Financial news

The Giant Sucking Sound of Financial Repression

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Via Wolf Street

In the US alone, it impacts nearly $40 trillion — with consequences for the real economy.

This is the transcript from my podcast, THE WOLF STREET REPORT:

It’s called interest-rate repression. Or more poetically, financial repression. It’s where central banks manipulate interest rates down to where investments with little credit risk, such as Treasury securities, FDIC-insured savings accounts and CDs, pay little or no interest, or pay less interest than the rate of inflation. People such as savers and retirees, and institutions such as pension funds, that depend on this cash flow have lost their income stream. In addition, the purchasing power of their principal is getting gradually wiped out by inflation.

How much money are we talking about? In the US alone, this interest rate repression impacts nearly $40 trillion. This includes savings products, Treasury securities, municipal bonds, and high-grade corporate debt. $40 Trillion with a T. A 2% reduction across the board cuts this income by $800 billion a year. And this has had an impact.

Central banks have accomplished this interest-rate repression by pushing short-term rates to zero or below zero, and by buying bonds and other assets to push long-term rates down too. These were emergency measures during the Financial Crisis that have become the “new normal,” as it has been called. This new normal has been going on for over a decade now.

Other central banks, including the ECB and the Bank of Japan, pushed their policy rates below zero. This, in addition to vast asset buying binges by those central banks, produced $13 trillion in negative yielding bonds. But that’s a different universe of idiocy that we’re not going to get into today. We’re going to stick to US conditions.

To the Fed’s credit, it is the only major central bank that has raised its policy-rate target a bit, from near-zero to a range between 2.25% and 2.5%, which are still historically low rates. But it is under immense pressure by Wall Street and by the White House to cut rates again.

So now we have this situation where short-term Treasury yields are low, and long-dated Treasury yields are even lower.

How much money are we talking about here? Let’s see. There are $22 trillion in Treasury securities. They’re held by individuals and institutions, including insurance companies, pension funds, and the Social Security Trust Fund.

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Then there is high-grade corporate debt. The category of triple-A to single-A-rated debt is about $3.3 trillion. These yields have been pushed down too.

Then there are $3.8 trillion in municipal bonds outstanding. Many of them trade below US Treasury yields. For example, the GO bonds of California, which is not exactly a paragon of fiscal rectitude. During trading last Thursday, the California 10-year yield was 1.76%. This was about one-third of a percentage point below the US Treasury 10-year yield of 2.08% on the same day.

Then there are $9.4 trillion in savings products, mostly savings accounts and CDs at banks. There are also about $3 trillion in checking accounts, payroll accounts, etc., but they’re not included here. These are just savings products.

So let’s add these categories up: They amount to $39 trillion.

A 1% reduction in interest spread across the board of just these four categories amounts to nearly $400 billion a year, that the holders of these products are being deprived of.

For example, the Social Security Trust fund, which holds $2.9 trillion in Treasury securities. Its investments earned an average effective interest rate in 2018 of 2.9%. That is down from 5.1% in 2008. And down from over 6% in 2003 and prior years. And it will fall further as some of the remaining higher-yielding long-dated securities from years ago mature and are replaced with new securities at lower yields.

Everyone talks about the Social Security Trust Fund, and what to do when it becomes insolvent as more claims will be drawn on it than money will be paid into it. It hasn’t shrunk yet, and reached a new record in June, thanks to rising contributions. But it will eventually start to shrink. And no one is talking about the Fed’s role in this shrinkage, namely the interest rate repression.

For the Social Security Trust Fund, the difference between earning 2.9% and 5% is $62 billion a year, that the fund is not earning in interest.

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This is playing out across the public and private pension fund universe. To dodge the curse of low interest rates, pension funds are chasing yield, and have aggressively increased their allocations to risky assets, such as stocks and alternative assets, such as private equity investments, and high-yield assets such as junk bonds and leveraged loans and Collateralized Loan Obligations or CLOs. During the next downturn, when these high-risk assets will take a hit, this move could widen by an enormous margin the pension crisis.

The clear beneficiaries of these central-bank policies are the borrowers – just about all borrowers except consumers borrowing on their credit cards, whose interest rates have remained sky-high. These borrowers are being subsidized by current and future retirees, by savers, by fixed-income investors, and ultimately by federal and state taxpayers when they’re called upon to bail out the pension funds.

A 2% difference in yields across the board takes nearly $800 billion a year in income from savers, current and future retirees, and fixed income investors, and hands this money to borrowers.

This is a gigantic sucking sound, to use Ross Perot’s immortal phrase, as this money gets transferred from these people and entities over here to those people and entities over there.

In addition, there is the side-effect that these low yields essentially force fixed-income investors to try to make up for this enormous loss of income by loading up on risk. So they’re chasing yield wherever they can find it, meaning that in the process, they’re bidding up prices of risky assets, thereby lowering their yields too, further inflating the already enormous asset bubbles. Institutional investors, like insurance companies and pension funds, are a big force behind this.

The other thing that is happening is that savers and fixed-income investors are having their cash flows gutted by this interest rate repression. This has been one of the major issues in the economy. Many of these people spend every dime of this interest income. When interest rate repression laid waste to their income streams, they in turn reduced their consumption. They had less money to spend, and they spent less.

It’s interesting to note that 2018 was the year that produced 2.9% economic growth in the US, the highest growth since the Financial Crisis. And this happened when interest rates were rising, and income streams of these people were rising due to higher interest rates on savings products and Treasuries, and these people spent this additional money they earned, and they felt better and were more confident of the future, and thus contributed more by spending more.

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The best way for the Fed to stifle economic growth is to pull the rug out again from under these consumers and gut their income by cutting interest rates.

According to this nutty strategy, the Fed would lower interest rates to stimulate inflation: In other words, it would target those savers and fixed income investors from both sides: First, cutting their incomes and then also cutting the purchasing power of this income.

Low rates are considered a stimulus, but for whom? For Wall Street and asset prices or for the real economy? Countries with negative interest rate policies, such as Japan, and the countries of the Eurozone are now being dogged by low and declining economic growth, despite, or likely because of the low interest rates and the destruction of cash flows.

Over the long term, and that’s what we’re talking about here – it’s been over a decade – interest rate repression is not a stimulus. It just creates asset bubbles. And it removes an enormous amount of income from people who would actually spend this income, and so they spend less, and this reduction in spending dogs the economy.

You can listen to and subscribe to my podcast on YouTube.

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