Oct. 16, 2018
There's nothing like watching the stock market take a trillion-dollar one-day loss to get your attention. That's what happened Wednesday, according to Wilshire Associates, which says the U.S. market fell by a total of $1.6 trillion (or 5 percent) that day and the four preceding trading days. As I wrote this on Thursday, the market was down another $200 billion, by my estimate.
To use the technical term: Yechhhh!
When you see things like this happening — stocks tanking, long-term interest rates rising rapidly, various supposed experts holding forth — it's tempting to run around, shriek and react to what's going on right now.
After all, we're supposed to react instantaneously these days, right? We've got Donald Trump tweeting about whatever crosses his mind at a given moment; we've got the news media and the political world reacting to Trump and to each other, consuming vast amounts of intellectual oxygen; we've got outrage and ranting emanating from all over the political and geographical maps.
So as a born contrarian, I decided to take what I call a sanity stroll Wednesday afternoon as the madness mounted. I wandered through the neighborhood in which I live, enjoying the weather and treating myself to an iced coffee rather than staying home to watch CNBC, be enslaved by my computer and twitch.
So now, I'd like to see if we can collectively step back a bit, take several deep breaths and do some thinking. As opposed to reacting.
To the extent that financial markets are rational in the short term — they are rational in the long term — having long-term Treasury rates rise make sense to me.
Why? Because long rates, which have been rising gradually all year before bursting into public view last week, had been held at artificially low levels for years by the Federal Reserve's so-called quantitative easing. That maneuver consisted of the Fed buying vast amounts of securities with money it created out of thin air.
Buying all those securities drove up their prices, which means that it drove down their interest yields. If a 4 percent long-term bond is issued at 100 percent of face value, it's yielding 4 percent. If it's trading at 110 percent of face value, it's got a "current yield" of only 3.64 percent and a "yield to maturity" (when it pays off at 100 and the 10 percent premium disappears) of even less.
With the Fed slowly unwinding quantitative easing — as it should be doing, since the financial crisis is long past — it makes sense that long-term Treasury securities are breaking through their artificially low yield levels.
In addition, the looming increase in the federal budget deficit will require the Treasury to increase the amount of money it borrows. Increased borrowing demand by Uncle Sam would lead to rising rates, all things being equal.
You keep reading and hearing that the Fed controls interest rates. But that's not right. The Fed, through something called the federal funds rate, controls short-term rates. It doesn't control long-term rates without doing the kind of extraordinary things that it started doing a decade ago.
The Fed, as you know, is gradually raising short-term rates to unwind the zero-percent rates it imposed in 2008-2009 to combat the financial crisis. But guess what?
Based on what I know (or think I know), the Fed raising short rates is keeping long-term rates lower than they might otherwise be.
Why? Because higher short rates imply lower inflation. And the higher that "bond vigilantes" expect inflation to be, the higher the interest rate they will demand to offset erosion of the money they invest in long-term securities.
This makes Trump's statements about the Fed on Wednesday totally absurd. "They're so tight, I think the Fed has gone crazy," he said.
But if the Fed did what Trump seems to want — loosened things and kept short-term rates at close to zero — long-term rates would doubtless have risen higher and more quickly than they have. And as a result, for reasons I won't go into here, the stock market would be lower than it is.
In fact, I think we should all be grateful that when Congress created the Fed in 1913, it made the Fed independent of the federal government, not part of it. The Fed is in business to do what it thinks is right, not necessarily what the people in power want it to do.
The Fed's record isn't perfect — whose is? — but it's out there doing the best it can. And, fortunately, it's independent rather than being subject to the whims of Congress or the president.
I suspect that long-term rates will keep rising, at least for a while. I also suspect that if Fed Chairman Jerome H. Powell keeps doing the right thing by shrugging of Trump's tweets, long-term rates will be lower than they would otherwise be. And our country and our economy will be better off than they would otherwise be.
And now, given how the market is lurching around, it may be time for another sanity stroll to my local coffee shop. Cold brew with cream, anyone?