The Duration Trap of Monetary Policy

 

The Duration Trap of Monetary Policy

Carlos M. Pelaez

Monetary policy would appear faster in execution than politically deadlocked fiscal stimulus in the effort to increase demand and accelerate growth. This post considers the adverse consequences of the duration trap of monetary policy. Section (I) recapitulates the past experience with the global hunt for yields resulting from zero interest rates and quantitative easing, (II) alternatives for monetary policy and (III) the duration trap. Economic indicators are covered in (IV), financial turbulence in (V), interest rates in (VI) and the conclusion in (VII). If you have difficulty in viewing the tables and illustrations go to: http://cmpassocregulationblog.blogspot.com/

I The Global Hunt for Yields. The objective function of money managers is to maximize the returns of the funds under management subject to control of risks such that the principal is preserved. There are multiple tools of risk management that are all subject to the uncertainty of predicting financial variables with which to project cash flows and returns on investment toward the future. Investors are constantly calculating the risks and returns of their positions to adjust them to new information or views on the future. Economic policy in the current decade has been dominated by efforts to prevent deflation using two tools: (1) near zero fed funds rates; and (2) quantitative easing. When fed funds rates are at the “zero bound,” or almost at zero, the Fed can still ease money by quantitative easing. The Fed can inject bank reserves by expanding its balance sheet with the purchase of long-term Treasuries or other securities. The policy focus is on the quantity of reserves and not on the fed funds rate (Ben Bernanke and Vincent Reinhart, Conducting monetary policy at very low short-term interest rates, AER 92, 2004, 87, cited in Pelaez and Pelaez, Regulation of Banks and Finance, 224). Quantitative easing injects reserves that can result in rebalancing of portfolios by investors which increases prices of alternative long-term securities (Bernanke and Reinhart op.cit. 88). Investment and economic activity could be stimulated by lower long-term interest rates. Increasing reserves over what is needed can also create expectations on the willingness of the Fed in maintaining quantitative easing until improvement of the economy. There are substantial hurdles of implementation and communication of quantitative easing but the policy advice for central bankers is acting “preemptively and aggressively to avoid facing the complications raised by the zero lower bounds” (Bernanke and Reinhart op cit. 90). Innovation in central banking as in other economic activities is always productive but as with all new tools of policy there are operational hurdles even with optimistic empirical analysis (Bernanke, Reinhart and Sack, Monetary policy alternatives at the zero bound: an empirical assessment, BPEA 2004, cited with other literature on Japan in Pelaez and Pelaez, Regulation of Banks and Finance, 224).

The Fed lowered its target rate of fed funds from 6.50 on May 16, 2000, to 6.00 percent on Jan 3, 2001, and then lowered the target continuously to 1.00 percent on Jun 25, 2003, raising the target by 25 basis points during 17 consecutive meetings of the Federal Open Market Committee (FOMC) beginning with a rate of 1.25 percent on Jun 30, 2004, and ending with 5.25 percent on Jun 29, 2006. The FOMC then lowered the target fed funds rate to 4.75 on Sep 18, 2007, and continued lowering aggressively until fixing it at 0 to 0.25 percent on Dec 16, 2008 (http://www.federalreserve.gov/monetarypolicy/openmarket.htm ). Quantitative easing in the first movement toward the zero bound with the target rate of 1 percent in Jun 2003 was in the form of the suspension of the issue of the 30-year Treasury for five years after 2001 with the objective of rebalancing portfolios of pension funds and similar investments with 30-year mortgage-backed securities. The purchase of long-term mortgage-backed securities increased their prices or equivalently lowered their yields, leading to refinancing of mortgages that injected more funds to households in after-mortgage payments income than tax reductions. Fed policy during the credit crisis was not fundamentally different in principle with the fed funds rate lowered actually to zero percent or 0.25 percent and quantitative easing in the form of aggressively expanding the balance sheet of the Fed. On Sep 8, the Fed balance sheet had credit of $2.3 trillion; the total Fed-owned portfolio of long term securities was $1.98 trillion composed of $724 billion of Treasury notes and bonds, $156 billion of federal agency debt securities and $1103 billion of mortgage-backed securities; and reserve balances at the Federal Reserve Banks were $1.04 trillion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ).

