Just a few months ago, Mohamed El-Erian was decrying a “paradox of financial conditions” as he called them. Writing in the Financial Times, El-Erian was speaking for quite a lot of establishment types, Economists mostly, who were perplexed by the misbehavior across the markets. The Fed like the ECB was trying to fight inflation, yet that fight was allegedly being undone by falling interest rates.
Both the Fed and ECB raised their policy benchmarks each by another quarter point just this week, continuing programs dating back to at least the middle of last year. For the American pseudo-central bankers, they’re up five hundred basis points since beginning on their consumer price quest last March. The ECB, getting started in July, officials there will modestly trail their counterparts with 375 bps of hikes when the latest becomes effective next week.
Yet, over the same months bond yields have changed by nowhere near those levels. It starts out well enough, the 3-month US T-bill rate has increased about 480 bps, roughly equivalent to the hikes. The 2-year note, however, the yield for that one is just 180 bps higher than it was mid-March ’22. Five-year notes return only 110 bps more (nominally, speaking).
European market interests are similarly confounding: short-term rates are up more in line with the ECB’s corridor, nowhere near for longer-term bonds.
These comparisons have gotten worse (from the policy perspective) since last fall. While authorities continued to hike, medium to longer-run nominal rates have largely declined, dramatically widening the gulf between central bank objectives and market reality.
This is both Alan Greenspan’s “conundrum” - if on steroids - along with being the core of El-Erian’s paradox. According to the latter in February:
“This time around, and according to longstanding indices, developments in financial conditions have divorced themselves from monetary policy. They are as loose today as they were a year ago before the Fed embarked on its 4.50 percentage point rate hiking cycle; and this loosening has been turbocharged since the December Fed policy meeting. All of this is consistent with last Friday’s stunning US payrolls report.”
We are led to think the so-called no-landing economy (remember that one?) of early February was due in no small part to the market “loosening” up what the Fed intended instead to tighten down. As El-Erian suggests, the stubbornly robust US economic results likely a consequence of the market negating the Fed’s intentions.
For their part, policymakers have taken a slightly different view – drawn from different calculations. Officials prefer to look at real yields and rates rather than nominal changes. As now-former Fed Governor Lael Brainerd calculated, also in February (and which El-Erian noted in his op-ed):
“Financial conditions have tightened considerably over the last year as the Federal Reserve and foreign central banks have tightened policy. Real yields have risen significantly across the curve over the past year: 2-year yields on Treasury Inflation Protected Securities (TIPS) have risen more than 4-1/2 percentage points to 2.1 percent, and 10-year TIPS yields have risen more than 2-1/4 percentage points to 1.2 percent. Short-term real interest rates have moved into decidedly positive territory.”
Starting first with Brainerd, are real rates really rising, or is it because the market view of inflation (and growth) potential isn’t? TIPS are, after all, paying out protection based on the CPI therefore the TIPS instrument is first and foremost about that factor.
And where the Fed artificially induces nominal rates to move higher – even when not as high as policy rates – this skews the “real” yield. In other words, the FOMC votes to increase alternative ST rates which then pulls bond yields in close proximity unnaturally upward. Unless inflation expectations rise, by simple arithmetic “real” yields are going to go up, a bit of circular reasoning.
But notice, too, how Brainerd runs into the same problem. LT “real” rates haven’t gone up nearly as much as those at the short end. No matter how you look at it, the financial paradox/Greenspan conundrum remains. Economists, of course, all believe what matters is up front where central bank policies are more influential (in the short run).
History shows that’s rarely been the case. Whatever the central bank-induced short end, what ultimately makes or breaks anything is what curves take from there.
The movement of interest rates itself is neither tightening nor loosening. Rather, the changes tell us whether there is effective tightening or loosening inside the monetary system for whatever reasons, private or public. Where Economists and “central bankers" (same thing) all believe the rate is itself the instrument, in truth yields or really calendar spreads merely signal the after-effects of actual monetary (and other financial) changes.
Not only do Economists have this wrong, they also have the direction backward. Milton Friedman did an excellent job exposing this interest rate fallacy on numerous occasions across several decades of his career. As he repeatedly had pointed out, one need only examine a simple historical chart for rates to see how inflation comes with those up high while deflationary depressions are riddled by ultra-low rates that can’t ever seem to get off them.
