FRONT PAGE CONTRIBUTOR
The Fed Gooses the Capital Markets
If you were watching capital markets closely yesterday, you saw a phenomenon that has rarely been seen before. I certainly never have. And it was linked to the Federal Reserve’s policy statement, released about 2:15pm Eastern time.
This was an extraordinary statement, containing several rarely-seen features. The first one, of course, was the commitment by the Fed to keep policy interest rates at or near zero until the middle of 2013. Never before to my knowledge has the Fed put a specific schedule on its interest-rate guidance. The expectation by market participants has been that the Fed would start raising rates as soon as economic conditions (notably unemployment) improved, and they could argue over the timing. Yesterday, that changed.
Any interest rate is the risk-adjusted sum of a series of shorter-term interest rates. When the Fed says that policy rates will be zero for the upcoming 24 months, they’re effectively telling the market that the interest rate on the two-year Treasury note is also zero.
That had an instant effect on the capital markets. It jacked the whole front-end of the yield curve down by nearly 30 basis points. The two-year note briefly traded at a record low yield of about 16.5 basis points. The 10-year note, which had been yielding about 2.30% at 2.15pm, suddenly zoomed upward in price, its yield plunging to an all-time low just above 2.03%.
All this happened in a matter of minutes. It was possibly the wildest move in rates that I’ve ever seen. And of course, the stock market followed rates lower, dumping about 350 Dow points in about 30 minutes.
What happened next was remarkable. About 2:45pm, rates suddenly reversed, and stocks came with them, leaping about 600 Dow points to close the session with solid gains. The two-year note finished the day yielding about 20 basis points, an all-time low, and the 10-year finished about 2.24%. After the close, talking heads rushed to explain the sudden reversal by saying that traders took half an hour to digest the Fed’s statements and decide that it was all good news after all.
I’m not buying that. You don’t really have time to think when the 10-year note is racing up to an all-time low yield. The shape of the tape yesterday afternoon just has the classic look of panic buying, followed by a panic reversal. It simply makes no economic sense for the 10-year yield to be near 2%. I also surmise (without direct evidence) that a lot of short covering went on in the final hour of stock trading yesterday.
Was it a “flash crash”? I doubt it. From what we know about flash crashes, they’re characterized by a withdrawal of liquidity as computer algorithms suddenly yank out their bids in market turbulence. But it looks to me that the rally in notes led the collapse in stocks. Lack of bids wasn’t the problem.
The other critically important aspect of the Fed’s announcement yesterday speaks to a new recognition that the problems faced by the US economy are structural in nature, rather than cyclical. This isn’t a garden-variety recession characterized by demand inadequacy, that can be alleviated with government stimulus spending. This is something different.
The Fed is silent on what the difference is. But if you’ve been reading me here at RedState for the past three years, you already know what I think: the consumer sector has to rebuild its personal balance sheets after the housing-bubble collapse. Individuals are trying to deleverage, a process that will reduce demand relative to trend for several years yet to come.
Deleveraging is secular, not caused by politics. But another major headwind in the economy comes from uncertainty among business people about future policy and regulations. It’s no exaggeration to say that the current Administration is the most anti-business in many years. Every time the President of the United States opens his mouth, he talks about raising taxes on business and capital. If you’re responsible for business investments and you have a pretty good idea that your future successes will be punished by higher taxes, wouldn’t you feel discouraged?
The bottom line is that structural changes in the global economy (including the still-huge problems in Europe) are needed to get things moving in the right direction again. A few hundred billion dollars in stupid stimulus spending isn’t going to do it. My interpretation is that the Fed is finally acknowledging this.
One more point, and this is something I’ve stressed repeatedly in private communications lately: we are NOT facing an imminent financial crisis in the manner of the disorders of 2007 and 2008. The liquidity impairments in interbank markets just aren’t there. The stock market in my view might yet have some way to fall, but we’re not at the edge of a meltdown. And the S&P debt downgrade is basically immaterial to the markets. But that’s a story for a different post.
And if you want an intensely contrarian market call, look at the 10-year note. No less recently than the last week of July, it was yielding over 3%. It’s had a simply incredible rally over the past two weeks. This rally might partially reverse over the next few weeks or months.