The intentions of policy have differed with their actual consequences. The intention of the Fed in lowering rates to zero or near zero percent is to stimulate investment, consumption, production and employment. The stimulus of monetary policy works by providing nearly unlimited amounts of credit at close to zero interest rates for short-dated funds and at long-term rates below what they would have been without quantitative easing in an effort of flattening the yield curve. The consequences were a global hunt for yields to protect own investments and money under management from the zero interest rates and unattractive long-term yields of Treasuries and other securities. The Fed distorted the calculations of risks and returns by households, business and government by providing central bank cheap money. The policy has been inspired by fear of deflation. The loss in the value of collateral by debtors because of deflation in the 1930s was an important restriction of the volume of credit, together with the dismantling of intermediation services by the banking panics, contributing to the propagation and unusual depth of the Great Depression (Bernanke, Nonmonetary effects of the financial crisis in propagation of the Great Depression, AER 1983, cited in Pelaez and Pelaez, Regulation of Banks and Finance, 201). However, a study of 17 countries over 100 years finds that in 90 percent of the cases of deflation there was no depression (Andrew Atkeson and Patrick Kehoe, Deflation and Depression, AER 94 (2004), cited in Pelaez and Pelaez, Regulation of Banks and Finance, 201). Short-term zero interest rates encourage financing of everything with short-dated funds, explaining the structured investment vehicles (SIV) created off-balance sheet to issue short-term commercial paper to purchase risky mortgages that were financed in overnight or short-dated sale and repurchase agreements (Pelaez and Pelaez, Financial Regulation after the Global Recession, 50-1, Regulation of Banks and Finance, 59-60, Globalization and the State Vol. I, 89-92, Globalization and the State Vol. II, 198-9, Government Intervention in Globalization, 62-3, International Financial Architecture, 144-9). Adjustable-rate mortgages (ARMS) were created to lower monthly mortgage payments by benefitting from lower short-dated reference rates. Financial institutions economized in liquidity that was penalized with near zero interest rates. There was no risk because the Fed guaranteed a minimum or floor price of all assets by maintaining low interest rates forever or equivalent to writing an illusory put option on wealth. The housing subsidy of $221 billion per year created the impression of ever increasing house prices. Fannie and Freddie purchased or guaranteed $1.6 trillion of nonprime mortgages and worked with leverage of 75:1 under Congress-provided charters and lax oversight. The combination of these policies resulted in high risks because of the Fed put option on wealth, excessive leverage because of cheap rates, low liquidity because of the penalty in the form of low interest rates and unsound credit decisions because the Fed put on wealth created the illusion that nothing could ever go wrong, causing the credit/dollar crisis and global recession (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 consequences of the global hunt for yields created by monetary and housing policy are shown in Table 1. The second column shows a dramatic rise of 87.8 percent in the Dow Jones Industrial Average (DJIA) from 2002 to 2007, a more modest increase in the NYSE financial index of 42.3 percent in 2004-2007, an increase in the Shanghai Composite index of 444.2 percent in 2005-7, a rise in the STOXX Europe 50 index of 93.5 percent in 2003-2007, and an increase in the UBS commodity index by 165.5 percent in 2002-2008. The zero or near zero interest rates fostered significant volatility by the carry trade from low yielding currencies into fixed income, commodities, high-yielding currencies, emerging stocks and any type of speculative position such as the price of oil rising to $149/barrel in 2008 during a global contraction (Pelaez and Pelaez, Globalization and the State, Vol. II, 203-4, Government Intervention in Globalization, 70-4). The 10-year Treasury traded at 3.112 percent on Jun 16, 2003, rising to 5.297 on Jun 12, 2007, collapsing to 2.247 on Dec 31, 2008 and rising to 3.986 percent on Apr 5, 2010. New house sales peaked historically at 1,283,000 in 2005, declining to 375,000 in 2009 while the median price jumped from $169,000 in 2000 to $247,000 in 2007 to fall to $203,000 in Jul 2010. The other two columns show the decline of risk financial assets during the credit crisis and the incomplete current recovery. The combination of short-term zero interest rates, quantitative easing and housing subsidy caused a worldwide hunt for yields that ended in a world financial crash and serious distortions in risk/return calculations.

