The Fed, Interest Rates And The US Dollar

Immediately following its interest rate cut, New Zealand’s central bank provided guidance suggesting that there may be more cuts in the future. The New Zealand dollar, nicknamed the Kiwi, is now weaker. New Zealand is worried about “low inflationary pressures and the expected weakening in demand.” The official additional comment from the central bank’s governor is that the Kiwi remains “over-valued” and still has “a significant way to go.” New Zealand is worried about commodity-glut pricing and deflationary forces.

South Korea cut its interest rate for a different reason. It is worried that the spread of MERS (Middle East respiratory syndrome), will weaken its economy. The outlook for South Korea is more monetary easing and lower interest rates.

The central bank of India cut as it prepares for monsoon season, with its negative economic impacts.

When we take inventory around the world, we see monetary policy easing in countries and banking systems nearly everywhere. Here is a partial list: all 19 countries in the Eurozone; many Eurozone neighbors, including Sweden, Switzerland, Denmark, and Norway; Australia and New Zealand; Asian countries like South Korea, Japan, China, and others. All that said, monetary policy cannot change the weather, treat viruses, or alter commodity gluts.

But differentials in monetary policy can change the value of a currency. Some central banks are forthright about that, like New Zealand’s. Others are more circumspect (European). And still others try to jawbone currency reactions (Japan). Regardless, central policy differentials change currency values. It is as simple as that. That is why the US dollar is destined to get stronger, perhaps even a lot stronger.

Let’s look at the United States through this lens.

American monetary policy stopped easing nearly a year ago, as quantitative easing declined on a schedule and eventually ceased. That schedule was put forth transparently by the Federal Reserve (Fed). Because the Fed chose to be predictable and to keep their word, they successfully tapered from $85 billion a month to zero without triggering major market shocks.

During that tapering period, the Fed began to change the holding maturity composition of its assets. The lengthening of asset holdings peaked and began to reverse. Our estimate from the weekly reports of the 12 Federal Reserve district banks shows that the Fed’s maximum duration reached 6. Think of that as an average maturity of six years of payment flows of all the Fed’s more than $4 trillion of assets. In fact, the duration number is a much more complex calculation that is beyond the scope of this short commentary. So we will keep it in simple form and just think about it as 6 years and an average of all the maturities.

The duration of the Fed’s assets prior to the financial crisis was close to 2. Thus, during the entire period of the financial crisis (2007-2009) and over the course of five years following it, the Fed tripled its duration of its asset holdings from 2 to 6 at the same time that it quintupled the size of those holdings. That is right. The Fed tripled maturities from what they used to be. Following the peak, the Fed started a gradual process of lowering asset duration. It has now reduced the duration of its holdings from 6 to 5.

When the Fed raises its asset holdings duration, it removes that duration from the marketplace. Think of it in the simplicity of a single transaction. The Fed goes into the market, creates the money to pay for a 10-Year Treasury note, and then purchases it. At current yield levels that note has a duration of about 9. That note is acquired from someone (a dealer) and placed on the Fed’s balance sheet as an asset. The seller has now replaced the Treasury note with freshly created money in the form of electronic cash that ends up as an excess reserve deposit at the Fed. That excess reserve deposit is a liability of the Fed. So the asset went up by the amount of the 10-year note acquired, and the liability of the Fed balance sheet went up by the excess reserve deposit.

Note that the cash has one-day duration. Take the transaction apart. The 10-year note’s duration moved from the market to the Fed, and the 1-day cash duration moved from the Fed to the market. Thus the market total duration went down due to the Fed’s policy action.

If everything else were equal, what would happen with that transaction? Interest rates in the market on 10-year notes would fall because a buyer (the Fed) bought it and raised the note price and hence lowered the note yield. At the same time, interest rates on cash would rise because a seller (the Fed again) inserted excess cash into the market. However, when the interest rate on cash is controlled by the central bank so that it is held at zero, the interest rate on that excess cash cannot rise, even though the interest rate on the 10-year note can fall.

Take this monetary exchange and extend it to policy. When the Fed lowers the duration of its assets, interest rates in the marketplace rise. When the Fed increases the duration of its assets, interest rates in the marketplace fall. A nickname for this is a “twist” – a forceful adjustment to the maturity structure of central bank assets. Remember, this simple example is constructed without considering other influences. All the central banks I listed at the start of this essay are outside and important influences at work right now.

For the last few months, the Fed has been gradually lowering its asset duration. It has been reversing a twist. As a result, we have seen the interest rate increase in the Treasury bond market. The 10-year note yield is higher because duration centered on the intermediate maturities is lower among the Fed’s asset holdings. By going from 6 to 5 the Fed has transferred that additional duration back to the market. The interest rate on cash remains near zero because cash interest rates are controlled by the Fed. So moving duration of the Fed’s holdings from 6 to 5 raised the rate on notes and bonds and hence on mortgages and other related debt instruments.