As he said in 1998:
“After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.”
Indeed, this aspect of money forms the basis for most mistaken interpretations including El-Erian’s paradox even though one rather easily explained through more than a century of consistent observation. Knut Wicksell, for example, had lectured about this same fallacy in a 1906 address before the Economic Section of the British Association.
Speaking about a “natural rate”, it was never high nor low itself rather depending upon the prevailing economic (small “e”) conditions of the time and how it compared to them. If the situation was positive and flourishing, we would expect the natural rate to be high because opportunity for profit would be, too. Conversely, “in periods of depression it is low, and expected to remain low.”
In terms of mapping out the direction for any economic system, yield and money curves therefore tell us something very important in their shape. Should they be upward sloping where yields are higher rather than lower moving further out into the future, that would strongly imply looser monetary therefore financial conditions just as Friedman said.
As Wicksell himself put it:
“When interest is low in proportion to the existing rate of profit, and if, as I take it, the prices thereby rise, then, of course, trade will require more sovereigns and bank-notes, and therefore the sums lent will not all come back to the bank, but part of them will remain in the boxes and purses of the public; in consequence, the bank reserves will melt away while the amount of their liabilities very likely has increased, which will force them to raise their rate of interest.”
Banks are, or were at one time, repositories for money and currency meaning a safe outlet for those. When trade in the real economy is brisk, money is being used, reused, and circulates freely. Thus, banks have to compete with the bustling economy for reserve funds. In general, interest rates naturally (pun intended) rise and more so when the competition heats up.
During depressions, or heading into one, banks wouldn’t have to outbid actual economic opportunities because those dry up and are purposefully avoided. Demand for safety instead goes way up, and therefore, in general, interest rates offered by financial participants trend way down.
When rate and money curves are inverted, it means ST rates sit above their LT counterparts. This certainly would not imply financial or monetary conditions are “loosening” as everyone in the mainstream asserts. On the contrary, it would strongly implicate market participants’ growing unease, an expectation to be in demand for safety as Wicksell had described more than a century ago.
As curves grow more inverted, the greater the expectation (and fear) over safety and liquidity in the real as well as financial economy.
These days that isn’t about stores of actual currency seeking the safety of any physical bank vaults since banks no longer store currency or money (they are essentially glorified bookkeepers). We don’t even use either to any meaningful proportion. This instead means that demand for safety in liquidity must be provided elsewhere, in other forms, replacing bank vaults with the very financial instruments in question.
The monetary situation is, obviously, more complicated. Even so, these guidelines have repeatedly held up whereas the “financial paradox” of El-Erian like Greenspan’s conundrum have not.
In recent days, the situation has deteriorated substantially. Thus, despite both the Fed and ECB hiking their benchmarks, markets all over the world essentially ignored them. Rates have declined further, even those for ST yields like the 2-year UST as well as 2-year German schätz. Ms. Brainerd might also be unnerved by how real yields are down significantly since February, too.
In futures markets like the one for 3-month term SOFR, participants are now pricing a more-than-trivial chance the FOMC votes to turn around and start cutting rates likely during its July meeting if not before at its very next decision in mid-June.
When (not if) that happens, markets are near-to-certain all interest rates including those for the Fed and ECB will be going down rapidly and aren’t likely to stop until they get back to around where they had been before the Fed’s artificial interruption. The timing for this U-turn really doesn’t matter.
And, looking around right now, it truly isn’t difficult to understand why that might be. Loosening monetary conditions since last November? Hardly.
This isn’t about the Fed or any official policies, either. Like Wicksell described, rates will go down on those instruments that offer safety in a similar enough way to what bank vaults once had during previously depressionary conditions. The greater the monetary dangers in the real economy, the higher the demand for the safety right now being priced more and more heavily in forward markets.
ST forward markets.
It only looks like some paradox when you start with all the fundamentals completely backward. Real and nominal, the deflation is here. The Fed didn’t make it with its rate hikes, either.
This very outcome had been increasingly and more strenuously priced into money curves beginning all the way back before Jay Powell and Lael Brainerd got started, and Mohamed El-Erian became enthusiastic about the attempt. It was only a matter of time. It is always a matter of curve time. And now it has just about run out.
