Dumping of Bond Duration and the Life Expectancy of the United States “Nascent Economic Recovery”
Carlos M Pelaez

The objective of this post is to analyze two critical threats to the longevity of the so-called “nascent economic recovery” of the United States: (1) the J-shaped yield curve; and (2) the combination of expansive fiscal and monetary policies. Rising long-term interest rates, with adverse effects on innovation, productivity, wages, investment and employment, may be driven by fiscal profligacy instead of Fed policy. The Fed is locked in $1.9 trillion holdings of long-term securities and cannot prevent the increase in the long-term segment of the yield curve caused by dumping of bond duration that will drive up all interest rates. The 10-year Treasury yield has increased from 2.86 percent on Dec 18, 2008, to 3.71 percent on Mar 12, 2010, while in the same period the 30-year Treasury yield has increased from 2.53 percent to 4.62 percent (http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield_historical_2008.shtml ) partly because of actual and expected record budget deficits and increasing public debt. The eventual unwinding of Fed holdings of securities may contribute to the rise of interest rates. Discussion below considers (I) recent releases of short-term economic indicators; (II) the J-shaped yield curve; and (III) the deteriorating fiscal environment. The concluding comments analyze the relation of private-sector borrowing costs, affecting investment, consumption, production and employment, to the interest rates on the public debt.
I, short-term indicators. The economic indicators released in the week ending on Mar 12 continue to verify the “nascent economic recovery” (http://www.federalreserve.gov/newsevents/testimony/bernanke20100224a.htm ). US exports of goods and services of $142.7 billion and imports of $180 billion resulted in a trade deficit of $37.3 billion slightly lower than the revised $39.9 billion in December. While the trade deficit increased by $0.4 billion in Jan 2010 relative to Jan 2009, exports increased by 15.1 percent and imports by 11.9 percent (http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf ). The highest deficits in trade of goods not seasonally adjusted were $18.3 billion with China and $7.2 billion with the Organization of Petroleum Exporting Countries (OPEC). Retail sales and food services increased in Feb 2010 by 0.3 percent relative to Jan and by 3.9 percent relative to Feb 2009. Retail trade sales increased by 0.3 percent in Feb 2010 relative to Jan 2010 and by 4.4 percent relative to Feb 2009 while sales of gasoline stations increased by 24.0 percent relative to Feb 2009. Total retail sales in the first two months of 2010 increased by 3.4 percent relative to the same period in 2009 while total sales excluding motor vehicles and parts increased by 3.9 percent (http://www.census.gov/retail/marts/www/marts_current.pdf ). Business inventories were unchanged in Jan 2010 relative to Dec 2009, declining by 8.6 percent relative to Jan 2009. The total business inventories/sales ratio was 1.25 at the end of Jan 2010 compared with 1.46 in Jan 2009 (http://www.census.gov/mtis/www/data/pdf/mtis_current.pdf ). The Reuters/University of Michigan consumer confidence index preliminary estimate declined to 72.5 in Mar from a final reading of 73.6 in Feb (http://www.bloomberg.com/apps/news?pid=20601068&sid=atQQZ7eI3Ylc ). Seasonally adjusted unemployment insurance claims declined by 6,000 to 468,000 in the week ending on Mar 6 and the less volatile four-week average was 475,000, increasing by 5000 from the previous week’s revised average of 470,500 (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). In short, increases in sales and reductions of inventories point to continuing recovery while job creation is not yet dynamic.
II, the J-shaped yield curve. On Mar 5, 2005, the percentage yields per year of Treasury securities were: 3-months 2.76, 2-years 3.73, 5-years 4.22, 10-years 4.56 and 20-years 4.93. The difference between the 10-year note and the 3-month bill was 89 basis points. The yield curve had the upward slope typical of expansions after six months of 25 basis points increases in the target of fed funds decided in meetings of the Federal Open Market Committee (FOMC). On Mar 12, 2010, the percentage yields per year of Treasury securities were: 3-months 0.15, 2-years 0.97, 5-years 2.42, 10-years 3.71 and 30-years 4.62 (http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml ). The difference between the 20-year Treasury and the 3-month bill on Mar 5, 2005 was 217 basis points (bp) while the difference between the 30-year and the 2-year Treasury on Mar 12, 2010 was 365 bp and 447 bp relative to the 3-month bill. Part of the Fed strategy may be to encourage portfolios holding long-end Treasury notes, providing more attractive yield than the 2-year note, with the objective of containing the pressure on the long-end segment of the yield curve. The J-shaped yield curve originated in the lowering toward zero of the fed funds rate with the FOMC target of 0 to ¼ percent since Dec 2008. The pressure of probable capital losses in holding long-term Treasury securities because of the actual and expected budget deficit and public debt is stronger than the Fed encouragement by maintaining the differential yield between 2-year and 10-year Treasury notes.
