or lose money, given that inflation and risk will be running higher than expected or as sold to investors.

Creditors and savers lose money in this ZIRP environment, while debtors gain. That has been the goal of the Fed all along, to manipulate the cost of money so as to provide a bailout to all of those debtors, deleveraging or not. The accepted term for this ruse is appropriate: Financial Repression. What the Fed does not admit to is that this practice has significantly skewed the risk-reward for investors willing to lend money, and has created systemic risks tied to the interest rate markets. Both of these side effects have an impact on private investment, and by extension, real economic growth. On a basic level, investors willing to lend money want to see the level of risk tied to the potential reward, as set by market pricing, not as manipulated by a cartel. If that reward has a manipulated ceiling, or has a higher than expected probability of losses (negative reward) due to interest rate dislocations, defaults or other risks not priced in, then investors will shy away from taking any risk at all: they simply will hoard their capital and not lend. We've seen strong evidence of that in the last 3-4 years, as a result of an accommodative Fed feeding overextended debtors looking for a cushy reprieve from the housing and credit market bubbles the Fed helped to create.

Much talk has been made recently about how and when the Fed will proceed to raise interest rates and unwind its growing balance sheet of Treasury and Agency (MBS) securities, bought to keep interest rates artificially low for government borrowing, public mortgage financing and debtor refinancing. Existentially, there is a threat that interest rates could rise without a Fed change in ZIRP: the interest rate markets could dislocate rates higher to more accurately reflect risks. The danger is that dislocation could be severe and lead to significant losses in bonds and in interest rate sensitive securities and derivatives, including currencies. It has been my conviction that the Fed has not quantified this "Black Swan" event or series of events. The severity is potentially very high given the collaterized nature of Treasury and Agency securities within the global financial system, including the repurchase agreement (repo) markets. Rated securities used as accepted collateral experiencing significant sharp losses will have a systemic effect across the system. Critics answer this existential threat by stating that the Fed could simply flood the system with liquidity (printed money), in the magnitude and durations needed to restore stability. This is a fallacy; as I have pointed out in other essays, the Fed is an endogenous (not exogenous) entity, not unlike a large hedge fund, and the belief that it could perpetually print money to save its "system" is as wrong-headed as believing in perpetual motion machines. Trust is not infinite, and Federal Reserve Notes and Treasurys carry risks tied to trust.

Creditors and savers (investors) held hostage by the financial repression of ZIRP have little wiggle room other than to continue to push for changes in the powers carried by the Federal Reserve. Those powers are sold to all of us as a common good, when in fact it has led to an involuntary wealth redistribution scheme, a tax meant to benefit government and politically recruited debtors, with a leveler outcome of stagnant or negative real growth. At its worst, these powers have throttled systemic risks and will continue to do so, instead of unshackling markets and investors to allow for markets to set price levels and risk-reward curves based on supply and demand, and not on politically-motivated cartel manipulations.

 

National Debts, Debt Monetization and Inflation

This last week marked the 40th anniversary of Nixon's move to break up the international gold standard, set by the Bretton Woods Agreement among 44 nations in 1944. The move represented a post WWII culmination of a U.S. balance of payments crisis, including a run on U.S. gold reserves that would trigger an insolvency event:

"Recently the markets had panicked. Great Britain had tried to redeem $3 billion for American gold. So large were the official dollar debts in the hands of foreign authorities that America's gold stock would be insufficient to meet the swelling official demand for American gold at the convertibility price of $35 per ounce." [1]

This insolvency event was chiefly driven by the unbalanced fiscal spending of the Johnson administration (e.g. the "Great Society" welfare state and other profligate spending), Nixon's inability to deal with rising deficits, and the growing shift of the U.S. from a creditor to a debtor nation, with a trade deficit that would likewise increase in coming years.

While Bretton Woods was a flawed international monetary system in many respects - imposing currency pegs and encouraging intervention by monetary "authorities" such as the IMF - the decision to make the dollar the reserve currency backed by gold was among the positive aspects that supported the growth of the U.S. as a net creditor nation.

