The Three Desperados
Eric Janszen

Always On Network's economic agnostic proposes an explanation of the magic behind low interest rates.

On February 2, 2005, the Fed completed its sixth quarter-point rate hike since June 30, 2004. At the time of that first rate hike, the target Fed Funds Rate was 1.25%, while the ten-year US Treasury bond closed that day at 4.62%. Eight months and six rate hikes later, the target Fed Funds Rate is 2.50% and the ten-year US Treasury bond is yielding 4.16%, even lower than when the Fed started tightening. So while the Fed Funds Rate has doubled, the long end of the bond market has actually declined. The effect is often referred to as a "flattening yield curve," in reference to the chart line of rising short-term interest rates approaching the chart line of rising long-term interest rates.

Ten-year US Treasury bond yields that seem stuck near 40-year lows—and the low mortgage rates that are derived from them—explain the mystery of the seemingly never-ending real estate bubble. But isn't this circumstance of diverging short- and long-term interest rates during a Fed tightening cycle highly unusual? A recent CBS MarketWatch article put it this way:

"Most likely, both short- and long-term yields would be rising with the Fed tightening, but with the short end of the curve rising at a faster clip.

"Short-term yields are indeed rising. But their longer-term counterparts are not.

'If this curve were to invert, which I don't think it will, it would be the first time since Bretton Woods [economic summit in 1944] that the curve was flattening with short-term and long-term rates going in opposite directions,' said Liz Ann Sonders, chief investment strategist with Charles Schwab."

What gives?

The same article quotes David Gilmore, a partner in research firm Foreign Exchange Analytics, offering the most commonly expressed explanation: "It is scary when one realizes that the U.S. yield curve is not really representative of inflation expectations in full, but reflects the visible hand of governments, the orgy of currency intervention in Asia, the recycling of $50 a barrel oil by OPEC, and more recently a determined effort by U.S. firms to reduce under funded pension liabilities."

In other words, long treasury bonds are so expensive, and yields so low, because they're so darned popular among The Three Desperados: Asian central banks, OPEC, and U.S. corporations.

Another view belongs to Federal Reserve Chairman Alan Greenspan, who said in testimony two weeks ago: "For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum." The "I don't know" response may or may not be honest, but it certainly sounds honest, and that's usually enough if you're running a central bank. Last week, however, Greenspan's predecessor Paul Volcker, speaking before a group at Stanford, lamented about the apparent unwillingness of the current Fed and others to try to understand what is going on. [Video of Volcker]

Maybe Volcker is not aware that there is another theory which both explains the peculiar demand for treasury bonds—and thus the low interest rates—and resolves Greenspan's conundrum. While it isn't comforting, at least it's an attempt to get at the truth.

Back when I was doing bubble research in 1999, I came upon a scholarly book called Debt and Delusion  by Peter Warburton. The book has become something of a cult favorite among professional, contrarian financial analyst types. In fact, if you want to buy a copy today, it will cost you $100 used, because it's out of print and in demand. In Chapter Seven, titled "Risk Markets and the Paradox of Stability," Warburton supplied—six years ago—a framework for understanding the peculiar bond price and interest rate movements that we are seeing today. Warburton explained:

"There is an even more serious dimension to the meteoric rise in the use of financial derivatives; the implicit credit system that operates within it. Quite apart from the inherent gearing of futures and options, relative to trades in the underlying securities, it is possible to use unrealized gains in financial assets (including derivatives contracts) as collateral for future purchases. The persistent upward trend in asset prices has amplified these unrealized gains and has enabled and encouraged the progressive doubling up of "long" positions, particularly in government bond futures. It is easy to envisage how the cumulative actions of a small minority of market participants over a number of years can mature into a significant underlying demand for bonds. While financial commentators are apt to attribute a falling US Treasury bond yield to a lowering of inflation expectations or a new credibility that the federal budget will be balanced, the true explanation may lie in progressive gearing."

If we accept Warburton's thesis of the effect of progressive gearing of bond derivatives on treasury yields, and that this applies to current circumstances—not as a factor of the anomaly of a flattening yield curve as suggested by Gilmore and others, but rather as the primary cause—we're still left wondering how this may be resolved. For an answer we turn to Martin Mayer, writing on the Over the Counter (OTC) derivatives market as a Guest Scholar in Economic Studies at the Brooking Institution in the same year (1999) when Warburton wrote his book:

"Derivatives markets guarantee a winner for every loser, but they will over time concentrate the losses in vulnerable sectors. Nature obeys Mayer's Third Law, which holds that risk-shifting instruments will tend to shift risks onto those less able to bear them, because them as got want to keep and hedge while them as ain't got want to get and speculate. The logic behind margin requirements in stock markets and capital requirements in banking also holds in the derivatives markets. Permitting highly leveraged institutions to hold private parties behind closed doors is the political version of selling volatility: the predictable likely gains will one day be overwhelmed by an equally predictable disastrous loss."

Warburton draws similar conclusions: "What is clear is that when the next global bear market in equities and bonds arrives, the unwinding of highly geared derivatives positions will trigger financial explosions in every corner of the developed world."

Back in 1999, many of us thought that the coming pop of the stock market bubble (which finally took place in 2000) was destined to be The Great Crash of our century. But in reality, those of us who worried about a repeat of the fallout of the 1929 equities crash were guilty of fighting the last war. The 1929 crash resulted largely from the unwinding of many years of intertwined, non-transparent and highly leveraged investment vehicles called Investment Trusts, the hedge funds of their day. But the damage to the real economy actually happened later, because the banking system had supplied most of the credit for those leveraged bets, so when the stock market went down it took the banking system with it. The real economy soon followed.

But banks did not participate much in the 1990s stock market bubble, thanks largely to post-Great Depression government regulations that limit banks' exposure to equities. Instead, to generate the profits denied them by regulations and regulators in other markets, today our nation's banks carry the liability of several trillion dollars of replacement value for the modern version of the intertwined, non-transparent and highly leveraged bets of the 1920s, but in the bond markets via OTC derivatives, rather than in the equity markets.

Under the rare anomaly of a flattening yield curve may lurk the seeds of the greatest risk to the financial system and the real economy to be seen since the last time the nation's banks supplied credit for massive, highly leveraged financial bets. AO members are invited to discuss this theory. Let's start with three questions: How might an unwinding of these OTC derivative positions in the bond markets come about? What impact might this unwinding have on the economy? What practical steps can AO members take to prepare?

Always On Network
ericjanszen [Trident Capital]