Carry Trade Sets the Limits to Rate Hikes
"To be sure, nobody in the Fed is seriously eying this rate. They are undoubtedly fully aware that a short-term rate at this level would definitely pull the rug out from under the whole U.S. financial system."
by Kurt Richebächer Although the Fed has moved its federal funds rate from 1% to 2.75%, its speakers, and Alan Greenspan himself, keep emphasizing that "easy money" is still in place. In his congressional testimony on Feb. 16, 2005, Mr. Greenspan said, "The cumulative removal of policy accommodation to date has significantly raised measures of the real federal funds rate, but by most measures, it remains fairly low ." The official target is to raise the Fed's federal funds rate to a "neutral" level. Although Mr. Greenspan has admitted not to know where that rate is until he gets there, there seems to be a general assumption that it implies sustainable economic growth with price-level stability. Where could that rate be in the U.S. case? We have learned that the inflation-adjusted federal funds rate has averaged around 2% over the postwar period. Given a present inflation rate for consumer prices of around 3%, this would put the "neutral" nominal federal funds rate presently at close to 5%, plainly far above its current reading of 2.75%. To be sure, nobody in the Fed is seriously eying this rate. They are undoubtedly fully aware that a short-term rate at this level would definitely pull the rug out from under the whole U.S. financial system. The crucial point to keep in mind is that America's present high level of asset prices has its foundation not - as is normal - in available savings, but in highly leveraged "carry trade," the extensive practice of financial institutions to ride the yield curve by borrowing short at low rates to buy higher-yielding assets, mainly longer-term bonds. By holding U.S. short-term rates at artificially low levels and also making unlimited liquidity available, the Fed has driven the carry trade to unprecedented extremes in history. The desired result was artificially low long-term interest rates to fabricate the housing bubble. But as short-term rates rise, the carry traders get squeezed. Implicitly, there comes a point when they are forced to liquidate their leveraged positions. However hawkish the Fed's talk about fighting inflation may be, the monstrous carry-trade bubble is setting narrow limits on any further rate hikes, regardless of what may happen to consumer price inflation. To put it briefly and bluntly, the Fed is no longer in control of its interest rate instrument. Considering the threat of collapsing carry trade, it would surprise us if they dared to move the federal funds rate above 3.5%, though this might barely match the current inflation rate. With 20 times leverage, or just 5% equity, as the virtual norm in bond carry trade, a rise in the yield of 10-year bonds by just one percentage point would more than wipe out the whole underlying equity. Judging from past experience, we presume that the Fed's hawkish tone about fighting inflation through faster rate hikes has the purpose of precisely preventing the need for such action by assuaging the markets.
For more from The Good Doctor, see The Richebächer Letter:
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