The author is CEO and Chief Investment Officer of Richard Bernstein Advisors
The Ferber Method, a sleep training technique, teaches babies to self-soothe and fall asleep on their own. It is as much a training technique for new parents to ignore their baby’s crying as it is for the child to learn to fend for themselves.
The US Federal Reserve should consider Ferberization bond investors and ignore the future “Conical crises” such as the market disruption that occurred when the central bank announced a tightening of monetary policy in 2013. The long-term health and competitiveness of the US economy may depend on the appeasement ability of bond investors to face facts.
The slope of the yield curve is a simple model of the profitability of credit. Banks pay short-term rates on deposits and other sources of funds and receive long-term rates by issuing mortgages, business loans, and other loan arrangements.
A steeper curve is therefore a simple measure of better bank profit margins and has, in past cycles, stimulated greater willingness to lend. Historically, the Fed’s survey of senior bank lending officials shows that banks are more willing to lend to the real economy when the yield curve is steeper.
With this simple model of bank profits in mind, the textbooks highlight the Fed’s control over short-term interest rates as a tool to control lending. The Fed cuts the cost of funding banks and boosts credit when it cuts interest rates. But it raises financing rates and cuts loans when it raises short-term rates. Coupling lower short-term rates with a steeper yield curve can be a powerful boost to bank lending.
However, the policies of this cycle have been unique. As US short-term interest rates are close to zero, the Fed has tried to stimulate the economy further by buying longer-term bonds and lowering long-term interest rates. These actions have indeed reduced the costs of long-term borrowing in the economy, but the willingness of banks to lend has been limited because credit lines have been tight and risk premiums low.
In previous cycles, banks might have been willing to lend despite a relatively flat yield curve, as they could improve narrow credit lines using leverage. However, regulations after the financial crisis now limit their ability to use leverage.
This combination of policies and regulations has fueled some of the growth in private lending. Private lenders are not subject to regulated leverage constraints and therefore can lend profitably despite a flat curve. The growth of private credit effectively reflects an involuntary disintermediation of the traditional banking system. This means that much of the liquidity destined for the real economy has been trapped in the financial economy.
The yield curve has started to steepen and the Fed should freely allow long-term interest rates to rise so that monetary policies benefit the real economy more fully. Allowing long-term rate hikes would not only begin to dampen financial speculation as risk-free rates rise, but could simultaneously encourage bank lending to the real economy.
Hence the need for the Fed to Ferberiser bond investors. Banks’ willingness to lend begins to improve as the curve begins to steepen, but some economists suggest the central bank should continue with its current strategy of lowering long-term interest rates due to the potential for a disruptive “taper tantrum” from bond investors. . The Fed must ignore investors’ tantrums and allow them to calm down.
The implications of the Fed’s investment allowing long-term interest rates to rise seem clear. Much of the speculation in the US markets is in assets such as venture capital, special purpose acquisition vehicles, tech stocks, and cryptocurrencies. These are “long-term” investments that have longer-term horizons factored into their valuations. They underperform when long-term rates rise because investors demand higher returns over time. The capital would probably be redistributed towards more tangible productive assets.
Investors and policymakers should be concerned that monetary policy is fueling speculation rather than supporting the lending facilities needed to replenish US registered capital and keep the country’s economy competitive.
Like a new parent for a baby, the Fed shouldn’t be rushing to pamper bond investor crises and should let financial markets calm down. Short-term financial market volatility could cause sleepless nights, but the Fed could free up the lending capacity of the traditional banking system by letting the yield curve steepen further.