The Policy of Lowering Bond Yields while Raising Inflation: The Duration Trap of Quantitative Easing
Carlos M. Pelaez
The objective of this post is to analyze the effects on global capital markets of the policy of lowering bond yields with quantitative easing while the Fed may commit to raising inflation to 2 percent at the next meeting on Nov 2-3 or at a subsequent meeting. Section (I) considers the environment of insufficient growth with unemployment and subdued inflation that may trigger further Fed action. Section (II) considers the theory of quantitative easing, (III) the hunt for yields resulting from near zero interest rates and related policies, (IV) the duration trap of quantitative easing, (V) the effects of quantitative easing on devaluation wars, (VI) economic indicators, (VII) interest rates and (VIII) the conclusion. If you have difficulty in viewing the tables and illustrations go to: http://cmpassocregulationblog.blogspot.com/.
I Insufficient Growth with Unemployment. Economic data are likely to reinforce the lack of comfort of Federal Open Market Committee (FOMC) members with their dual mandate of promoting the goals of “maximum employment” and “price stability” mandated in Section 2a of the Federal Reserve Act (http://www.federalreserve.gov/aboutthefed/section2a.htm). Table 1 shows that the first estimate of GDP is a third quarter 2010 year-equivalent rate of growth seasonally adjusted of 2.0 percent, which is slightly higher than 1.7 percent in the prior quarter (http://www.bea.gov/newsreleases/national/gdp/2010/pdf/gdp3q10_adv.pdf). The first five rates of growth of GDP from IIIQ2009 to IIIQ2010 in the current expansion are mediocre at best compared with the expansion from IQ1983 to IQ1984 shown in Table 1. There is an economic and social trauma in the unemployment or underemployment of nearly 27 million persons. Aggregate demand is contributing to growth with percentage point contributions by personal consumption expenditures (PCE) of 1.79 and gross private domestic investment of 1.54, with net exports contributing negative 2.01. GDP in the third quarter of 2010 grew by 3.1 percent over the level in the third quarter in 2009. Inflation is evidently below the informal target of 2 percent of the Fed. The price index of gross domestic purchases excluding food and energy increased by 1.1 percent in the third quarter of 2010 relative to the same quarter in 2009 and the PCE index excluding food and energy increased by 1.3 percent.
Table 1, Quarterly Growth Rates of GDP, % Annual Equivalent SA
| Quarter | 1981 | 1982 | 1983 | 1984 | 2008 | 2009 | 2010 |
| I | 8.6 | -6.4 | 5.1 | 7.1 | -0.7 | -4.9 | 3.7 |
| II | -3.2 | 2.2 | 9.3 | 3.9 | 0.6 | -0.7 | 1.7 |
| III | 4.9 | -1.5 | 8.1 | 3.3 | -4.0 | 1.6 | 2.0 |
| IV | -4.9 | 0.3 | 8.5 | 5.4 | -6.8 | 5.0 |
II Quantitative Easing. A fair interpretation of numerous pronouncements by members of the FOMC is that the decision at the meeting on Nov 2-3 or a subsequent meeting could be: (1) another round of quantitative easing or large-scale purchases of long-term securities to lower their yields; and (2) credible commitment to maintain price stability, which means a symmetric inflation target of 2 percent. Since inflation is at around 1 percent, the Fed would take sustained measures to raise it closer to 2 percent. This section analyzes some of the theoretical reasons for this policy.
If the forecast of the central bank is of recession and low inflation with controlled inflationary expectations, monetary policy should consist of lowering the short-term policy rate of the central bank, which in the US is the fed funds rate. The intended effect is to lower the real rate of interest (Lars Svensson, Escaping from a liquidity trap and deflation, JEP 2003 (17, 4), 146-7). The real rate of interest, r, is defined as the nominal rate, i, adjusted by expectations of inflation, π*, with all variables defined as proportions: (1+r) = (1+i)/(1+π*) (see http://www.econlib.org/library/YPDBooks/Fisher/fshToI19.html). If i, the fed funds rate, is lowered by the Fed, the numerator of the right-hand side is lower such that if inflationary expectations, π*, remain unchanged, the left-hand (1+r) decreases, that is, the real rate of interest, r, declines. Expectations of lowering short-term real rates of interest by policy of the FOMC fixing a lower fed funds rate would lower long-term real rates of interest, inducing with a lag investment and consumption, or aggregate demand, that can lift the economy out of recession. Inflation also increases with a lag by higher aggregate demand and inflation expectations (Ibid). This reasoning explains why the FOMC lowered the fed funds rate in Dec 2008 to 0 to 0.25 percent and left it unchanged.
