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Thursday, August 15, 2019

Sub-Zero Treasury Rates: Expect QE on Steroids

Do not mistake the Federal Reserve's signals of sub-zero interest rates for some concern for our economy. If you actually look at the numbers, they are signaling a return to Quantitative Easing.

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In the last couple of days alarm bells have been going off about a pending U.S. recession, based in part on news that the so-called yield curve has flipped: long-term Treasury bond interest rates are suddenly lower than short-term rates. Taken in isolation it is correct to interpret this as a sign of a recession: higher short-term rates is a sign of short-term uncertainty in the economy; the same uncertainty that drives up short-term rates will drive down long-term rates due to higher demand. 

Investors simply prefer the long-term security of a ten- or thirty-year bond.

However, today's situation on the bond market is not primarily caused by rising worries about a recession. More than that, it is a preparation by the market for another round of Quantitative Easing. The signs are in the tea leaves - all you need to do is look at them through the prism of the federal budget.

Investors clamored into the safety of U.S. government bonds, sending the 30-year Treasury bond yield below 2% for the first time ever and the 10-year Treasury note yield below 1.5%, a three-year low. Around 2:00 p.m. ET, the yield on the benchmark 10-year Treasury note, which moves inversely to price, hit a three-year low of 1.475%, while the yield on the 30-year Treasury bond was at 1.944%, after earlier falling to 1.941% for the first time ever. The 2-year Treasury yield was 1.467%, its lowest level since Oct. 2017.

The two-year Treasury bond dropped below two percent in June, but took a sharp dive around August 1 when it dropped from 1.74 percent to 1.58 percent. (Its most recent drop, the one that made the news, was not as dramatic but still noticeable.) The drop at the turn of the month correlated with news about a budget deal on Capitol Hill and the subsequent debate about the budget deficit. 

The ten-year bond dropped similarly from 2.06 percent on July 30 to 1.71 percent a week later. The 30-year bond dropped from 2.58 percent to 2.23 percent. When all bond rates fall, it is a sign of something else than worries about a recession. 

Investors in the sovereign debt market smell massive Quantitative Easing coming - and not just any QE. This one is going to be big.

Former Federal Reserve Chairman Alan Greenspan says he wouldn’t be surprised if U.S. bond yields turn negative. And if they do, it’s not that big of a deal. “There is international arbitrage going on in the bond market that is helping drive long-term Treasury yields lower,” Greenspan, who led the central bank from 1987 to 2006, said in a phone interview. “There is no barrier for U.S. Treasury yields going below zero. Zero has no meaning, beside being a certain level.” 
Strictly speaking, zero interest has no profound meaning, but in reality it does. It is the very tip-of-the-toe limit before bond yields go negative. Once they do, the entire debt market changes character. Investors no longer get paid to lend money to the government. They have to pay to lend government money.

This is a big deal, of course, because it creates an incentive for investors to go elsewhere in the market with their money. That means going after higher-risk investments, pouring more money than usual into stocks, real estate and risky bonds in subprime segments of the debt market. The theoretical reason for encouraging an increased flow of money into equity markets is that it lowers the cost of business investments. That, in turn, should stimulate economic growth.

In reality, business investments depend only to a limited degree on access to capital. The European situation is not one of risk-capital rationing, simply because the relationship between business investments and GDP growth is not as suggested by the theory behind QE. The relationship is the exact opposite: generally, some 90 percent of business investments can be explained by variations in aggregate demand. 

In other words: growth leads investments. Businesses do not borrow money unless they have good reasons to know they will be able to pay it back. They won't be able to pay back their loans unless they have good reasons to expect that their new capital stock will produce revenue. They have no good reason to expect revenue unless there is growth in the market for which they will produce.

Plain and simple: if you want GDP growth, stimulate the real growth driver, namely private consumption. That, however, takes tax cuts, something Europeans fear more than the plague. 

Quantitative Easing will not help consumers, in Europe or in America. Yet that is precisely where we are heading. Back to Alan Greenspan, who normalizes negative interest rates in U.S. Treasury bonds by putting those rates in an international perspective:
Negative yields are confounding traditional fixed-income investors. Lenders traditionally were compensated for parting with their money, while borrowers paid to use that cash for some purpose. That’s no longer the case in many markets outside the U.S., with more investors coming to grips with the changing dynamics of global markets over the last few years ... more central banks embarking on policy easing has resulted in more than $15 trillion of negative-yielding bonds worldwide. Add in U.S. stock-market volatility that is prompting investors to scoop up Treasuries and the result is yields on benchmark U.S. securities racing toward record lows.

Now we are talking. Investors are anticipating the Federal Reserve returning to QE, but they are also factoring in that when this happens, it is going to be a massive QE. Zero interest rates will not do the job; the money printing that brings back zero rates will not suffice to monetize all the debt that the U.S. government is going to sell over the next couple of years. 

It is important to keep in mind that Greenspan is not speaking in isolation. He is sent out there to drop a hint or two of what the Federal Reserve has in mind. That, again, is massive money printing to fund an exorbitant budget deficit. 

Of course, there are many problems with a return to QE, but we can best summarize it as a light version of the Mad Monetary Theory (MMT) that the far-left flank in the Democrat party has been pushing for some time now. The plain meaning of MMT is that government prints as much money as it wants, spends as much money as it wants and then, when it defaults on its loans, allows people to trade their government debt for future tax liabilities. 

This is not the place to get into the details of this so-called theory. I have covered it at length in other articles, such as this one and this one. For anyone who wants to foresee what MMT does to a country, I recommend a close look at Venezuela. 

For the sake of clarity, we are not going to become Venezuela simply because the Federal Reserve returns to QE, even if it is a QE on steroids. However, a new QE that pushes our interest rates into negative territory is yet another step down the path that eventually blurs the line between us and socialist disasters like Venezuela. Therefore, we need a strong, vigorous public debate about the federal government's budget deficits - and the Federal Reserve's apparent plans to put its money-printing on over time. 

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