 

Table 1, Volatility of Assets

DJIA	10/8/02-10//1/07	10/1/07-3/4/09	3/4/09-4/16/07
% Change	87.8	-51.2	60.3
NYSE Financial	1/15/04-6/13/07	6/13/07-3/4/09	3/4/09-4/16/10
% Change	42.3	-75.9	121.1
Shanghai Composite	6/10/05-10/15/07	10/15/07-10/30/08	10/30/08-7/30/09
% Change	444.2	-70.8	85.3
STOXX Europe 50	3/10/03-7/25/07	7/25/07-3/9/09	3/9/09-4/21/10
% Change	93.5	-57.9	64.3
UBS Commodity	1/23/02-7/1/08	7/1/08-2/23/09	2/23/09-1/6/10
% Change	165.5	-56.4	41.4
10-Year Treasury	6/16/03	6/12/07	12/31/08	4/5/10
%	3.112	5.297	2.247	3.986
Dollar/euro	7/14/08	6/03/10	8/3/10
USD/EUR	1.59	1.216	1.323
New House	1963	1977	2005	2009
Sales 1000s	560	819	1283	375
New House	2000	2007	2009	2010
Median Price $ 1000s	169	247	217	203

Sources: http://online.wsj.com/mdc/page/marketsdata.html 

http://www.census.gov/const/www/newressalesindex_excel.html

 

II Alternatives for Monetary Policy. The Wall Street Journal asked six authorities on monetary policy what the Fed should do next (http://professional.wsj.com/article/SB10001424052748704358904575477580959771188.html?mod=WSJ_hpp_RIGHTTopCarousel_5 ). John Taylor and Alan Meltzer concur on a return to rule-based policy such as using the Taylor rule by which the target of fed funds is set equal to 1.5 times the rate of inflation and 1.5 times the gap of actual and potential GDP plus one, with more focus on the long term. Richard Fisher uses the statement in the FOMC that “a number of participants reported that business contacts again indicated that uncertainty about future taxes, regulations and health care costs made them reluctant to expand their workforces”( http://www.federalreserve.gov/newsevents/press/monetary/fomcminutes20100810.pdf 7) to withhold further expansion of the Fed balance sheet until fiscal and regulatory policy are closer to the needs of employment creation. Frederic Mishkin warns about monetizing the debt and the high costs of using quantitative easing in normal circumstances. Ronald McKinnon proposes fed funds rate of 2 percent and long-term rates of 4 percent to avoid the liquidity trap of zero interest rates. Vincent Reinhart reminds the Fed statutory need for action when growth and employment are weak and inflation low that in the presence of zero interest rates leaves only unconventional policy as an alternative.