The fear of the Fed is expected deflation or negative Ï€*. In that case, (1+ Ï€*) < 1, and (1+r) would increase because the right-hand side of the equation would be divided by a fraction. A simple numerical example explains the effect of deflation on the real rate of interest. Suppose that the nominal rate of interest or fed funds rate, i, is 0.25 percent, or in proportion 0.25/100 = 0.0025, such that (1+i) = 1.0025. Assume now that economic agents believe that inflation will remain at 1 percent for a long period, which means that Ï€* = 1 percent, or in proportion 1/100 =0.01. The real rate of interest, using the equation, is (1+0.0025)/(1+0.01) = (1+r) = 0.99257, such that r = 0.99257 - 1 = -0.00743, which is a proportion equivalent to –(0.00743)100 = -0.743 percent. That is, Fed policy has created a negative real rate of interest of 0.743 percent with the objective of inducing aggregate demand by higher investment and consumption. This is true if expected inflation, Ï€*, remains at 1 percent. Suppose now that expectations of deflation become generalized such that Ï€* becomes -1 percent, that is, the public believes prices will fall at the rate of 1 percent in the foreseeable future. Then the real rate of interest becomes (1+0.0025) divided by (1-0.01) equal to (1.0025)/(0.99) = (1+r) = 1.01263, or r = (1.01263-1) = 0.01263, which results in positive real rate of interest of (0.01263)100 = 1.263 percent.
Irving Fisher also identified the impact of deflation on debts as an important cause of deepening contraction of income and employment during the Great Depression illustrated by an actual example (The debt-deflation theory of Great Depressions, Econometrica 1933 (1, 4), 346):
“By March, 1933, liquidation had reduced the debts about 20 percent, but had increased the dollar about 75 percent, so that the real debt, that is the debt measured in terms of commodities, was increased about 40 percent [100%-20%)X(100%+75%) =140%]. Unless some counteracting cause comes along to prevent the fall in the price level, such a depression as that of 1929-1933 (namely when the more the debtors pay the more they owe) tends to continue, going deeper, in a vicious spiral, for many years. There is then no tendency of the boat to stop tipping until it has capsized”
The nominal rate of interest must always be nonnegative, that is, i ≥ 0 (John Hicks, Mr. Keynes and the Classics, Econometrica 1937, (5, 2), 154-5):
“If the costs of holding money can be neglected, it will always be profitable to hold money rather than lend it out, if the rate of interest is not greater than zero. Consequently the rate of interest must always be positive. In an extreme case, the shortest short-term rate may perhaps be nearly zero. But if so, the long-term rate must lie above it, for the long rate has to allow for the risk that the short rate may rise during the currency of the loan, and it should be observed that the short rate can only rise, it cannot fall”
The interpretation by Hicks of the General Theory of Keynes is the special case in which at interest rates close to zero liquidity preference is infinitely or perfectly elastic, that is, the public holds infinitely large cash balances at that near zero interest rate because there is no opportunity cost of foregone interest. Increases in the money supply by the central bank would not decrease interest rates below their near zero level, which is called the liquidity trap. The only alternative public policy would consist of fiscal policy that would act similarly to an increase in investment, increasing employment without raising the interest rate.
