By Terry Connelly
It is one of life’s paradoxes that whenever anyone does something that appears to be fundamentally stupid, common experience tells us that there probably is a good reason! This apparent contradiction applies to financial markets as well as to other human endeavors.
For several weeks now, the holders of 10-year Treasury securities have been fleeing the market, selling out at record rates in excess of the billions that the Federal Reserve is committed to purchase. The third edition of its “Quantitative Easing” program is designed to keep interest rates on those same securities low -- exactly the opposite of what happens when sellers are far more numerous than buyers!
The initial trigger for these sales supposedly was Fed Chairman Ben Bernanke’s comments in Congressional testimony in late May. He effectively said that the Fed might well start dialing back its QE purchases if the economy continues to improve in what the central bank views as a sustainable pace and the risk of deflation recedes. Treasury bond market participants seemed to read this hypothetical as not just a soft prediction but rather a hard promise. And one that portended an earlier than anticipated literal tightening of short-term interest rates, which the Fed had clearly stated would not be increased until unemployment fell at least to 6.5% -- a point Bernanke even reiterated. Yields on the 10-year bond jumped nearly 100-basis points in just a couple weeks.
After some initial overreactions even by experienced commentators, many Fed Board members and some close to the Chairman opined that the market was overreacting. But the damage was done, as QE itself was being effectively withdrawn or at least neutered by the Treasury sell-off. The sell-off seemed to be based on a notion that either the Fed was wrong about the likely improvement in the economy over coming months, or they were just kidding about not raising interest rates until unemployment went down substantially. Either way, the bond traders and investors seemed to be cutting off their nose to spite their face (i.e., racking up increasing losses in the “fire sale” as they all headed for the exits at once). You would think they would know better, being conservative types, but panic they did.
The opportunity to stop the rot and clear things up at the mid-June Fed meeting was not lost on Bernanke and his colleagues: the Board pointed out the data they were seeing indicated improvements, as well as their new forecast for better days ahead including unemployment down to 7% by mid-2014. They also authorized the Chairman to lay out a “tapering timetable” for gradually ending QE from December through next June if (and only if) the economy improved along the lines the Fed was now predicting. And the Chairman also took pains to emphasize that even if tapering did come to pass, the extraordinarily easy money rates the Fed has set in place would remain just that, possibly even after unemployment passed through 6.5% on its way down, which the Fed was not forecasting until 2015 at the earliest!
Bond market irrationality
Clear enough, right? No reason to panic out of Treasuries, right? No reason to reject the ancient advice of bond traders themselves “Don’t fight the Fed,” right? Ah, not so fast. The sellers kept right on selling 10-year Treasuries. Yields jumped to ever 2.70 as soon as the first good jobs report was announced in early July, as the “good news is bad news” mentality proved yet another excuse for the bond vigilantes to renew their fight with the Fed by again challenging the Fed’s clear view that the degree of the bond selloff is unwarranted.
But is that the whole story? Just a hissy-fit thrown by hedge fund bond traders and their clients who never liked Bernanke (too academic) or Obama (too liberal) and want to bring them both down by blowing 10-year Treasury yields (not to mention the mortgage rates they benchmark) through the roof and in the process kill both the housing and the hiring revival, sending the US back into recession just as Bernanke’s successor takes over and Obama faces a Congressional election?
Conspiracy theories are fun to play with, especially on talk radio, when they involve big money, but the sense here is that something far less dramatic but no less significant explains the bond market irrationality that now prevails. From one perspective, it ain’t so dumb after all. And that perspective comes from the big US banks.
A win for banks
For years since the Great Recession set in, commentators of all stripes have complained that banks have not been lending enough to help the economy get moving gain. Some have blamed the banks for this, as the Fed has been shoveling money into their coffers by bond-buying at keeping short-rates low to make the basic banking premise of “borrow short (and cheap) and lend-long (and dear)” at least half-true. Others, however, blame the Fed and other regulators for tying up the banks’ capital and keeping long rates (the benchmark for bank lending profits) too low through its QE intervention in the ‘”free market.”
It seems that Bernanke’s Congressional slip of the tongue gave the banks an idea of how to get out from under the Fed’s box and the public’s blame by taking a short-term balance sheet hit by dumping their Treasury holdings and thereby forcing up long rates that are key to their loan profits. Most of them (witness JP Morgan and its London Whale trader) have more capital than they know what to do with anyway. Given how low junk bond rates had been under QE prior to Bernanke’s comments, it’s understandable how hard it really was for the banks to make money on commercial loans to their usual customers. Selling their 10-years was simply a good long-term investment, and so far it has worked – long rates are up, so they can charge more for loans and now they’ll actually make more of them. And maybe business will increase hiring after all and we can all recover!
As Gordon Gekko would say, ”greed, for lack of a better word, is good!” -- especially when everyone else is thinking it’s stupid.
Terry Connelly is an economic expert and dean emeritus of the Ageno School of Business at Golden Gate University in San Francisco. Terry holds a law degree from NYU School of Law and his professional history includes positions with Ernst & Young Australia, the Queensland University of Technology Graduate School of Business, New York law firm Cravath, Swaine & Moore, global chief of staff at Salomon Brothers investment banking firm and global head of investment banking at Cowen & Company. In conjunction with Golden Gate University President Dan Angel, Terry co-authored Riptide: The New Normal In Higher Education.