What record low 10-year rates tell us about the toxic effects of permanent zero

On Twitter the latest buzz is about the US ten-year government bond hitting a record low of 1.6713%. Some are amazed that the world of ‘financial repression’ where long-term yields are lower than consumer price inflation can go on and on without a hiccup. Well don’t be. Long-term interest rates are a series of future short-term rates. If the central bank is telling you that zero rates are practically permanent i.e. permanent zero, wouldn’t you expect the term structure to eventually flatten? That’s what has happened, folks – just as in Japan.

So what does this mean for you and me? Well, first of all, what’s your savings account statement saying? Is it telling you you can spend a lot more because you are flush with interest income or is it telling you you better save more if you expect to retire without having to live on cat food? Here’s another question: does this bode well for consumption or ill? Clearly, it bodes ill via the interest income channel but it could bode well if you and I leverage up a bit as debt service costs are down. And that is the point of low rates, by the way.

The Fed is squeezing interest rates down to levels where you see private portfolio preference shifts, a euphemism for the risk seeking return mentality that arises from artificially low real fixed income returns and that forces up risk assets. But this can only go one for so long.

See, eventually there will be another recession and the question should be what happens to all those toxic assets on bank balance sheets. What happens if new loans go sour too? If you recall, US FDIC-insured institutions recorded $35 billion in Q1 2012 accounting gains. But the quality of those accounting gains was dubious. Here’s the key line to note:

Lower provisions for loan losses and higher noninterest income were responsible for most of the year-over-year improvement in earnings.

That means FDIC insured institutions are under-provisioning and earning money through non-lending channels. These institutions are taxpayer guaranteed by the FDIC because they take deposits and lend that money in support of economic activity. Yet, what the FDIC is telling you is that institutions are not earning money through the traditional interest income channel which is the source of their FDIC guarantee. And that’s as you should expect in a permanent zero environment.

After all, that’s what regulatory forbearance is all about, by the way. The S&L crisis is a prime example:

So what happened in the S&L crisis is that in the early 1980s American banks got slammed by Volcker’s high interest rates. Lending long and borrowing short meant that they were losing money as short rates skyrocketed. What’s more is that the S&L model was busted by money market funds which competed with the S&L’s low cost deposit funding base. The fix was what is known as regulatory forbearance, which is a fancy way of saying regulators looked the other way as insolvent banks continued to operate as if they were solvent.

The thinking here was that giving the banks a bit of time to "earn" their way back into solvency would keep the 1980-1982 crisis from becoming another Great Depression. There was no Great Depression in 1982. But S&L executives ended up loading up on risky high yield assets, knowing that it was a heads-I-win tails-you-lose situation since their banks were already insolvent. Many like Charles Keating turned to fraud and looting, what criminologist and law professor Bill Black calls control fraud.

So, what we should expect going into the next downturn is an environment in which banks have much less net interest margin as the yield curve is as flat as a pancake due to permanent zero. As the downturn takes form, risk assets will be selling off and loans will be souring such that the sources of accounting gains today will turn to sources of accounting losses. And then the worry again will be about bank solvency. When I see record low yields in the United States, that’s what I am seeing.

  1. Woj says

    Wonderful post. Those who understand how rates are set have been expecting continually lower rates under what will be effectively permanent zero. I also agree with the view that much of banks profits recent are merely accounting gains. It seems that the complacency building over the past couple years in the US may be hiding increasing systemic risk building up in the background. The next crisis/recession will almost certainly occur with short-term rates still at 0 and I have no clue what the Treasury/Fed response will be this time around. 

  2. Artie Gold says

    This has been the concern for the last decade and more; because of the upwards redistribution of income (and lack of broad upwards pressure on wages) we’ve entered a state where any tick up in interest rates produces a recession. Raise the inflation target, push money into the system *from the bottom* and eventually there will be enough strength that a higher interest rate environment can be sustained. 

  3. David_Lazarus says

    Great post but I am wondering how does the Fed think it will be able to exit this policy? The current policy seems to be encouraging more lending or at least refinancing at lower rates but as soon as rates normalise the banks will, as in the S&L crisis, start to suffer squeezed margins and higher losses. As for the forbearance policy we already have that. The banks were insolvent in 2008, yet we are allowing them to trade their way back to solvency. Do they actually expected the public to bail them out indefinitely without any form of recourse? 

    The recent accounting gains will inevitably be reversed and has any allowance been made for that?

    1. ChrisBern says

      Great question this, “How does the Fed think it will be able to exit this policy?”   I suspect it’s a combination of the Fed operating in emergency-mode where they are almost completely ignoring long-term concerns in order to attempt to create short-term benefits such as avoiding a recession or propping up equity and real estate markets.  And I also think the Fed truly believes that the economy just needs a few good boosts in order to reach escape velocity–which is absurd given the history of major credit crises and debt overhangs.

      I seriously don’t think the Fed has any idea how much danger they are putting the U.S. economy in over the long-term.  They are making unprecedented and quite high-risk gambles, all in the unspoken name of making sure bondholders don’t lose any money and that we don’t suffer a few really tough years in the short term.  It’s high-time we restructure debt, force losses on those who deserve them, and move on with our lives.  I don’t think the economy will really recover until we do…or else until a massive amount of time passes e.g. 15 years.

      1. David_Lazarus says

        Yes they clearly think that all the economy needs is a little extra boost and all will be well again. As Edward has commented since the crisis is that this is a debt problem. The problem is that eventually should there be another crisis, and there will be, then the appetite for further tax payer funding will evaporate and there will be riots on the streets. The other factor is that the politics are so corrupt that they need banks funding them so will do everything to save them. It is a symbiotic dance of death. Eventually the next crisis will eliminate everyone involved. That is why the Greeks are now likely to vote the centrist parties out even more on June 17th.

        As for recovery I said three years ago that it would be a multi decade stagnation, as it will take this long to clear the debt. Look at Japan more than twenty years of stagnation. The problem is that the UK and US cannot survive this long as they are even more indebted than the Japanese were, and they lack domestic savings. Only Italy has the prospects to cope over such a timescale. Forcing debt write offs would be good, I suspect that it will not be allowed because of the political cycle. 

  4. Conscience_of_a_conservative says

    We need to be careful when talking about low long term treasury rates. How much is due to Fed Policy and how much is due to a flight to safety. With the turmoil in Europe, I’m not sure which is having the greater effect. Are you?

    1. ChrisBern says

       One could ask the same question of Japan.   :)        I’d say in months like this past one, .the drop in rates was almost entirely due to flight to safety.  But the flight to safety yield drops have a tendency to reverse themselves during risk-on periods.  The combination of Fed action and just general deflationary tendencies have been forcing rates lower persistently for a few years now.

      1. Edward Harrison says

        Well put!

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