An influential view on the policy required to steer the economy away from the liquidity trap is provided by Paul Krugman (Japan’s slump and the return of the liquidity trap, BPEA, 1998 (2)). Suppose the central bank faces an increase in inflation. An important ingredient of the control of inflation is the central bank communicating to the public that it will maintain a sustained effort by all available policy measures and required doses until inflation is subdued and price stability is attained. If the public believes that the central bank will control inflation only until it declines to a more benign level but not sufficiently low level, current expectations will develop that inflation will be higher once the central bank abandons harsh measures. During deflation and recession the central bank has to convince the public that it will maintain zero interest rates and other required measures until the rate of inflation returns convincingly to a level consistent with expansion of the economy and stable prices. Krugman summarizes the argument as (Ibid, 161):
“The ineffectuality of monetary policy in a liquidity trap is really the result of a looking-glass version of the standard credibility problem: monetary policy does not work because the public expects that whatever the central bank may do now, given the chance, it will revert to type and stabilize prices near their current level. If the central bank can credibly promise to be irresponsible—that is, convince the market that it will in fact allow prices to rise sufficiently—it can bootstrap the economy out of the trap”
This view is consistent with results of research by Christina Romer that “the rapid rates of growth of real output in the mid- and late 1930s were largely due to conventional aggregate demand stimulus, primarily in the form of monetary expansion. My calculations suggest that in the absence of these stimuli the economy would have remained depressed far longer and far more deeply than it actually did” (What ended the Great Depression? JEH 1992 (52, 4), 757-8, cited in Pelaez and Pelaez, Regulation of Banks and Finance, 210-2). The average growth rate of the money supply in 1933-1937 was 10 percent per year and increased in the early 1940s. Romer calculates that GDP would have been much lower without this monetary expansion. The growth of “the money supply was primarily due to a gold inflow, which was in turn due to the devaluation in 1933 and to capital flight from Europe because of political instability after 1934” (Romer, op. cit., 759). Gold inflow coincided with the decline in real interest rates in 1933 that remained negative through the latter part of the 1930s, suggesting that they could have caused increases in spending that was sensitive to declines in interest rates. Bernanke finds dollar devaluation against gold to have been important in preventing further deflation in the 1930s (http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm):
“There have been times when exchange rate policy has been an effective weapon against deflation. A striking example from US history is Franklin Roosevelt’s 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the US deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market”
Fed policy is seeking what Irving Fisher proposed “that great depressions are curable and preventable through reflation and stabilization” (Fisher, op.cit, 350).
III The Hunt for Yields. The Fed has already implemented the policy of near zero interest rates and lower long-term bond rates in two occasions. There was fear of deflation in 2002-2003 (Pelaez and Pelaez, International Financial Architecture, 18-27, The Global Recession Risk, 83-94). Quantitative easing can be interpreted as injecting huge amounts of bank reserves by purchasing long-term securities that could lead to lowering long-term interest rates as portfolios are rebalanced toward long-term fixed income securities, causing a decrease in their prices equivalent to lower yields. Policy would flatten the yield curve with long-term yields dropping toward the zero fed funds rate. This policy is almost identical to that before the credit crisis. The Fed lowered the fed funds rate to 1 percent in Jun 2003 and maintained it at that level with the forward guidance that it would remain at low levels indefinitely and kept it at 1 percent until Jun 2004. Treasury suspended the issue of 30-year bonds from 2001 to 2005 with the intention similar to quantitative easing of channeling duration-matching funds in pension funds from 30-year Treasuries to investment in mortgage-backed securities that would raise the price, equivalent to lowering the yield, to attain the elusive flat curve with all yields close to the zero bound. The $201 billion yearly subsidy of housing ensured continuing investment in long-term mortgage-backed securities. Fannie and Freddie jumped into the policy of affordable housing for all and purchased or guaranteed $1.6 trillion of nonprime mortgages. Monetary policy created the illusion of selling a put or floor on wealth or equivalently a ceiling on interest rates. The combination of these policies eroded calculations of risk and return, increasing leverage, decreasing liquidity by encouraging financing of everything in overnight sale and repurchase agreements and mispriced credit and rate risk, causing the credit crisis and global recession (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4).