The credit/dollar crisis and global recession originated in four almost contemporaneous policies that stimulated excessive construction and high real estate prices, highly-leveraged risky financial exposures, unsound credit and low liquidity: (1) the interruption of auctions of the 30-year Treasury in 2001-2005 that caused purchases of mortgage-backed securities (MBS) equivalent to a reduction in mortgage rates; (2) the reduction of the fed funds rate by the Fed to 1 percent and its maintenance at that level between Jun 2003 and Jun 2004 with the implicit intention in the “forward guidance” of maintaining low rates indefinitely if required in avoiding “destructive deflation”; (3) the housing subsidy of $221 billion per year; and (4) the purchase or guarantee of $1.6 trillion of nonprime mortgage-backed securities by Fannie Mae and Freddie Mac (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). The combined stimuli mispriced risk, causing excessively risky and highly-leveraged exposures as the public attempted to obtain higher returns on savings. The increase of the fed funds rate by 25 basis points per meeting of the FOMC from Jun 2004 to Jun 2006 raised the fed funds rate from 1 percent to 5.25 percent around the time that house prices peaked. The response of the Fed to the credit/dollar crisis was the reduction of the fed funds rate from 5.25 in Sep 2007 to 0 – ¼ percent in Dec 2008 without any subsequent change. The Fed faces an even more difficult challenge in the current environment than in 2004 because the Fed balance sheet increased by 115.7 percent from $855.1 billion in February 2008 to $1844.9 billion in February 2009 (Pelaez and Pelaez, Regulation of Banks and Finance, 225-6, Financial Regulation after the Global Recession, 158-9). The Fed balance sheet for the week ending Mar 10, 2010, lists holdings of $1029 billion of MBS, $709 billion of Treasury notes and bonds and $169 billion of Federal agency securities for a combined portfolio of long-term securities of $1.9 trillion; the balance sheet has $1188 billion of excess reserve balances deposited at the Fed and now $50 billion in the supplementary financing account that will grow to $200 billion in weekly additions of $25 billion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ).
The critical issue of monetary policy is unwinding the Fed’s portfolio of $1.9 trillion of long-term securities and returning excess reserves to banks without interest rate shocks that could cut short the life of the “nascent recovery.” The Fed has been considering and testing six policies of exiting the monetary stimulus. The paths of increasing interest rates in the two past cyclical upswings have not been without turmoil. First, stress tests of banks use parameters of the bond market crash in 1994, which started in the US by the tightening of the fed funds rate from 3.00 percent in Feb 1994 to 6.0 percent in Dec 1994 (Pelaez and Pelaez, International Financial Architecture, 114-5, The Global Recession Risk, 206-7). The yield of the US 30-year Treasury bond increased by 150 basis points, causing declines in bond prices because increases of yields of 100 basis points caused declines of prices of 13 percent, which were magnified by typical leverage of 10:1. There was an increase in 30-year mortgage rates of 200 basis points that caused the loss of most of the value in some funds of MBS. Second, the increase of fed funds targets by 25 bp during 17 consecutive meetings of the FOMC from Jun 2005 to Jun 2006 (http://www.federalreserve.gov/fomc/fundsrate.htm ) increased monthly payments of mortgages, which were originally lent and borrowed on the belief induced by Fed policy that interest rates would remain low indefinitely, maintaining real estate and asset values. The rate increase caused collapse of real estate values and mortgage defaults. There are multiple alternatives of Fed tightening of interest rates between the two extremes in 1994 and 2004-2006. A major risk is that almost any change in policy stand could trigger expectations that could cause sharp overshooting of interest rates because tightening occurs now from zero interest rates. Record budget deficits and growing federal debt toward 90 percent of GDP constitute an even more important restriction of Fed policy, which is entirely out of its control.
