The Implications of Low Real Rates

The ECB’s shocking confession: Yesterday the ECB came clean with the idea that the bank might not be capitalized sufficiently for its role as the central bank for Europe. Specifically, the ECB is worried that its 5.8 billion capital base is sufficient to withstand losses it might incur from its €72 billion portfolio of sovereign debt. Just a 10% loss in these positions, which seems pretty much a sure thing in my opinion, would wipe out the ECB’s capital. Is this any way to run a central bank?


I find this part of the EU story just remarkable. Since I never paid any attention to how the ECB gets its capital, I just assumed that the ECB had the ability to print new euros, as needed, just as the Fed does in the US. That is not the case. Apparently, the ECB is capitalized by contributions from its members, and if they take a loss, then those losses needs to be made up from somewhere. 


Effectively, because the ECB was in the market supporting the debt of the peripheral EU sovereigns, they now risk their own existence in the process. I find this to be a completely remarkable situation! How could they let themselves get into this position? And unfortunately, any capital raise would need to be approved by the members of the EU, and be subjected to public opinion by each of the members of the EU. Will these countries like the idea that they are now directly funding ECB earned losses? One of the tenants of running a central bank is to make sure your balance sheet is full of risk free assets, and despite this basic rule, the debt of the PIIGS is fraught with risk. This is more evidence of how flawed the European Monetary Union is. Expect to see more about this story in the weeks and months ahead. Despite this news, the Euro is stronger over the last couple of days.


* Interest rates: Over the past two months, rates on 10 year treasuries have risen by 90 basis points. Additionally, the rates on par priced FNMA mortgage backed securities also rose by 90 basis points. Is this signaling an increase in inflation expectations, or crowding out by the US government’s voracious appetite to fund its $1+ trillion annual deficits?


A look at 10 year rates and 10 year TIPs helps shed some light on this question. Below I present rates from various points in time since late August, when the concept of additional QE by the Fed was suggested by Bernanke. October 7th was the date which the 10 year hit a 2010 low yield of 2.38%; November 3rd was the date which the Fed announced the latest QE2, and December 6th was right before the tax compromise between Obama and the Republicans was announced. Here is the data: 


         Nominal Rates   Real Rates

Date       10 yr         10 yr TIPs      Inflation Expectations

Aug 26     2.50            0.90                  1.60

Oct 7      2.38            0.46                  1.92

Nov 3      2.57            0.41                  2.16

Dec 6      2.92            0.70                  2.22

Dec 14     3.37            1.13                  2.24


The fourth column displays the difference between the 10 year treasury, and the TIP’s yield, which represents the market’s expectations for inflation over the next 10 years. As the chart shows, this reading was at 1.60% in late August, and rose to 2.16% by the time the Fed made their QE2 announcement in early November. Remarkably, the yield on the 10 year treasury moved very little from late August to November 3rd, while the yield on tips dropped 50 bps, reflecting an increase in inflation expectations.


Ironically, as yields rose from November 3rd to December 6, TIPs yields rose by almost the same amount. In other words, once QE2 was announced, rates rose, not because of an increase in inflation expectations, but in all likelihood, due to expectations that the increased economic activity will create more demand for credit. Or looked at another way, the real rate of return, as measured by TIPs yields, is going up, and that is a good leading indicator that the markets are perceiving that the economy is improving.


From December 6th to today, rates on both TIPS and treasuries rose by a similar amount, which probably is a reflection of greater demand for credit since the economy is now expected to do better. In addition, you can also presume that an increase in the government’s demand for credit, expected to add an additional $900 billion over 2 years to our deficits, also caused rates to increase.


This discussion, which I was planning on doing sometime this week, is also timely, as it agrees with the conclusion of the Op-Ed piece by Jeremy Siegel in today’s WSJ. His contention is that the Fed’s QE2 is actually working, as evidenced by the recent rise in interest rates. From the time period between November 3rd and December 6th, this is clearly what might have been playing out. Since December 6th, it can be debated whether higher rates reflect an increase in demand for money from the Treasury (to fund greater deficits), or do the higher rates reflect demand for credit from an improving economy? Stock priceschopped around during this time period, so we cannot draw any conclusions from this source. Nonetheless, while rates are rising, so are stock prices, and I think it would be safe to conclude that QE2 is helping boost asset prices. And since there is a positive wealth associated with rising stock prices, to the extent that the equity party continues, which is not certain in my opinion, then QE can take some of the kudos for that.


* What a good economy looks like: Way back when, when I was in graduate (MBA) school, one of my finance professor derived that the long term return from capital was 3%, covering 100 years of data. This implies that real rates (ie- TIPs) should be at 3% if capital (in dollars), had a productive use which returns a 3% yield. Since TIPs yields are still quite low (1.14%) relative to the long run returns on capital, it suggests that our economy is still sucking wind in quite a bad way. In fact, I would argue that the current configuration of the US’s financial system is such that too much capital has chased real estate assets over the course of time, and since that sector has so underperformed everything else, that the bar is set really low for investors in such instruments as treasuries. If we had a vibrant economy with lots of high yielding alternatives for investors or corporations, then there is no way that the real yield on treasuries would be a measly 1.14%.


This leaves me with the concept that our government needs to come up with incentives which allows investors to want to invest money in this country. In a simplistic fashion, rules concerning health care for workers, and other related benefit costs, have priced the US out, as a place for corporations to build new factories. The bottom line, is that while the US has taken decades to transform itself into a better place to work, we have also encouraged a great migration of industry away from our country. And it is along those lines which structural changes need to occur, so as to make the US, and dollar investments, a better alternative, and one which commands a real return of at least 3%. With real rates at 1.14%, we are a long way off. Let me conclude by saying that no amount of QE will do for the country, what smart policies to promote economic growth on our shores, will do.