The consequences of the global hunt for yields created by monetary and housing policy are shown in Table 2. The second column shows a dramatic rise of 87.8 percent in the Dow Jones Industrial Average (DJIA) from 2002 to 2007, more modest increase in the NYSE financial index of 42.3 percent in 2004-2007, increase in the Shanghai Composite index of 444.2 percent in 2005-7, jump in the Nikkei Average by 131.2 percent between 2003 and 2007, rise in the STOXX Europe 50 index of 93.5 percent in 2003-2007, and increase in the UBS commodity index by 165.5 percent in 2002-2008. Zero or near zero interest rates fostered significant volatility by the carry trade from low yielding currencies into fixed income, commodities, currencies, emerging stocks and any type of speculative position such as the price of oil rising to $149/barrel in 2008 during a global contraction (Pelaez and Pelaez, Globalization and the State, Vol. II, 203-4, Government Intervention in Globalization, 70-4). The 10-year Treasury traded at 3.112 percent on Jun 16, 2003, rising to 5.297 on Jun 12, 2007, collapsing to 2.247 on Dec 31, 2008, and rising to 3.986 percent on Apr 5, 2010. New house sales peaked historically at 1,283,000 in 2005, declining to 375,000 in 2009 while the median price jumped from $169,000 in 2000 to $247,000 in 2007 to fall to $203,000 in Jul 2010. The other two columns show the decline of risk financial assets during the credit crisis and the incomplete current recovery. Central bank policy induced the financing of nearly everything with short-dated funding at very low interest rates. When year-end consumer price inflation rose from 1.9 percent in 2003 to 3.3 percent in 2004, 3.4 percent in 2005, 2.5 percent in 2006 and 4.1 percent in 2008 (ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt), the FOMC increased the target on the fed funds rate by 17 consecutive rounds of 25 basis points in meetings from Jun 2004 to Jun 2006, raising the rate from 1 percent to 5.25 percent. The combination of short-term zero interest rates, quantitative easing by suspending the auction of 30-year Treasuries and housing subsidy caused a worldwide hunt for yields that ended in a world financial crash, global recession and serious distortions in risk/return calculations.
| DJIA | 10/08/02- 10/01/07 | 10/01/07- 3/4/09 | 3/4/09- 4/6/10 | |
∆% | 87.8 | -51.2 | 60.3 | |
| NYSE Financial | 1/15/04- 6/13/07 | 6/13/07- 3/4/09 | 3/4/09- 4/16/07 | |
∆% | 42.3 | -75.9 | 121.1 | |
| Shanghai Composite | 6/10/05- 10/15/07 | 10/15/07- 10/30/08 | 10/30/08- 7/30/09 | |
∆% | 442.2 | -70.8 | 85.3 | |
| Nikkei Average | 5/01/03- 2/23/07 | 2/23/07- 3/06/09 | 3/06/09- 4/01/10 | |
∆% | 131.3 | -60.6 | 56.8 | |
| STOXX Europe 50 | 3/10/03- 7/25/07 | 7/25/07- 3/9/09 | 3/9/09- 4/21/10 | |
∆% | 93.5 | -57.9 | -64.3 | |
| UBS Com. | 1/23/02- 7/1/08 | 7/1/08- 2/23/09 | 2/23/09- 1/6/10 | |
∆% | 165.5 | -56.4 | 41.4 | |
| 10-Year Treasury | 6/10/03 | 6/12/07 | 12/31/08 | 4/5/10 |
∆% | 3.112 | 5.297 | 2.247 | 3.986 |
| USD/EUR | 7/14/08 | 6/07/10 | 8/13/10 | |
| Rate | 1.59 | 1.192 | 1.323 | |
| New House | 1963 | 1977 | 2005 | 2009 |
| Sales 1000s | 560 | 819 | 1283 | 375 |
| New House | 2000 | 2007 | 2009 | 2010 |
| Median Price $1000s | 169 | 247 | 217 | 203 |
Sources: http://online.wsj.com/mdc/page/marketsdata.html
http://www.census.gov/const/www/newressalesindex_excel.html
The prospect of another flood of central bank money at zero interest rates has reversed the collapse of financial assets resulting from the sovereign credit doubts in Apr. Table 3 shows that the dollar has devalued by 16.9 percent while every financial asset has risen: equities, commodities and the price of the 10-year Treasury. What will happen to long-term bonds if the Fed succeeds in increasing inflation?