Third, the budget deficit and government debt. The estimated federal budget deficit by the Congressional Budget Office in the first five months of 2010 is $655 billion, which exceeds the deficit in the same period in 2009 by $65 billion (http://cboblog.cbo.gov/?p=480 ). Spending adjusted for shifts in payment dates increased by $188 billion in the first five months of the fiscal year or 14 percent. Revenue declined by 7 percent or $65 billion. The budget proposal results in record deficits of $1.5 trillion in 2010, or 10.3 percent of GDP, and $1.3 trillion in 2011, or 8.9 percent of GDP (http://cboblog.cbo.gov/?p=482 ). The budget proposal of the executive would increase the federal debt from $7.5 trillion at the end of 2009, or 54 percent of GDP, to $20.3 trillion at the end of 2020, or 90 percent of GDP.
An important release is the Fed’s Flow of Funds Accounts of the United States (http://www.federalreserve.gov/releases/z1/Current/z1.pdf ). The net worth of US households, measured as the difference between assets and liabilities, was estimated at $54.2 trillion at the end of the fourth quarter of 2009, increasing by $0.7 trillion relative to the third quarter. In 2009, household net worth of the US increased by $2.8 trillion. Domestic debt of the nonfinancial sector increased in 2009 by 3.25 percent around 2.5 percentage points less than the rate of growth in 2008. The domestic nonfinancial debt outstanding in the US was $34.7 trillion at the end of the fourth quarter of 2009 distributed as: $13.5 trillion by households, $11.0 trillion by business and $10.2 trillion by government. The growth rate of 3.25 percent of the total domestic nonfinancial debt of the US in 2009 differed significantly by components: -1.7 percent for households, -1.8 percent for business, 4.8 percent for state and local government and 22.7 percent for the federal government. The private sector reduced debt while government increased debt sharply.
For the week ending on Mar 5, 2010, the Fed provides the following percent per year rates and yields: 3-month CD 0.20, 3-month Eurodollar deposit 0.40, 2-year interest rate swap 1.08, Aaa corporate bond 5.24, Baa corporate bond 6.26, state and local bonds 4.36 and conventional mortgage 5.05 (http://www.federalreserve.gov/releases/h15/current/h15.htm ). Treasury securities provide the universal benchmark of securities because they are free of credit risk but not of price or rate risk. The same institution that issues the securities, the government, prints the money paid at redemption, that is, the government never runs out of money with which to pay the debt. Moreover, the dollar continues to be the currency used as reserves by other countries. Thus, yields of private securities are quoted as spreads relative to the yield of the Treasury security with similar maturity. The spreads over Treasury of privately-issued securities are positive because the issuers do not have the power of creating legal tender in redeeming debt. The increase in interest rates of bills and notes of the Treasury will raise all other interest rates of equivalent maturity not only in the US but also likely in other regions overseas.
The conventional analysis of anticipating the Fed’s decision on interest rate tightening because of inflation, economic recovery or improving job markets may be inapplicable in the current environment. Under the FOMC zero interest rate target and the two trillion dollar quantitative easing, the 10-year Treasury yield has increased from 2.86 percent on Dec 18, 2008, to 3.71 percent on Mar 12, 2010, while in the same period the 30-year Treasury yield has increased from 2.53 percent to 4.62 percent (http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield_historical_2008.shtml ). The rise in long-term yields may be partly pushed by the “nascent recovery” as in past expansions but will be increasingly driven by the financing of record budget deficits and refinancing of increasing maturing debt while command of resources transfers from private economic activity to government spending with likely adverse impact on future innovation, productivity, wages, investment, growth and employment. Fiscal deficits and debt/GDP ratios are commonly underestimated. Profligate fiscal attitudes need to be replaced by credible and transparent measures that reverse the budget deficit and debt/GDP ratio. Failure to reverse budget deficits and rising trends of the ratio of debt to GDP will increase long-term interest rates as investors reduce their holdings of Treasury notes and bonds in fear of decline in their prices. The Fed may attempt to maintain short-term interest rates near zero but long-term interest rates will rise as a result of dumping of bond duration. Capital budgeting decisions by the private sector will be frustrated by the inability of matching rates of cash inflows obtained from long gestation projects with equivalent long-term debt cash outflows at costs of borrowing that result in positive net present value. At some point taxes will increase and government expenditure will contract after shock waves created by the premature end of the nascent recovery without sufficient creation of new jobs for full employment. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)