June 27, 2012

What’s Next For Rates & Fiscal Policy?

June 27, 2012

What’s Next For Rates & Fiscal Policy?

Since we finally reached our 1.47% 10-year Treasury note yield target, folks have been asking, “What’s next for Treasuries and home loan rates?”

The fact is that the U.S. economy is in a dismal state despite averaging $1.518 trillion in deficits per year for the past 3.5 years. We are not exactly in an austerity mode. Massive deficit spending has not really been Keynesian but is more the result of structural problems with Social Security and Medicare/Medicaid. Gigantic spending on wars in the middle-East have also hurt but these are not structural.

Accommodative fiscal policy has been accompanied by accommodative monetary policy – low rates and ineffective increases in money supply by the Fed.

Suggestions that we need a QE3 to get the economy going are absurd.

Why? Because the banking system has already more money that it knows what to do with. Banks have been under enormous pressure from politicians. A few weeks ago, Chase chief Jamie Dimon had to explain a $2 billion trading loss. This is the same Congress which has created the fiscal cliff calling for large tax hikes and decrease government spending when this calendar year ends.

Banks have no idea what to do with their cash until Congress and the President settle the fiscal cliff issue and they are reticent to do anything which they will later be taken to task for. Keep in mind that 90% of the money banks have belongs to depositors. That money is sitting idle in part because banks are still lacking confidence in the economy and part because the regulations consequent to Dodd-Frank have not all been spelled out. Excoriating banks and bankers may be politically exigent but it has the effect of making them less likely to lend the $1.5 trillion in excess reserves they have parked at the Fed.

A QE3 would prop up equities and keep Treasury yields low but this is merely another monetary fix for the fiscal junkie. It would numb the pain but when it inevitably wore off the problem would be worse. Another QE will have the effect of monetizing more Treasury debt and, consequently, two problematic side effects:

(1) keeping Treasury yields low which is great for you as a borrower and great for me as a loan officer but has the effect of allowing narcotizing the economy to the pain we will suffer when the large national debt needs to be serviced at traditional yields and,

(2) making very difficult the task the Fed will have in drawing down this excess money supply before it can cause very serious inflation.

In short a QE3 would be a formula for high inflation, high interest rates and disastrous debt servicing costs.

The blueprint for what we should be doing is either Simpson-Bowles or the idea of a debt commission proposed by Professor Brauer and myself. We need to start thinking long-term. Absent a plan for fiscal sustainability, all we are really doing is applying Grecian Formula to a graying economy.