Table 3, Stock Indexes, Commodities, Dollar and 10-Year Treasury
| Peak | Trough | ∆% to Trough | ∆% to 10/29 | ∆% Week 10/29 | ∆% T to 10/29 | |
| DJIA | 4/26/10 | 7/2/10 | -13.6 | -0.8 | -0.1 | 14.7 |
| S&P 500 | 4/23/10 | 7/20/10 | -16.0 | -2.8 | 0.01 | 15.7 |
| NYSE Finance | 4/15/10 | 7/2/10 | -20.3 | -11.1 | -1.0 | 11.6 |
| Dow Global | 4/15/10 | 7/2/10 | -18.4 | -3.2 | -0.5 | 18.7 |
| Asia Pacific | 4/15/10 | 7/2/10 | -12.5 | 1.5 | -0.4 | 15.9 |
| Japan Nikkei Average | 4/05/10 | 8/31/10 | -22.5 | -19.2 | -2.4 | 4.3 |
| China Shanghai | 4/15/10 | 7/2/10 | -24.7 | -5.9 | 0.1 | 25.1 |
| STOXX Europe 50 | 4/15/10 | 7/2/10 | -15.3 | -6.2 | -0.3 | 10.7 |
| DAX | 4/26/10 | 5/25/10 | -10.5 | 4.3 | -0.1 | 16.4 |
| Dollar EUR | 11/25 2009 | 6/7 2010 | 21.2 | 7.9 | 0.1 | -16.9 |
| DJ UBS Comm. | 1/6/10 | 7/2/10 | -14.5 | -0.1 | -0.6 | 16.9 |
| 10-Year Treasury | 4/5 2010 | 10/29 2010 | 3.986 | 2.603 |
T: trough; Dollar: positive sign appreciation relative to euro (less dollars paid per euro), negative sign depreciation relative to euro (more dollars paid per euro)
Source: http://online.wsj.com/mdc/page/marketsdata.html
IV Quantitative Easing Duration Trap. Svensson proposes the “foolproof way” of escaping the liquidity trap that (Svensson, op. cit., 161):
“Consists of announcing and implementing three measures: 1) an upward-sloping price-level target path, starting above the current price level by a price gap to undo; 2) a depreciation and a crawling peg of the currency; and 3) an exit strategy in the form of the abandonment of the peg in favor of inflation or price-level targeting when the price-level target path has been reached”
The recovery of the gap between actual inflation and what would occur without deflation intends to increase asset values of debtors back to their original levels before deflation so that they can service their debts and expand output and employment. The discussion of the exit strategy from the “shock and awe” quantitative easing of the bloated fed balance sheet consisted of the existence of tools of increasing interest rates in changing conditions (http://www.federalreserve.gov/newsevents/testimony/bernanke20100210a.htm).
The auction of Treasury Inflation Protected Securities (TIPS), adjusted by consumer price inflation, on Oct 25 was sold at a yield of negative 0.55 percent while the equivalent five-year fixed-rate Treasury yielded 1.18 percent. The difference between the TIPS and the five-year Treasury was 1.18 – (-0.55) = 1.18 +0.55 = 1.73 percent (http://professional.wsj.com/article/SB10001424052702303443904575578350767989926.html?mod=wsjproe_hps_LEFTWhatsNews). This suggests expectation of inflation of 1.73 percent. TIPS held by the public are only $593 billion or about 7 percent of total debt held by the public of $8.5 trillion (http://www.treasurydirect.gov/govt/reports/pd/mspd/2010/opds092010.pdf).
In 1952, Harry Markowitz provided a foundation for analysis of portfolio selection by considering “the rule that the investor does (or should) consider expected return a desirable thing and variance of return an undesirable thing” (Portfolio Selection, Journal of Finance 7 (1, Mar), 77). Investors desire higher expected returns under constraints of volatility or risk measured by standard deviation of returns. In a landmark contribution, James Tobin derived the liquidity preference schedule by displacing the equilibrium under alternative choices of restrictions on expected return and standard deviation or risk (Liquidity preference as behavior toward risk, RES 1958 (26, Feb), cited in Carlos Manuel Pelaez and Wilson Suzigan, Economia Monetária, Atlas, 1978, 230-5, with the econometric analysis of broader research by Pelaez and Suzigan, História Monetária do Brasil, Segunda Edição, Universidade de BrasÃlia, 1981), which Tobin later extended to a more general framework (Tobin, A general equilibrium approach to monetary theory. JMCB 1969 (1, Feb), cited in Pelaez and Suzigan, Economia Monetária, 120-30). Economic agents are assumed to have a fixed amount of monetary assets, consisting of money or cash holdings and a perpetuity (consol) paying a fixed interest rate forever. The risk of the perpetuity is the possibility of capital gains or losses resulting from fluctuations of the interest rate. When interest rates are very low, there may be a generalized perception by investors that rates and risk only have one direction, which is increasing rates, resulting in capital losses.
