Trouble in Yellen-Land

Bond markets and the Fed aren’t making sense.

The Fed (“Yellen”) rose the Federal Funds Rate (FFR) last Wednesday, June 12th to a range of 1.00% to 1.25%.

The Fed has two mandates: (1) to keep prices stable (i.e. keep inflation around 2%) and (2) to minimize unemployment. In other words, stabilize the economy by cooling it off when growth gets too fast and heating the economy up when growth slows.

The mechanisms to do this are two fold. The Fed can raise the “Federal Funds Rate” (FFR), making short term credit less available. The FFR is the lowest rate at which a financial institution can borrow. If you raise the lowest rate available in US markets, everything else should follow. Right?

Wrong. The FFR is a very short term instrument. Changes in the FFR only change short term interest rates. (See: Term Structure of Interest Rates). This brings us to our second weapon in the Fed’s arsenal: the Balance Sheet. The Fed can buy and sell securitized mortgages and government debt. They can hold assets on their balance sheet to synthetically alter the supply of debt at longer tenors.

Quantitative Easing (QE) by the Fed flooded markets with cash by purchasing bonds in the open market in order to promote lending (i.e. liquidity). The Fed’s balance sheet exploded… I mean EXPLODED. Check this post for relativity. In the most recent Fed statement, the Committee agreed it would soon be time to bring the balance sheet back to “normal”. This means they will no longer buy new treasuries or redeem matured securities.

Once balance sheet normalization begins, there will be less demand for Treasuries and yields should rise, ceteris paribus. Right?

However, longer term treasury yields have fallen while short term rates rose. This results in a flatter yield curve. Growth in the US and the world remains tepid; and inflation in the US remains under the 2% target rate, but the Fed sees fit to continue tightening monetary policy.

So what gives Janet? 

This morning, Lisa Shalett, Head of Wealth Management Investment Resources at Morgan Stanley, wrote: “… we believe the Fed has embraced a new narrative that extends beyond its mandate of full employment and 2% target inflation.”

The Fed isn’t raising rates because our economy is heating up; they’re trying to combat the next recession proactively. They’re ‘normalizing’ the FFR and the balance sheet back to levels where they can reasonably combat the next recession.

OK, but why the flatter yield curve?

A colleague of mine introduced the idea of relative interest rates as an additive theory. The risk/reward profile of US debt is one of the best in the world. For example, the 10-year government debt yield in Singapore is comparable to the same rate in the US. Would you rather have Singaporean dollars or US dollars given current market conditions? That being said, we have seen a sell off in the US dollar since the beginning of the year. Take a look at what has happened to the US dollar since President Trump took office:


The dollar has rallied and subsequently sold off since the election. In my colleague’s argument, the dollar should rise. If there is a high demand for Treasury bonds, we will see a rise in demand for dollars. You can’t buy US government debt with foreign currency; you have to convert it to US dollars first. More buying of USD pushes up the price.

The recent bond market rally on the long end of the yield curve has pushed rates lower. This could be from more demand as per my colleague’s point; or the bond market is calling bullsh*t on the Fed’s optimistic outlook for the economy because a movement from stocks into bonds signifies a move to safety. When the 10- to 2-year spread tightens, it signifies lower growth expectations in the future.


When Trump was elected, stock markets rallied. The so called “reflation trade” became all the buzz and a “risk-on” mentality became popular. Check out the pop in the 10 to 2 on November 8-10th. This was a spark of optimism that the US economy might see some fiscal stimulus. Since, the bond market has postulated that the current administration might not be able to meet goals in respect to healthcare and infrastructure stimulus, thus spreads have narrowed and expectations tempered.

To review:

The Fed says we’re growing at a healthy clip, with inflation rising. Their reflation narrative is weak, and the bond market isn’t buying it.The Fed is trying to stockpile ammo before the next recession.

What I’m watching:

An inverted (i.e. negative) 10- to 2-year spread has preceded EVERY recession in recent history. Check it out:


Keep an eye on the 10 to 2.

What I’m Reading:

Thanks for reading,

– Tommander-in-Chief


Disclaimer: there are SO MANY moving parts in finance. It’s impossible to point to any one factor because it’s always a combination of several or many factors that affects markets.

Trouble in Yellen-Land

Who’s got the power?


When interest rates go up, and they will, the 50% increase across the board will topple markets, namely bond markets.

Today’s interest rates are unprecedented. The lowest possible bound for an interest rate USED to be 0%. In finance terms, we call it the ZLB or the zero lower bound. Today bond yields in Germany and Denmark (among others) are NEGATIVE! What does this mean for me, the common investor?

Examples of Interest Rates  in History, for relativity:

I’ll admit, I’m not finished with the 700+ page novel written by Sidney Homer first published in 1963. The preface is packed with insightful information such as:

1.) In ancient India, the going rate of interest on livestock was 100%. Then: You can borrow my cow for one year, if after the year is over you’ll pay be back with two cows. Today: I’ll let you use my house for a year, but after that, I’m gunna need that house back, plus a whole extra house.

