Fed Yield Curve Building an Instability

At the Futures Industry Association annual conference in Chicago last month, I interviewed economist Howard Simons about the fate of the US dollar and if Federal Reserve policy should adapt quickly to defend it. Simons is the president of Rosewood Trading, Inc., and a strategist for Bianco Research. In addition to authoring hundreds of articles for financial and trading publications from Bloomberg to Futures Magazine in the past 15 years, he is the author of The Dynamic Option Selection System: Analyzing Markets & Managing Risk (John Wiley & Sons, 1999).

Most recently, Simons was the special academic advisor to NQLX, known formerly as Nasdaq Liffe Markets, where he directed the development of equity market derivatives. Concurrently he had been a clinical professor of finance at the Illinois Institute of Technology’s Center for Law & Financial Markets, where he directed, at various times, the Center’s fixed income, energy, and trading tracks. Mr. Simons began his career as an economist with the Amoco Corporation and went on to design econometric trading systems for crude oil traders.

I’m relating a chunk of his career and accomplishments because I’m about to explain a point of view of his that is very macro and very complex. I just want readers to understand that this isn’t coming from your average market analyst (think me), but from someone who lives and breathes economic research (he’s got a Bloomberg terminal in his house, for crying out loud!). This guy not only knows his stuff, but he loves to teach, so he has no vested interests in spinning the truth for any alliance with any institution.

So, I put the question to him: “Howard, is it the Fed’s job to defend the dollar, and if so, should they raise interest rates now to do so?”

Technically speaking, “No.” That was his answer on the Fed’s job, and whether they should step in to defend “arbitrary” exchange rate levels. But he elaborated that the Fed was still a very large force in determining the dollar’s value indirectly through monetary policy and, therefore, they can’t ignore the effects of that policy. Simons calls the central bank’s current trick to save the economy and its wealth “the right of seinurage,” which is simply the oldest money trick of all—print more of it (you can see our 2 ½ minute interview when it posts on the site Monday morning).

Borrow Short, Lend Long—Until the Music Stops

I agree with Simons about the Fed’s appropriate “hands off” response to the dollar at this time when it has much bigger things to worry about and focus on. I’ve written many articles here about this topic and the piece I wrote for MarketWatch on October 29^th, “Decline and Fall of the U.S. Dollar” was the third-most read article that day with more than 200 comments. My views obviously sparked some emotional opinions for many.

But here’s what I learned from the good professor that I didn’t even consider previously. If the Fed holds short rates at zero, the positive sloping yield curve encourages certain types of behavior among investors and borrowers that does more than create the obvious potential asset bubbles in stocks and commodities.

What occurs is at least two effects: (1) normally risk-averse savers are forced out of conventional money-market instruments to seek higher yields in longer-term and riskier vehicles, and (2) corporate borrowers are encouraged to shorten the maturity of their debt and become what he calls “floating rate payors at the short end.”

These behaviors build an instability in money and bond markets that will not be unwound smoothly or gradually. It’s similar to the problem we created in the housing market earlier this decade where low short rates encouraged banks to offer home borrowers very attractive ARMs that allowed them to buy more house than they could afford, with little forethought about where the future yield curve would have them re-set in a few years.

From Pushing on a String, to Pulling on a Spring

Simon’s “yield curve instability” thesis is also a function of what the Fed does on the long end. Treasury notes and bonds aren’t sitting at such low yields merely because of Fed quantitative easing measures. The current curve also encourages institutional investors to borrow short and buy bonds, thereby locking in over 4%, even though you’ve got a huge maturity mis-match. A couple of weeks ago on CNBC PowerLunch, I referred to this situation as the yield curve being “unnaturally fixed.” Denis Kneale made a smug remark that we had a good laugh about, but after the laughter, you still have to wonder.

I wonder if the Fed has gone from “pushing on a string” with extraordinary liquidity measures to “pulling on a spring” that will make the yield curve shift dramatically and cause money-market participants to scramble for vital liquidity. If you recall the credit crisis of 2008, it wasn’t so much that money market funds were in jeopardy… that was a symptom of a much larger problem. Corporate borrowers could not use the markets the way they needed to fund their daily businesses. That was a severe “shut-down” risk for the entire economy with huge potential shockwave effects.

When the Fed begins to withdraw from quantitative easing, the yield curve will have already started to shift. Inflation hawks and dollar defenders think we can withstand 2% rates right now. But the forward yield curve I look at every week at the CME through Eurodollar deposit futures (and Howard Simons probably looks at every hour in his research lab in the suburbs of Chicago) says that the market isn’t anticipating short rates near 2% until early 2011.

This is because of two factors. First, the market in aggregate (essentially the big and smart money like PIMCO and Blackrock and quantitative hedge funds controlling trillions of dollars) believes the Fed will stay on hold for a while because Ben Bernanke and Co. fear a Japan-style deflation far more than rising inflation down the road. Second, the yield curve, natural or otherwise, is encouraging borrowing and lending that builds in big duration gaps to capture big yield spreads.

When these guys think the Fed is even thinking about pulling the liquidity plug, they will move yields where they are destined. This also creates a feedback loop that CNBC economist Steve Leisman talks about when he refers to the “terminal rate.” This is the idea that once Fed transparency reveals “this is where we are headed,” the market will take rates there too quickly and suffocate the recovery.

So, who knows when this economy is really out of the woods? The Fed isn’t taking any chances and is going to escort Goldilocks all the way until they are certain—even if they lead her right into heavy traffic.