An important channel of transmission of quantitative easing is that “if money is an imperfect substitute for other financial assets, then large increases in the money supply will lead investors to seek to rebalance their portfolios, raising prices and reducing yields on alternative, non-money assets. In turn, lower yields on long-term assets will stimulate economic activity” (Ben Bernanke and Vincent Reinhart, Conducting monetary policy at very low short-term interest rates. AER 94 (2), 88, cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 158, Regulation of Banks and Finance, 224). The commitment of the Fed to purchasing long-term securities is designed to impress on investors that prices will increase and yields decline for asset classes that are related to long-term borrowing costs of firms, such as corporate debt and asset-backed securities collateralized with loans.
The intended policy appears to be a symmetric inflation target of 2 percent (for inflation targeting see Pelaez and Pelaez, Regulation of Banks and Finance, 108-11, Financial Regulation after the Global Recession, 85-7). Frederic Mishkin proposes that the Fed make its inflation target explicit (http://www.ft.com/cms/s/0/4b6276f8-df95-11df-bed9-00144feabdc0.html). The symmetric target means that the Fed will take measures preventing inflation from falling below 2 percent or rising above 2 percent. Currently, with core PCE inflation around 1 percent, the Fed seeks an increase of inflation to 2 percent. It is difficult to measure by how much yields of long-term bonds will adjust to such a rise in inflation. As shown in Table 2, the 10-year Treasury traded at 3.112 percent on Jun 16, 2003, rising to 5.297 on Jun 12, 2007, collapsing to 2.247 on Dec 31, 2008, and rising to 3.986 percent on Apr 5, 2010 while year-end consumer price inflation rose from 1.9 percent in 2003 to 3.3 percent in 2004, 3.4 percent in 2005, 2.5 percent in 2006 and 4.1 percent in 2008 (ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt). An example illustrates the risks. On Oct 29, the Treasury with coupon of 2.63 percent traded at price of 100.08 or equivalent yield of 2.62 percent (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-291010). If yields were to back up to the level of 3.986 percent traded on Apr 5, the price for settlement on Nov 1 would be 89.0833, for a principal loss relative to the price on Oct 29 of 10.9 percent. The price for delivery on Nov 1 with the yield of 5.297 percent traded on Jun 12, 2007 would be 79.8076 for a capital loss of 20.3 percent. Central banks operate monetary policy “under considerable and unavoidable uncertainty about the state of the economy and the size and lag of the economy’s response to monetary policy actions” (Svensson, op.cit. 146).
The duration trap is that duration is higher the lower the coupon and higher the lower the yield, other things being constant. Coupons and yields are currently very low and quantitative easing may lower further both coupons and yields. Professor Jeremy Siegel, of the Wharton School, and Jeremy Schwartz, of Wisdom Tree, analyze the risks of capital losses of positions in Treasuries with high duration in a must-read opinion article for the Wall Street Journal (http://professional.wsj.com/article/SB10001424052748704407804575425384002846058.html ). An increase in yields of 10-year Treasuries from 2.8 percent, at a much higher level at the time of their writing, to the 4 percent almost reached in Apr would cause a capital loss exceeding three times the current yield of 10-year Treasuries (Ibid). Such an increase could occur as Siegel and Schwartz point out because of acceleration of the rate of growth of the economy. They quote data from the Investment Company Institute that from Jan 2008 to Jun 2010 the outflows from equity funds totaled $232 billion while $559 billion flowed into bond funds. There may be another but similar avenue for a rise in stocks compared to decline of bonds. Companies are holding $3 trillion in cash (http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=aFzUwxN3LKsQ ). After all recessions and similar events, there is need for reorganizations in which companies change business models, selling entire divisions or lines of business to acquire others. The boom in takeovers at the turn of the 1990s was driven by the changes caused by the third industrial or technological revolution that created excess capacity by technological/organizational change, government policy and globalization; exit by the capital markets is value creating compared to alternative liquidation (Michael C. Jensen, The modern industrial revolution, exit and the failure of internal control systems, Journal of Finance 1993, cited in Pelaez and Pelaez, Globalization and the State Vol. I, 49-51, Government Intervention in Globalization, 46-7). Bloomberg estimates that $3.51 trillion of deals were announced in 2006 and $4.02 trillion in 2007 (http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=aFzUwxN3LKsQ ). The cash-rich position of companies suggests that they can leverage to take opportunities of changing or improving their business models in what is necessary reorganization in economies worldwide. The other catalyst of stock markets could be a shift away from the policy of legislative restructurings and regulation in a new reality created after Nov that more adequately balances the role of the private sector in economic allocation and job creation. The combination of new consolidation via capital markets and inflow of funds into equities and away from bonds could trigger the realization of capital losses in bond positions with long duration.
