The Fed model and shocks to the price of credit (wonkish)

“…changes in this ratio have often been inversely related to changes in the long-term Treasury yields, but this year’s stock price gains were not matched by a significant net decline in interest rates. As a result, the yield on ten-year Treasury notes now exceeds the ratio of twelve-month-ahead earnings to prices by the largest amount since 1991, when earnings were depressed by the economic slowdown.”

-Ed Yardeni, Deutsche Morgan Grenfell 1997

The Fed model

In the quote above, Ed Yardeni was talking about the price-earnings ratio of the S&P 500. That’s simply price divided by earnings.

In what later came to be known as the “Fed Model,” the theory is that rising interest rates hurt equity valuations. The key is the inverse relationship, earnings divided by price or the earnings yield for stocks. Bond and stock market are thought to be in equilibrium when the S&P’s forward earnings yield equals the 10-year Treasury bond yield. So fair value for stocks in the Fed model is when the 10-year yield and the one-year forward S&P 500 earnings yield exactly match.

Of course, bond yields have gone down from a secular high above 15% in the early 1980s. So it makes sense that stock prices have gone through the roof in that time. Moreover, it makes sense that people would call this the Fed model. After all, the Fed itself made the linkage in prepared material for the 1997 Humphrey-Hawkins testimony, the same year Yardeni wrote his report for Deutsche.**

**(Note: the Humphrey-Hawkins testimony is the Federal Reserve Chairman’s semiannual address to Congress, backed by a Monetary Policy Report. New Fed Chairman Jerome Powell just gave his remarks on February 23rd.)

This is why people worry when Dalio, Gross and Gundlach talk about a bond bear market. If bond yields are rising, then, according to the Fed model, eventually stocks should be falling. And given that the S&P 500 earnings yield is almost 4%, bond yields will have to rise a lot to bring long-term Treasury yields into equilibrium.

Where Mises and malinvestment meet Minsky and Ponzi investment

Now, it’s not even clear the Fed actually thinks about equity market valuations this way. Nevertheless, we have heard a few Fed officials suggest market valuations are stretched.

Let me suggest a different way of thinking about it. What if it’s not the level of interest rates that matters? What if it’s the change in the level of interest rates that drives markets?

I was thinking about this yesterday when I was re-reading a post I wrote 10 years ago on the 2008 US economy. That post had an interpretation of business cycles that was very much of the Ludwig von Mises strain. I wrote that malinvestment was a key driver of business cycle volatility. This is where interest rates are below a level that attracts capital to speculative capital investments. In terms that Hyman Minsky would use, think of malinvestment as an increase in speculative and Ponzi investors as the business cycle lengthens.

The key, here, though is the deviation of interest rates from a level that discourages a higher percentage of speculative and Ponzi capital investment. The further below that level rates go, the more malinvestment occurs as a proportion of total capital investment. Think of excessive shale oil investment during the Fed’s QE regime as an example.

Now, these deviations are endemic to capitalism, meaning you don’t need the Fed to get animal spirits increasing speculative bets. But since the Fed, as monopoly supplier of reserves, sets base rates, it has a lot of influence across the curve. Monetary policy can, therefore, exacerbate the business cycle.

This has nothing to do with Natural Interest Rates

By the way, I’m not talking about the natural rate of interest here. That’s a theory that works only because it assumes a limited supply of money. In that world, interest rates help allocate a limited savings base to investments. And there is a rate of interest where the two, savings and investment, balance. This is called the natural rate of interest.

But we know from various sources that money supply is endogenous. Money supply actually increases as the demand for money does, not because of a limited hoard of savings. And in the end, you don’t have a limited supply of savings to ration for credit. Loans create deposits. And those bank deposits increase the money supply. The Bank of England told us this.

I would say the natural rate of interest is zero. From the government’s perspective, there is no functional difference between any of its obligations. Bank notes, electronic credits, treasury bills and bonds are all liabilities that the government can expunge with a keystroke. The government – through the Fed -could buy every single interest-bearing liability with reserves it created out of thin air – if it wanted.

In a fiat money environment, the first function of the Treasury bonds is to serve as a vehicle to help the Federal Reserve hit a target Fed Funds rate. The second is to give holders of government obligations a return on their investment. After all, bank notes or bank reserves don’t pay much if anything.

My delta shock model

But, let’s go back to Ludwig von Mises’ concept of malinvestment. This deviation from a base works in both directions. Just as ‘lower for longer’ can make speculative investment attractive and skew capital allocation decisions, a sudden rate hike regime can also have a large impact.

It’s the change in the level of interest rates that matters in this model, not the level. So irrespective of how high interest rates are, if the change, the delta, is large enough, it will produce an economic shock.

I think of these credit shocks as being similar to how macroeconomic shocks happen. For example, I have often said that it is not the level of jobless claims that matter, it’s the change from one period to the next. So for example, every recession since unemployment insurance claims have been record has been led by or coincident with weekly initial jobless claims rising by 50,000 for a sustained period. There are no false positives either.  That means that when the number of people who get thrown involuntarily out of work each week rises by 50,000  for a month or two, the loss of income is large enough to shock the economy into recession.

A shorter or smaller climb is digestible without recession. But, at some level, and I use 50,000 as the marker, it’s just too much of a shock to employment, income and consumption.

The same is true for credit. If the Fed raises rates too fast, the shock to speculative and Ponzi borrowers is too great for them to be able to hedge their bets. And they default. So it’s not the level that matters but the change in the level.

Possible corollaries of a delta shock interest rate model

The first and most obvious conclusion is that raising rates too quickly can precipitate recession. Boston Fed President Eric Rosengren recently joined fellow FOMC members in preparing us for an accelerated hike timetable. The risk is that this timetable acceleration catches debtors out. They have to roll over loans at a level that creates financial distress or induces bankruptcy. Either way, capital spending and employment would be impaired, and eventually consumption too.

The second corollary here is that a delta shock in credit prices is limited by the zero lower bound. Basically, if rates are at 2%, you can only cut them 2%. Maybe that’s not enough of a credit shock to have a meaningful impact. Since the Fed Funds rate has come down over a 35 year period, the average Fed cutting cycle has been much more than that.

• In July 1981, federal funds went from 19% to 12 3/8% in that cycle (6 5/8%)
• In April 1982, federal funds went from 15%  to 8 1/2% in that cycle (6 1/2%)
• federal funds went from 9.75% in May 1989 to 3% in November 1982 (6 3/4%)
• From November 2000, federal funds went from 6.50%  to 1% in July 2003 (5 1/2%)
• federal funds went from 5.50% in July 2007 to 0% by the end of 2008 (5 1/2%)

This is why people are talking about negative rates and raising the inflation target. Unconventional monetary policy is attractive when interest rate policy is unavailable.

The lack of cutting runway is also why there is some suspicion that the Fed is trying to raise rates in part to have ammunition for the next downturn. Still, as the Fed ‘normalizes’ policy, it should be mindful that doing so too quickly could derail credit markets. And that would undermine the Fed’s objectives in raising rates.