Ladies and gentlemen, that is a Fed tightening. Simply put: the Fed has increased the home mortgage rate and all term-related debt financing rates.

Let’s get back to the world view. Most places in the world have near-zero interest rates on short-term instruments like cash. In Europe, the Eurozone, and in other European countries, that interest rate is now a negative number. There is a penalty or storage fee imposed by the central bank for holding your cash. The bank pays you nothing and charges you to warehouse your cash electronically. The same is true now in the commercial bank that then deposits those excess reserves with the central bank. The central bank charges the commercial bank a storage fee, and the commercial bank charges the customer. It is counterintuitive for those who grew up believing that a bank deposit should pay the customer some interest rather than charge the customer a storage fee.

Now we are going to experience a widening policy divergence around the world. The spread between the negative rate in Europe and the positive rate in the US is about to widen. That is what will happen when the Fed raises interest short-term interest rates above the zero lower bound.

In the United States, we are contemplating an increase coming soon in the short-term interest rate. The Fed will discuss the issue in a few days. The Fed may or may not give us guidance. Most market agents believe the Fed will make the first hike before the end of 2015. Most expect it to be a 0.25% increase in the targeted short-term rates.

In the rest of the world, the opposite is happening. Monetary easing is continued; duration is extracted from markets; excess reserves are increased; and interest rates are pressured lower. That results in a stronger US dollar. Around the world, the marginal transaction will favor the currency managed by the central banks that are tightening their policies. It will also mean weakening currencies for central banks that are easing their policies.

We believe the dollar will increase in value relative to other currencies. That trend will intensify as the US economy continues its economic recovery, which appears more sustainable.

Here is a sample calculation. The interest rate on an excess reserve deposit by a Swiss commercial bank depositing at the Swiss central bank is a negative number, -0.75%. An excess reserve deposit in an American bank at the American central bank, the Fed, is a positive number, 0.25%. The spread between the Swiss Franc and the US dollar is 100 basis points, or 1%. If the US raises its rate by 0.25%, the spread widens to 125 basis points. This math can be done in Denmark, Sweden, the Eurozone, and elsewhere. Higher short-term interest rates in the United States will attract inflows from the rest of the world and will attract transfers from US investors who have been avoiding cash equivalents that have been earning zero.

As a final note, this writer had a series of meetings last week with institutional clients. One of those clients manages a multibillion-dollar pool of cash equivalents. That portfolio manager has been dealing with interest rates and a level of zero or next to zero. That has been going on for six years. As soon as she is able to reallocate into a functioning, cash-equivalent, high-credit-quality market, she will be making portfolio changes to capture a few extra basis points in yields for her clients. She has already developed the strategies that can be applied to do so. She is waiting for the Fed to make the first quarter-point interest-rate hike.

Multiply her portfolio by hundreds and thousands of portfolios worldwide. The changes will be dramatic. When they come, the dollar will get stronger; and the currencies that have weakening fundamentals and a stimulative, expansive central bank will get weaker still. Meanwhile, the Fed does not know how much or how little a shock it will administer to the markets or to the economy. And it may not be focused on the shift in duration and what it means.

We expect the Fed to move very slowly. Raise rates a quarter point this autumn and then pause and let the markets adjust. Wait a while and then move another quarter early next year and pause again. We would like the Fed to tell us how they will carry out this reversing of policy so that, as happened with QE tapering, markets may adjust in a predictable and transparent way. That is how to minimize the damage. That is what worked last year in ending the QE experiment.

We will know more soon. This week the Fed may offer clarity. Or they may give us a mixed message. But it is important to look at what they do as well as what they say.

Seeing what they do means tracking the duration the Fed takes from or gives to the market every week. We invite the Fed to add more comments about the duration insertion and extraction process in its post-meeting message. But wishing and hoping and even inviting policymakers to speak clearly are not strategies. Measuring duration is.

Presently we see opportunity in spread product in bonds. We hold minimal Treasury instruments. And we remember that stocks are long-duration assets. So if the Fed moves slowly and if the Fed maintains a longer duration number for its balance sheet, the stock market has the underpinnings to sustain the price levels and momentum we have seen. The same is true for housing and real estate in general. Thus the US economy may continue on a gradual and improving recovery path.

When the Fed changes duration, the change affects all of these asset classes. The weekly Thursday afternoon Fed reserve bank reports are now on the critical indicator list. At Cumberland, we calculate that duration of the Fed holdings each week.