V. Quantitative Easing and Devaluation Wars. The Fed does not have a mandate on exchange rates, which is the province of Treasury policy. Research at the Federal Reserve Bank of St. Louis finds that long-term yields in the US declined on average by 74 basis points in the purchase events of quantitative easing; the decline of 10-year yields was by an average of 45 basis points in foreign markets of advanced economies. The dollar declined on average by 6.56 percent in the events of quantitative easing, ranging from depreciation of 10.8 percent relative to the Japanese yen to 3.6 percent relative to the pound sterling (http://research.stlouisfed.org/wp/2010/2010-018.pdf). It is quite difficult with limited experience to measure by how much the dollar would depreciate relative to other currencies because of a new program of quantitative easing of unknown dimensions and structure of acquisition of securities.
There has been significant appreciation of exchange rates of most countries relative to the dollar since their trough to Oct 29 as shown by the sixth column in Table 4. Countries have used various types of measures to prevent appreciation of their currencies that diminishes the competitiveness of their exports. The diversity of national interests may create a hurdle in coordination of policies that already failed with the doctrine of shared responsibility (Pelaez and Pelaez, The Global Recession Risk, Globalization and the State, Vol. II, 180-194, Government Intervention in Globalization, 167-70, and earlier events in International Financial Architecture, 1-63).
Table 4, Exchange Rates
| Peak | Trough | ∆% P/T | Oct 29 2010 | ∆% T Oct 29 | ∆% P Oct 29 | |
| EUR USD | 7/15 2008 | 6/07 2010 | 10/29 2010 | |||
| Rate | 1.59 | 1.192 | 1.394 | |||
| ∆% | -33.4 | 14.5 | -13.9 | |||
| JPY USD | 8/18 2008 | 9/15 2010 | 10/29 2010 | |||
| Rate | 110.9 | 83.07 | 80.37 | |||
| ∆% | 24.6 | 3.3 | 27.1 | |||
| CHF USD | 11/21 2008 | 12/8 2009 | 10/29 2010 | |||
| Rate | 1.225 | 1.025 | 0.984 | |||
| ∆% | 16.3 | 4.0 | 19.7 | |||
| USD GBP | 7/15 2008 | 1/2/ 2009 | 10/29 2010 | |||
| Rate | 2.006 | 1.388 | 1.604 | |||
| ∆% | -44.5 | 13.5 | -25.1 | |||
| USD AUD | 7/15 2008 | 10/27 2008 | 10/29 2010 | |||
| Rate | 0.979 | 0.601 | 0.983 | |||
| ∆% | -62.9 | 38.9 | 0.4 | |||
| ZAR USD | 10/22 2008 | 8/15 2010 | 10/29 2010 | |||
| Rate | 11.578 | 7.238 | 6.985 | |||
| ∆% | 37.5 | 3.5 | 39.6 | |||
| SGD USD | 3/3 2009 | 8/9 2010 | 10/29 2010 | |||
| Rate | 1.553 | 1.348 | 1.293 | |||
| ∆% | 13.2 | 4.1 | 16.7 | |||
| HKD USD | 8/15 2008 | 12/14 2009 | 10/29 2010 | |||
| Rate | 7.813 | 7.752 | 7.75 | |||
| ∆% | 0.8 | -0.03 | 0.8 | |||
| BRL USD | 12/5 2008 | 4/30 2010 | 10/29 2010 | |||
| Rate | 2.43 | 1.737 | 1.702 | |||
| ∆% | 28.5 | 2.0 | 29.9 | |||
| CZK USD | 2/13 2009 | 8/6 2010 | 10/29 2010 | |||
| Rate | 22.19 | 18.693 | 17.628 | |||
| ∆% | 15.7 | 5.6 | 20.5 | |||
| SEK USD | 3/4 2009 | 8/9 2010 | 10/29 2010 | |||
| Rate | 9.313 | 7.108 | 6.667 | |||
| ∆% | 23.7 | 6.2 | 28.4 |
Symbols: USD: US dollar; EUR: euro; JPY: Japanese yen; CHF: Swiss franc; GBP: UK pound; AUD: Australian dollar; ZAR: South African rand; SGD: Singapore dollar; HKD: Hong Kong dollar; BRL: Brazil real; CZK: Czech koruna; SEK: Swedish krona; P: peak; T: trough