III The Duration Trap. A critical issue of monetary policy is the future consequences of lowering long-term interest rates. The Fed is now reinvesting the maturing portions of its portfolio into long-term Treasury securities of similar characteristics. Professionals use a variety of techniques in measuring interest-rate risk: (1) the full-valuation approach in which securities and portfolios are shocked by 50, 100, 200 and 300 basis points to measure their impact on asset values; (2) stress tests requiring more complex analysis and translation of possible events with high impact even if with low probability of occurrence into effects on actual positions and capital; (3) value at risk (VaR) analysis of maximum losses that are likely in a time horizon; (4) short-hand convenient measurement of changes in prices resulting from changes in yield captured by duration and convexity; and (5) careful consideration of yield volatility (Frank Fabozzi, Gerald Buestow and Robert Johnson, Measuring Interest-Rate Risk in Handbook of Fixed Income Securities, http://www.amazon.com/Handbook-Fixed-Income-Securities/dp/0071440992/ref=sr_1_1?s=books&ie=UTF8&qid=1284300146&sr=1-1#_ ). Frederick Macaulay introduced in 1938 the concept of duration in contrast with maturity for analyzing bonds (http://www.nber.org/books/maca38-1 ). Duration is the sensitivity of bond prices to changes in yields. In economic jargon, duration is the yield elasticity of bond price to changes in yield, or the percentage change in price after a percentage change in yield, typically expressed as the change in price resulting from changes of 100 basis points in yield, with the mathematical formula being the negative of the yield elasticity of the bond price or -(dB/d(1+y))((1+y)/B) where d is the derivative operator of calculus, B the bond price, y the yield and the elasticity does not have dimension (http://papers.ssrn.com/sol3/cf_dev/AbsByAuth.cfm?per_id=89567 4). The duration trap is that duration is higher the lower the coupon and higher the lower the yield, other things being constant. Coupons and yields are currently very low and quantitative easing may lower further both coupons and yields. Consider a simplified example. A 10 year bond with semiannual coupon of 7.5 percent issued at price of 100 with yield of 15 percent. If yield increases to 16 percent the price of that bond falls to 95.0909 for a loss of 4.91 percent. On Sep 10, the yield of the 10-year Treasury was 2.795 percent. If a bond were issued at price of 100 with semiannual coupon of 1.3975 percent (2.795 divided by 2) and the yield were to increase from 2.795 percent to 3.795 percent, its price would fall to 91.7428 for a loss of 8.26 percent. Bloomberg reports that duration in Bank of America Merrill Lynch indexes of corporate debt reached a record of 5.69 on Aug 31 (http://noir.bloomberg.com/apps/news?pid=20601087&sid=a_4aQI_skhqE&pos=4 ). A note with coupon of 5.25 percent maturing in 2055 would lose 6 percent of face value after an increase of yield by 50 basis points. The consequences of zero interest rates and quantitative easing in the form of yield hunts have not been considered in monetary policy. Duration dumping during a rate increase may trigger the same cross fire selling of high duration positions that magnified the credit crisis. Traders reduced positions because capital losses in one segment, such as mortgage-backed securities, triggered haircuts and margin increases that reduced capital available for positioning in all segments, causing fire sales in all segments (Markus Brunnermeier and Lasse Pedersen cited in Pelaez and Pelaez, Regulation of Banks and Finance, 223). In fear of deflation, Fed policy has been inflating and deflating investor positions and wealth allocations by distorting risk/return calculations.

IV Economics Indicators. Economic indicators continue to show deceleration of the US economy and weak employment conditions. The Beige Book of the Fed confirms deceleration of the US economy: “reports from the twelve Federal Reserve Districts suggests continued growth in national economic activity during the reporting period of mid-July through the end of August, but with widespread signs of a deceleration compared with preceding periods” (http://www.federalreserve.gov/fomc/beigebook/2010/20100908/fullreport20100908.pdf i).

Trade in goods and services in Jul reduced the current account deficit, which is good news because the trade deficit contributed negatively to GDP growth in the second quarter. The trade account of the US registered a deficit of $42.8 billion in Jul equal to exports of goods and services of $153.3 billion less imports of $196.1 billion, which was lower than $49.8 billion in Jun. Exports in Jul were $2.8 billion higher than $150.6 billion in Jun, or 1.8 percent, while imports were lower by $4.2 billion relative to $200.3 billion in Jun or 2.1 percent lower. US exports of goods in Jan-Jul 2010 reached $722 billion or higher by 22 percent than $590 billion in the same period in 2009 while imports were $1082 billion or 25.9 percent higher than $583 billion a year earlier (http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf ). Information-sector revenue increased by 0.8 percent in the second quarter of 2010 relative to the first quarter and is higher by 2.7 percent than in the second quarter of 2009 (http://www2.census.gov/services/qss/qss-current.pdf ). The lag in new orders in data from the index of the ISM for industry is being reflected in involuntary inventory accumulation. Seasonally adjusted (SA) inventories of merchant wholesalers increased by 1.3 percent in Jul relative to Jun and by 2.5 percent from Jul 2009. Sales of merchant wholesalers rose by 0.6 percent in Jul relative to Jun and by 12.7 percent from Jul 2009. The increasing accumulation of inventories with lagging sales resulted in an inventory/sales ratio for Jul of 1.16, which is still lower than 1.27 in 2009 (http://www2.census.gov/wholesale/pdf/mwts/currentwhl.pdf ). The Fed finds an annual equivalent decline of consumer credit of 1.75 percent in Jul with revolving credit falling at 6.25 percent and nonrevolving credit increasing at 0.5 percent (http://www.federalreserve.gov/releases/g19/Current/ ).

