There has been much recent discussion on the “interest rate inversion,” meaning short-term interest rates are higher than longer-term interest rates. When you buy a bond, you are lending money to a borrower. If the borrower has to repay you in ten years, there are many things that can go wrong, making him unable to pay. If a borrower has to repay you next week, there are far fewer things that can go wrong. In other words, the longer the time before repayment, the more risk the lender is taking. Increased risk requires increased reward to the lender, which means the borrower pays a higher interest rate to the lender. This is normal.
The bond market is much larger than the stock market. Popular legend on Wall Street is that the bond market is much smarter than the stock market. When short term interest rates get higher than long term interest rates, the wise old bond market is saying there is greater risk in the short term than the long term, making short term rates higher. Some people believe this is an indicator of pending recession, but I do not. The joke is that interest rate inversions have successfully predicted ten of the last three recessions.
When the Federal Reserve System was created in 1913, it was given a dual mandate of controlling both unemployment and inflation. It was long thought that an increase in one caused a decrease in the other. This dual mandate also created a box for the Fed’s thinking. At the time, there was no “shadow banking” market, which is now larger than the traditional banking market. The Fed supervised the entire market in 1913 but less than half today. This is unfortunate.
Another change is that the Fed originally only had control over short-term rates, but now has much more control over long-term rates. This came about right after the 2007/8 global financial crisis, when “quantitative easing” allowed the Fed to buy and hold long-term Treasuries. Today, the Fed is are now the largest holder of Treasury bonds. To buy a Treasury bond, you are competing with the Fed.
The largest component of the shadow banking market is repurchase agreements, known as repos. This is a form of short-term borrowing. One party puts up collateral and the second party lends against the collateral, which is repurchased by the first party at maturity. For example, you put up certificate of deposit for $1 million, and I lend you $950 thousand, but you are required to repurchase that CD from me in 90 days for $1 million. In other words, you have paid $50 thousand to borrow $950 thousand for 90 days.
That cost will vary, depending on the quality of the collateral. If it is a CD from a shaky bank, you will pay a higher amount. In our example, that might mean you pay $75 thousand for a $925 thousand loan for 90 days. To get the best rate, you put U.S. Treasury bonds as collateral, which increases demand for U.S. Treasuries. The “shadow” bond market has been screaming for more long-term Treasury bonds, to act as collateral, reducing costs in the repo market.
Remember – increased demand means buyers are willing to pay more. Paying more for bonds causes the fixed interest rate to effectively decrease. If a $1,000 bond pays 3 percent, it pays $30 each year, no matter how much the bond-buyer paid for the bond. If that bond-buyer paid $1,050 for the bond, the yield drops to 2.86 percent. ($30/$1,050 = 2.86 percent) In other words, increasing demand for bonds drives down the actual interest rate received. With rates on 30-year Treasury bonds now about 2.25 percent, which means there is very strong demand. Or, it could mean there are too few 30-year Treasury bonds to buy!
Remember, the Fed remains inside the dual mandate box of fighting unemployment and inflation! But, there is no unemployment nor inflation to fight. So, what should the Fed be doing? Protecting our financial system by getting even more active in the long-term market. It needs to “feed the beast” by selling the long-term bonds in its portfolio, which will increase long-term rates and control the interest rate inversion. Don’t even think about lowering short-term rates! Feed the shadow market which is screaming for better collateral for repo’s.
This dysfunction in the shadow bond market is not a result of the trade war. If the President wants to continue lambasting the Fed (and calling the governors he appointed “boneheads”), he should lambast them for the right reasons. The problem is not that interest rates are too high. Do you know of any projects killed because interest rates are too high? In Europe, not even negative interest rates have been enough to stimulate their economy. Instead, the Fed needs to take control of the shadow bond market.
The President is pushing the Fed to cut rates, as that normally weakens the dollar, which is good for the weakening manufacturing sector. However, it is normal for the dollar to be strong, when our economy is strong and the rest of the world is economically weak, as they are today.
Investors should remember the bond market is smarter than the equity market. The reason the repo market is screaming is they need better credit quality for the collateral, which is a very bearish signal. The interest rate inversion does not worry me, but the demand for better repo collateral does.