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Where is Recent Market Turmoil Heading? Yield Curve Control

Figures

The United States Federal Reserve Bank building on Constitution Avenue, Washington, D.C. The Fed must weigh its options carefully.

Photo by MDart10 / Shutterstock.com

Corporate finance columnist Les Nemethy examines what has been driving recent market turbulence in the United States, and what options the Federal Reserve may have to settle things down. Spoiler alert: they are limited.

Financial markets are currently experiencing unprecedented circumstances. Already high debt levels are spiraling out of control: total U.S. debt has reached USD 80 trillion, some 400% of GDP. (Plus, there are well over USD 100 tln in unfunded future liabilities for pensions, Medicare, etc.) Past growth was artificially subsidized by an unsustainable debt bubble.

There has been massive and continuous stimulus since 2008, now reaching a crescendo: the U.S. Senate last week approved USD 1.9 tln of stimulus (in addition to USD 4 tln of stimulus in 2020). The United States is also discussing another USD 3 tln infrastructure plan.

Money supply growth has been high and is accelerating: 22% of circulating U.S. dollars were printed in 2020 alone, according to somagnews.com.

The largest financial market in the world is the U.S. Treasury market, and the most important economic signal is U.S. Treasury interest rates. (The rates going from 0-30 years create a curve known as the yield curve).

The 10 year interest rate shot up by 60% in February 2020 (reaching 1.6% on March 5). Markets (and presumably also the Fed) are concerned not just about the absolute rate, but the speed at which rates are rising. 

Interest Impact

Higher interest rates impact individuals, corporations and government. For example, if the cost of financing USD 80 tln of U.S. federal government debt goes up just 1%, that’s an increased interest cost of USD 800 billion per year, more than a quarter of federal tax receipts.

The United States experienced a post-World War II record 16% deficit-to-GDP ratio in 2020, as politico.com has pointed out, and that is quite an accomplishment given the very low interest rates at the time. 

The world is awash in such massive debt levels, it cannot support higher interest rates. 

What are the Fed’s options? It is caught between the proverbial rock and a hard place. There is the option of letting interest rates rise, which would rapidly suck oxygen out of the economy, causing a crash that might rival or even exceed the Great Depression.  

The only possible justification for recent equity valuations has been low interest rates; a rise in interest rates triggered the recent tantrum on stock markets; interest rates rising much further could trigger a crash.  

The other option for the Fed is to suppress interest rates via Yield Curve Control, or YCC. It can do so because it may print virtually infinite amounts of money, with which it may buy bonds (thereby driving up prices bonds and reducing yields).

YCC was successfully used after World War II to help pay back mountains of wartime debt. We are likely to see YCC for the first time since the 1940s.

The Fed will do everything possible to avoid YCC, a massive distortion of free markets which would increase moral hazard and risk taking. The Fed will wait until there is a trigger point of pain in financial markets, which leaves no choice. 

Bumpy Ride

The turbulence of the past weeks is a prelude to the volatility we are likely to experience in coming weeks, until either interest rates subside without YCC (unlikely) or the Fed implements YCC.

Why are interest rates rising? The Fed claims it indicates a healthy recovery; an likelier explanation is that rising inflation expectations are driving up interest rates. If the latter, it has the power to drive interest rates much higher.

There are many direct and indirect signs of inflation:

• Commodity prices from soybeans to metals are rising dramatically, working their way into the supply chain.

• Transport and logistic costs are also rising (container costs from China to the United States have more than doubled in 2020).

• There has been strong job growth in America; a doubling of the minimum wage is under consideration by Congress.

• Chinese exports were 60% higher in February 2021 compared to a year ago.

• Microchips shortages are creating bottlenecks. For example, several auto manufacturers had to shut plants for weeks.

Many market observers foresee an unleashing of demand once the pandemic subsides, speeding up velocity of money.

While acknowledging that there are also strong deflationary forces at work, I would wager that over a two-to-five year horizon, inflationary forces will dominate.

Inflation often appears as a surprise; once the toothpaste is out of the tube, it’s very difficult to put it back in. Inflation expectations will push interest rates to a level leaving the Fed no choice but to implement YCC.

YCC would likely suppress 10 year interest rates below 2% in the United States, with lesser rates on shorter maturities. It would represent an unprecedented transfer of wealth from savers to borrowers and cause a loss of confidence in the U.S. dollar, leading to its devaluation. This, in turn, will help trigger even higher inflation in the States. Turbulent times lie ahead.

Disclaimer: This article does not constitute investment advice and makes certain projections for the future which may or may not materialize.

Les Nemethy is CEO of Euro-Phoenix Financial Advisers Ltd. (www.europhoenix.com), a Central European corporate finance firm. A former World Banker, he is author of Business Exit Planning (www.businessexitplanningbook.com) and a former president of the American Chamber of Commerce in Hungary.

This article was first published in the Budapest Business Journal print issue of  March 12, 2021.

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