It is worthwhile to review what has happened since Nixon declared a fiat end to the gold standard, allowing the dollar to float. By removing the restrictions of a dollar-to-gold conversion, debt monetization by monetary authorities (in particular the Federal Reserve) could ensue without check, under pretense of the "full faith and credit" of the sovereign.

The figure at the top depicts the geometric growth of the U.S. national debt, the broad M3 money supply metric, and price inflation as represented by the original Consumer Price Index (CPI) calculated before 1984 [2,3], resulting in an 82% decline in the purchasing power of the dollar. Such national debt growth does not take into account the 'unfunded' liabilities faced by the U.S. government through Medicare, Medicaid and Social Security programs, which exceed $100T.

Keynesians and Post-Keynesians have misguidedly supported deficit financing and debt monetization to stimulate aggregate demand and to prevent deflationary or disinflationary relief during debt deleveraging cycles. When will they wake up to the damage caused by such fiscal and monetary policies, chief among them financial instabilities that occur due to the unsustainability of perilously high debt loads, the understated risks due to artificially low interest rates, and the growing lack of confidence in the dollar?

[1] "The Nixon Shock Heard 'Round the World," Lewis E. Lehrman, WSJ, August 15, 2011.
[2] Graph is taken from "Modern Monetary Madness and King George III," May 8, 2011. 
[3] The pre-1984 CPI is tracked by ShadowStats.com HERE.

Failed Fed Auction an Early Warning?

Not widely reported except by Bloomberg, the Federal Reserve (Fed) had a rare failed auction last week of mortgage-backed securities (MBS) "purchased" by the Fed from AIG during its $182.5B bailout in 2008/9. The Fed bought a total of $52.5B of MBS from AIG as part of the bailout package, forming the "Maiden Lane II" portfolio of distressed crisis assets on its balance sheet. Why should investors and traders care about this event? Keep reading.

In a June 8 dutch auction, investors only bought $1.9B of $3.8B of debt offered, causing market spectators to question the quality of MBS assets that AIG dumped on the Fed (or that the Fed overpaid for). The byline is that the Fed ended up selling the assets into a weak(ening) market, a casualty of bad timing. The irony is that the Fed was offered $15.7B from the rescued-and-lingering AIG for repurchase of the remaining $31B Maiden Lane II portfolio in March. Perhaps the Fed saw such a discount repurchase (reverse repo, actually) as a giveaway that would get too much press attention as a taxpayer loss, and decided that selling into the open market was a more tenable option. Credit markets in February-March were at a 2-year "high" of health, but have since deteriorated somewhat, with both MBS and corporate high-yield (junk) debt spreads increasing along with the price of credit default swaps for major banks and bond insurers.

So why should investors and traders care about this event? First, failed Fed auctions are a rarity. Second, the Fed has some $2.8T of "crisis assets" on its balance sheet [1], with ~$2T collected since fall 2008. Yes, the majority of those assets are Treasuries bought via quantitative easing asset swaps, and are AAA-rated, of the very highest quality debt (for now). Likely, the Fed won't be unwinding its balance sheet anytime soon, given some show of recent economic weakness and calls for even more quantitative easing from some quarters. The questions that arise are: Is selling into a weak market a destabilizer for credit/debt markets, and what is the risk of more failed auctions as the perception of quality deteriorates? Could those failed auctions ever be mint-Treasury auctions by the Treasury [2], forcing the Fed to continue loading its balance sheet and monetizing debt? And then there's always the question of all that muni-debt...

Note I am not just another "chicken little" on the issue of failed auctions and bond market turmoil, as the quality of debt has always been, and always will be, the paramount concern. If the 2008 crisis taught us anything, an oversupply of debt in the market can have destabilizing consequences, especially if quality of that debt declines. Investors and traders need to be vigilant of any signs of worsening conditions.

[1] Public view of the Fed's balance sheet can be found HERE.
[2] Newly-issued Treasury auctions can be tracked HERE.