Market Analysis

Monetary March Madness

As the yield curve inverts, let us consider how bizarre the Fed’s latest announcement is.

Aaaaaaaaaaaah, the Fed.[i] You may have heard the US yield curve inverted Friday morning, with the 10-year US Treasury yield crossing a shade below the 3-month rate. Media is making a big deal of this, although it seems hard to call it bad news. Surprises move markets most, and people have been eyeing inversion for months. Heaping media attention today basically vaporizes any negative surprise power, making this priced in, and making expectations easy for reality to beat.

This is a big, global world. The yield curve indeed influences banks’ loan profits—banks borrow at short rates, lend at long rates and profit off the spread—yet government bond rates don’t translate directly to banks’ rates. Banks’ funding costs have trailed US government rates since the Fed began raising overnight rates, thanks to a glut of deposits relieving banks of the need to compete for funding by offering higher rates. Meanwhile, business and mortgage loan rates are above government rates. So, banks’ business models likely remain profitable. This is doubly true considering far lower—even negative—rates abroad, which allow banks to fund lending cheaply elsewhere. (Why we often say the global yield curve trumps any individual nation’s.) So this is a time to own stocks. But it is worth considering how we got here.

Wednesday, the FOMC announced its long-awaited blueprint for winding down the winding down of their balance sheet. Come October, instead of letting up to $50 billion worth of Treasury bonds and mortgage-backed securities roll off the Fed’s balance sheet, the Fed will keep the total value of its portfolio static. But there is a twist. In addition to resuming reinvestment of all maturing Treasury bonds, it will reinvest the proceeds of up to $20 billion worth of mortgage-backed securities into Treasurys. So, not only will the Fed stop shrinking its balance sheet, it will resume increasing its holdings of Treasury bonds. Though this move is too small to move the needle, it is curious and seems counterproductive.

This isn’t technically a resumption of quantitative easing (QE). To fit the QE definition, the Fed would have to be creating new reserves and increasing its total balance sheet in order to buy Treasurys. It is more like Operation Twist, the bizarre program where the Fed reduced its short-term bond holdings and upped its long-term bond weighting without changing the size of its balance sheet, deliberately flattening the yield curve. At MarketMinder Managing Editor Todd Bliman’s clever suggestion, I’m tempted to nickname it Operation Shout.[ii]

Still, it is weird. One reason most observers think the Fed has shelved short-term rate hikes for now is the nearly flat US yield curve. At market close on Tuesday, the eve of the Fed’s decision, the spread between the 10-year US Treasury yield and the 3-month yield was just 16 basis points.[iii] If you are worried about a flat yield curve, it seems rather nonsensical to start buying more medium and long-term bonds. Yes, $20 billion is a drop in the bucket relative to the nearly $16 trillion US Treasury market. But bond purchases are bond purchases, and more of them theoretically speaks to lower long-term interest rates. Not to read too much into any three days’ market movement, but we don’t think it is a coincidence that inversion came less than 48 hours after the Fed’s announcement.[iv] Markets seem to know the score, even if policymakers and headlines don’t.

Several media outlets called Wednesday’s move accommodative, laboring under the flawed perception that a big Fed balance sheet and bond purchases amount to loose monetary policy. Friends, it is nothing of the sort. Truly accommodative policy would mean doubling down on what many folks wrongly called quantitative tightening: not just letting bonds roll off the balance sheet, but actually selling them. Though the Fed is just one player in global bond markets, the supply they would add to the market could help support at least incrementally higher long-term interest rates and a steeper yield curve. People would likely whine about the corresponding drop in reserves, arguing that takes money out of the system, but there is scant evidence this would dry up loan growth. Most of the reserves created through QE are sitting idle—excess reserves, doing nothing but earning a small return at the Fed. If they were backing loans, they would be “required” reserves. With over $1.5 trillion in excess reserves still sloshing around the system, the Fed should have some bandwidth to do so.[v] Not that they will. But they could.

I guess this is all just a way of pointing out that most commentators still see quantitative easing backward and the Fed is still getting some things wrong. Again, this is all largely fine for stocks. A slightly inverted yield curve is barely distinguishable from the slightly positive yield curve in the months preceding today, making the widespread handwringing even more confusing. Even with a flattish yield curve, loan growth chugged along at a decent clip. Additionally, the global yield curve remains positive—critical in a globalized world where big, multinational banks can borrow in one country, hedge for currency risk and lend in another—all in the blink of an eye. US banks can easily bypass higher short-term rates here by borrowing in the eurozone, Japan or Sweden, porting the funds here with a quick mouse click, and lending to US households and businesses. Arbitrage helps the world keep spinning. Therefore, until and unless more major yield curves invert, global credit markets should be a-ok.

So carry on, and let others’ yield curve fears create more positive surprise potential for global stocks. The wall of worry just got taller, likely signaling more room for stocks to climb.


[i] This sentence should be read out loud, in the manner of a drunk Orson Welles.

[ii] I mean, the Fed did kinda shake it up baby now. But will they work it on out?

[iii] Source: St. Louis Federal Reserve, as of 3/22/2019.

[iv] Ibid.

[v] Ibid.

 

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.