2.) In early 20th century Indo-China, loans on rice were given at a rate of 50% annually commonly.

3.) In British Columbia, a phenomenon called “potlatch” was first documented. The Kwakiutl, an Candaian Indian tribe, used thin white blankets currency, roughly valued at $0.50 per item. The citizens of this tribe would give the blankets as ‘forced loans’ to one another, with the expectation of receiving what they gave plus interest. “Wealthy Indians vied with each other to see who could give away the most blankets, all with the understanding that even more would be given back—usually double.” – (p. 23, Homer) Kind of wonky huh? They gave because they were greedy.

4.) In Northern Siberia, domesticated reindeer, horses, and sheep were used to collateralize loans. They exchanged the animals like currency, usually charged at an annual rate of 100%.

All in all, lending is not new, but this new environment of negative interest rates is new. You have never  had to PAY someone so they can use your money, that just seems backwards. Remember quantitative easing (QE*)? The Europeans are doing the exact same thing. However, the European Central Bank (ECB) are buying up these negative interest charging bonds because the ECB is attempting to inject liquidity into markets. The ECB is allowing banks to use their cash and they’re paying the banks interest… hmm…

The goal of QE* is to inject liquidity into markets to avoid disastrous outcomes. The program is designed to allow debt to be more readily available for the average consumer. Lowering interest rates and loading up commercial banks with cash will help settle investors’ concerns surrounding a global financial meltdown without a doubt. This being said, if times are bad (economically), the average consumer will become risk averse, and will stay as far from debt as possible until things get better. When consumers get a pay raise or a new job, they might think about taking out a loan to build a new deck or get a new car. Demand drives supply and the policy makers who control interest rates and QE can only control supply. No matter how hard they try to get us to take out debt, we just won’t do it unless market conditions are appropriate. The final result of QE in the United States was a massive increase in the amount of cash that banks hold in reserves.

The graph below shows the level of reserves banks have on their balance sheet from 1984 to 2008. In 1999, banks jacked up their reserves because of Y2K scares; if the whole system imploded at the turn of the century, they wanted to have enough cash on hand to prevent a catastrophic collapse of our financial system. Notice how the level was just shy of $70 billion.

Screen Shot 2016-08-02 at 5.44.39 PM

This graph below shows what has happened to reserves since the beginning of quantitative easing. In 1999, (from above) the level of reserves his $70 billion, here $70 billion isn’t even on the scale. This is where all the bailout money went, onto the balance sheets of big banks.

Screen Shot 2016-08-02 at 5.45.07 PM

Holding reserves used to be an implicit tax for banks, because the more cash they held, the more return they were missing out on (opportunity cost, for you econ buffs). The banks could have put the currency to work in stocks or bonds to achieve a higher return. However, the less cash a bank has on hand, the more risky the institution is. The Fed instituted a return on cash of 50 basis points (0.5%) in order to incentivize holding cash reserves (both required* and excess). The banks can hold all of it in cash and make a half a percent annually or they can buy negative yielding bonds. It’s a positive, riskless yield. Why wouldn’t banks take advantage?

*Note: by law, the required reserve ratio in the US is 10% for big banks.

QE works as a mechanism to prevent economic collapse, but demand drives supply; thus, you cannot force people to buy things they don’t want (except maybe in Communist Russia where they don’t actually tell you what you’re taking until you’re disqualified for the Olympics) QE cannot create prosperity because no matter how available you make debt, it is the preferences of the consumers that ultimately drives demand for loanable funds.

The Federal Reserve of the United States holds way, way more power than Donald Trump and Hilary Clinton, yet when they make a statement in the press, it usually doesn’t even make the front page. The Fed has the power to control interest rates. They also have the power to create money, as in printing currency (yup, money growing on trees). They control what you pay on your mortgage and they control how much interest your money makes (in markets and in savings accounts). This affects how soon you will be able to retire, how much your house is worth, how much your pension has in cash (i.e. how much risk your pension can take), how much your kid’s college fund will make… you name it, the Fed controls it. The best part is, you didn’t get to elect these officials. The US government deemed it too risky to put big financial decisions in the hands of under-informed citizens (*cough* Brexit *cough*).

Thanks for reading.

– tommander-in-chief.

Note: For more on pensions taking on too much risk check out this economist article,




Side note on bond prices –

Bond prices are inversely related to bond yields. That is, when the rate on a bond rises, it’s price will drop. Because today’s rates are so low, the effect that a rise in interest rates will have will be massive. For a little relativity, interest rates (the fed funds rate) in 1999 was around 5%. A 50% increase in this rate would raise the rate to 7.5%, which is a massive jump. Now, we are debating a 25 basis point* increase in rates, which brings them from 25-50 bps to 50-75 bps. This may seem trivial, but that represents the same 50% increase in the fed funds rate!

*Note: a basis point is a ten thousandth of a percent; 1 basis point = 0.01%


Who’s got the power?