Note: percentages calculated with currencies expressed in units of domestic currency per dollar; negative sign means devaluation and no sign appreciation
Source: http://online.wsj.com/mdc/public/page/mdc_currencies.html?mod=mdc_topnav_2_3000
VI Economic Indicators. Economic indicators continue to depict a slowly growing economy with relatively weak labor markets. The National Association of Realtors index of existing home sales increased from an annual seasonally adjusted rate of 4.12 million in Aug to 4.53 million in Sep or by 10.0 percent; sales are lower by 19.1 percent relative to 5.60 million in Sep 2009 (http://www.realtor.org/press_room/news_releases/2010/10/sept_strong). Sales of new homes reached the annual seasonally-adjusted rate of 307,000 in Sep, which is above 6.6 percent relative to the Aug rate of 288,000 but 21.5 percent below 391,000 in Sep 2009. The rate without seasonal adjustment in the first nine months of 2010 was 257,000, which is 11.7 percent below 291,000 in the same period in 2009 (http://www.census.gov/const/newressales.pdf Table 1, 2). The unadjusted rate in the first nine months of 2005 was 995,000 (http://www.census.gov/const/newressales_200509.pdf Table 1, 2). Total orders for durable goods seasonally adjusted increased by 3.3 percent in Sep after declining by 1 percent in Aug but fell by 0.8 percent excluding transportation because of bulky orders for aviation and parts. Total sales without seasonal adjustment rose by 15.0 percent in Jan-Sep 2010 relative to a year earlier and excluding transportation by 14.2 percent (http://www.census.gov/manufacturing/m3/adv/pdf/durgd.pdf). Initial jobless claims seasonally adjusted were 434,000 in the week ending Oct 23, declining by 21,000 from 455,000 in the prior week (http://www.dol.gov/opa/media/press/eta/ui/current.htm). The employment report to be released on Nov 5 will provide further information on the job market.
VII Interest Rates. The 10-year Treasury yield rose to 2.60 percent on Oct 29 relative to 2.56 percent a week earlier and 2.51 percent a month earlier. The yield of the 10-year Treasury is still well below 3.986 percent traded on Apr 5. The yield of the 10-year government bond of Germany traded at 2.51 percent, which corresponds now to only 9 basis points less than the comparable Treasury.
VII Conclusion. Economists have developed an elegant and persuasive theory and policy of central banking when economic conditions are weak, inflation low and interest rates at the zero bound. In practice, the policy causes wide swings in prices of financial assets and serious distortions of risk/returns calculations by households, business and government. Escaping the liquidity trap may deliver financial markets in a tortuous route to the duration trap with expectations of a capital loss and a difficult exit of quantitative easing. Policy may cause undesirable shocks to investor portfolio positions and asset/liability management exposures of financial institutions. (Go to http://cmpassocregulationblog.blogspot.com/ http://sites.google.com/site/economicregulation/carlos-m-pelaez)
http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )
