Abstract


Verbal stance as a viable tool of monetary policy is described. Immediate risks of rate hike for leveraged financial institutions are outlined. The root causes of sovereign debt crisis in Europe are outlined. The future course of Fed`s actions on interest rates is proposed; the feasible downsides of such policy for USD are put forward.

The unconventional measures deployed by the Fed in the wake of financial crisis of 2007-09 were initially sold to public as transient means to enhance liquidity in the markets and prevent total collapse of banking system in the US. While some programs, implemented by the Fed, were transitory – TARP, TALF, CPFF etc. were unwound at some point, the main tool of monetary easing – the fed fund interest rate is being kept intact at 0.25% for over 5 years. This Fed`s persistence, inexplicable by any traditional arguments, raises pertinent questions from general public, forced to forgo risk-free return on its savings, and provides endless fodder for financial commentators, speculating on the future course of Fed`s actions.


Verbal stance – essential tool of monetary policy


In current conditions of artificially depressed interest rates, every Fed`s emanation – be that the official FOMC statements, the transcripts of FOMC meetings, also known as minutes, or press-conference held by the Fed Chair – is thoroughly parsed by public, eager for a hint of coming changes in monetary policy. This justified anxiety of interest rate hike expectations prevalent among investors has helped Fed to transform its mere verbal stance into viable instrument of monetary policy that channels flow of funds into the desired asset classes.


Indeed, the efficiency of this tool predicates on a premise that the forthcoming monetary policy changes are fully reflected in currently held rhetoric. When fallacy of this premise will become obvious to significant number of investors this game of confidence, so dexterously played by the Fed for years now, will be over – the expectations of risk-free returns on US dollar denominated assets will give way to fears of losses inflicted by inflation. This seismic shift in investor sentiments will lead to reassessments of risks that in its turn will reshape allocation of savings across asset classes not only in the US but around the globe.


Leveraged balance sheets of insolvent financial institutions


Over the course of many decades now any significant downturn in stock market was mitigated by Fed`s slashing of interest rates. The commonly accepted rationale behind this course of actions by the Fed goes as follows: the reduction in borrowing costs alleviates already strained funding of assets bought on margin by providing additional liquidity for commercial banks and market players. Being technically correct, this explanation fails to grasp the full picture by condoning such an important factor as influence of rate cut on investments balance sheets of leveraged financial institutions.

[td] Fig. 1. Balance of leveraged financial institution

Balances of leveraged financial institutions are quite vulnerable to vicissitudes of stock market – downturns in nominal prices of shares, amplified by leverage (fig. 1), might render institutions insolvent. Timely interest rate cut of appropriate size mitigates the losses inflicted to stock portfolio by negative market dynamics. Nominal price increase of bonds in investment portfolio, induced by rate cut and magnified by leverage even higher than used for carrying stocks, can partially or fully offset the decline of nominal values of stocks on balance thus buoying solvency of leveraged financial institutions. Failure to slash interest rates at critical time might have devastating fallout for the whole financial system – initial nominal losses on stock portfolio can set off the margin spiral that in its turn will exacerbate losses and lead to unraveling of the whole system of the leveraged finance. Obviously, interest rate cut is the most far-reaching and powerful instrument in the arsenal of Fed`s tools that keeps integrity of overall rather shaky system.


Valuable lessons from sovereign debt crisis in Europe


This efficiency of interest rate cut comes at great price – destruction of national savings by rising inflation and misallocation of capital, induced by artificially set interest rates, skew the whole structure of economy. The only way for the central bankers to alleviate the undesired consequences inflicted by depressed interest rates is to apply this tool in very restricted manner – rates should not be slashed too deep and must be brought back to the “normal” levels as soon as possible. The success of this policy tool, deployed by the central bank, can be judged only after the interest rates are normalized without knocking the markets into tailspin and economy into recession.

Data: ECB
Fig. 2. Refinancing interest rate set by ECB, %

The roots of sovereign debt crisis in Europe, flabbergasting to many, are laid bare if discussed in context of interest rate interference of ECB over preceding period of time. In its attempt to normalize interest rates, slashed to all-time low in the wake of financial crisis of 2007-09, ECB embarked on a series of rate hikes – rates were increased by 25 b. p. twice, in April and July of 2011 (fig. 2). Alas, the fallout of these puny hikes had devastating effects for overly leveraged banking system and burdened

Data: St. Louis Fed.
Fig. 3. Yield on 10-year sovereign government bonds, %

by unsustainable debt sovereign governments in Europe – yield on government bonds of Greece, Italy, Ireland and Portugal spiked (fig. 3), rendering many financial institutions insolvent. Indeed, deleveraging of commercial banks in Europe, resulting from adoption of Basel III, along with lowering of credit rating of some nations had negative effects on ability of these nations to borrow, but the main cause of crisis was undoubtedly interest rate hike.


The future course of Fed`s action on interest rates and perspectives of another bout of QE


Unlike majority of public, befuddled by the root causes of sovereign debt crisis, the Federal Reserve has learned its valuable lesson – over the period of more than 5 years the interest rates have never been raised and Fed`s balance has never been contracted. The explanation of this staunch policy is clear – the interest rates cannot be hiked without toppling the whole financial system, inured to near-zero interest rates. The Fed cannot help but to resort to the last tool available – the game of confidence. Alas, as every game of confidence, this game, masterfully played by Federal Reserve so far, is inexorably coming to its end – once the expectations of the forthcoming rate hikes vanish among investors, the public will turn its back on US dollar denominated assets. While it is impossible to pinpoint the date when this sea change in investor sentiments will occur, the fallout of this change of heart can be assessed by unbiased observer.


The most conspicuous among many downsides of QE programs is accumulation of excess reserves of commercial banks deposited at the Fed. So far the annual yield on these reserves, paid by the Fed, is 0.25% that is significantly lower than even the officially calculated inflation rate. The only reasonable explanation of this persistent willingness to lose money due to inflation is the deeply rooted expectations of future gains caused by rate hike. When investors will realize that interest rates cannot be raised, the seismic shift in allocation of savings will commence – the excess liquidity currently deposited with the Fed might look for better returns in other currencies. Even if small portion of this massive liquidity, that currently exceeds 1.8 trln US dollars, moves out of US dollars into other currencies then US dollar will face imminent decline against wide swath of other currencies. This initial loss of US dollar might render the US bond market both shaken and stirred – the devaluing US dollar will wipe off already meager yields on fixed-income instruments, triggering exodus of both foreign and domestic investors. At this moment decline of US dollar becomes self-sustaining and irreversible.


The possible trigger that might unravel this downward self-sustaining spiral of US dollar decline might be the beginning of QE4 program – the US government will have to refinance 5 trln of its debt in short-term obligations over the course of the forthcoming year. It is rather difficult to imagine that this process will go smoothly without Fed`s assistance, let alone in the environment of raising interest rates.

The Federal Reserve will not raise interest rates and will embark on new QE program next year. The current uptrend in US dollar will be proved to be a head fake and the new trend in Forex market – irreversible decline of US dollar – will become driving force of capital allocation around the globe.
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