The Mortgage Bankers Association unadjusted purchase index rose 4.0 percent in the week of Sep 8 and was 38.8 percent lower relative to the same week in 2009 (http://www.mbaa.org/NewsandMedia/PressCenter/73876.htm ). SA initial claims of unemployment insurance fell to 451,000 in the week of Sep 4, or by 27,000 from the earlier week’s revised 478,000 (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). The revision may bring in more information because nine states were estimating data in the midst of the labor holiday.

V Financial Turbulence. Improvement in financial markets and economic recovery has been accompanied by continuing volatility or financial turbulence of financial variables shown in Table 2. The factors of financial turbulence have been: (1) uncertainty on the growth rate of China that may affect commodity prices and Asian interregional trade and economic growth; (2) sovereign risks in Europe with doubts on bank exposures and adequacy of stress tests to measure risks; (3) decelerating economic growth and weak employment markets in the US; (4) fiscal and regulatory uncertainties in the US that restrict investment, consumption and hiring; and (5) uncertainties that monetary policy consisting of quantitative easing my trigger another global hunt for yields. Most major indexes registered gains in the week ending on Sep 10, especially in Asia Pacific and Europe but in markets characterized by hesitation and low volumes.

 

Table 2, Stocks, Commodities, Dollar and 10-Year Treasury

	Peak	Trough	% Trough	% 9/10	Week 9/10
DJIA	4/26/10	7/2/10	-13.6	-6.6	0.1
S&P 500	4/23/10	7/2/10	-16.0	-8.8	0.5
NYSE Financial	4/15/10	7/2/10	-20.3	-12.5	-0.3
Dow Global	4/15/10	7/2/10	-18.4	-10.3	0.6
Asia Pacific	4/15/10	7/2/10	-12.5	-4.5	1.6
Shanghai	4/15/10	7/2/10	-24.7	-15.8	0.3
STOXX Europe	4/15/10	7/2/10	-15.3	-5.1	1.4
Dollar	11/25/10	6/25/10	22.3	19.4	1.7
USB Com	1/6/10	7/2/10	-14.5	-6.5	0.5
10-Y Tr	4/5/10	8/6/10	3.986	2.795

Source: http://online.wsj.com/mdc/page/marketsdata.html

 

VI Interest Rates. The yield curve shifted upward for the first time in several weeks on Sep 10 with the 10-year Treasury rising to 2.80 percent (rounding 2.795 percent) above 2.71 percent a week earlier and 2.74 percent a month earlier (http://markets.ft.com/markets/bonds.asp?ftauth=1284306977315 ). Increasing risk positions in other fixed income with new placement of corporate debt may explain part of the increase in Treasury yields. The Wall Street Journal quotes data from Dealogic and S&P’s Leveraged Commentary & Data Group that in two days before Sep 8, $51 billion of new corporate bonds and leveraged loans went to market, with $19 billion in new high-grade bonds on Sep 8 alone (http://professional.wsj.com/article/SB10001424052748703453804575479712501514050.html?mod=wsjproe_hps_LEFTWhatsNews ). The 10-year government bond of Germany traded at 2.40 percent for a negative spread of 40 basis points relative to the equivalent Treasury. The Treasury with 2.63 coupon maturing in Aug 2020 traded at 98.53 (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-100910 ). If the yield were to backup to the recent peak of 3.986 on Apr 5, the price for settlement on Sep 13 would be 88.9880 for a loss of principal of 9.7 percent. Further quantitative easing may be an inopportune policy option.

VII Conclusion. Financial and regulatory shocks constrain economic growth and prevent job creation. Increasing purchases of long-term securities by the Fed may create a duration trap with adverse effects in the future. Economic policy is at a low level of credibility, requiring drastic reformulation that aligns policy measures with the needs for growth and employment creation. (Go to http://cmpassocregulationblog.blogspot.com/ http://sites.google.com/site/economicregulation/carlos-m-pelaez)

http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )