Wednesday, September 26, 2012

The Gift That Keeps on Giving: The Low Interest Rate

Clearing Inventory and Stocking Up for the Shopping Season
Retail stores are clearing their inventory to stock new merchandise for the shopping season - Christmas is only three (3) months away!  Apple released its newest smart phone offspring, and Microsoft will help introduce a new line of consumer electronics sporting its much touted Windows 8 operating system.  Toy companies, film studios, and other companies will begin releasing their new products to the general public in the coming months.

The Federal Reserve meanwhile is clearing its inventory (short-term US treasuries) and stocking the shelves with its newest product: Lower Interest Rates under its famous Quantitative Easing (QE) brand.  This will be the 3rd and most highly anticipated edition.  Expected to retain features such as stock market rally and consumer inflation, the newest edition will also feature Fed frustration and bubble anxiety.

The 30-year Federal Reserve policy.

Surgeon General Warning: Possible side-effects may include lower saving rate.
Beating the Competition
Eastman Kodak developed (no pun intended) the digital camera's core technology and subsequently failed to develop (again no intended pun) the digital camera into a profitable product.  Eastman neglected the digital camera in favor of its top money maker - film.  Later, after competitors seized on the consumer electronics revolution of the 1990's, Eastman's appeal to consumers waned in the digital age.  

In 2012, Eastman Kodak filed for bankruptcy.  It failed to respond to a market driven by consumer demand for innovative consumer electronic products - like the digital camera. Despite its moat, Eastman could not slay the dragon - oddly enough, a dragon it created and very well could have tamed for its advantage.  Will the same fate become of the Fed?

Absolutely not. Because the Fed unlike Eastman has very little competition, if any.  The only other competition to the US dollar are barter and relocation to another country.  Relocation must no be to one of the half-dozen countries that use US dollars as official currency, or to one of the many dozen who happily except it in their robust tax-exempt black market.  Good luck with that.

The Catalog History
In case you missed the previous Fed product releases, refer to the following three (3) charts of Federal Reserve holdings:
From the following three (3) charts we see details of the following events: QE 1.0, QE 2.0, Operation Twist (QE 2.1) and one other event.  From the mortgage-backed security (MBS) chart you can see the blue line overlap the red line - indicating that nearly all MBS holdings are long-term.  We can safely assume the Fed will continue to purchase long-term MBS under QE 3.0.
The Fed will purchase MBS at a $40 billion per month rate for an indefinite period.  This makes sense!  Because under QE 2.1 the Fed south to drop the interest rate spread between long-term treasuries and long-term MBS by buying only long-term treasuries (decreasing their interest rates relative to the MBS).

The Fed will continue to release QE 2.1.  The simultaneous purchase of long-term securities should keep secondary-market rates between the two more competitive (spread) and it should keep the interest rates low.

Kung-Fu Grip Included
It makes sense to do QE 3.0 because rates are too darn high.  No one in their right mind wants to take out a 30-year mortgage at 3.6% interest, but soon they will be able to get the same mortgage at 3.45% interest.  Which is much more reasonable.

Has the Federal Reserve been giving the U.S. economy a teaser rate for 30 years?

Perhaps the Fed fears a recession, and in anticipation of an increase in mortgage defaults the Fed will put the potential losses on its books - how generous.  We did recently see poor job numbers from the Bureau of Labor Statistic - a paltry 96k jobs added and a further decrease in the participation rate (retiring boomers?).

This is just a sign of the strong U.S. economy as boomers head toward early retirement in their equity laden houses, living off decades worth of thrifty savings and reputable investments.

So either the Fed wants decrease interest rates to spur home purchases into another bubble, or the Fed wants to play probable-hero by helping banks externalize the cost of a soon-to-be recession.  How about more of the status quo medicine and doom?
But Who Will Buy?
Real-wages, house prices, marital status, children, career prospects, savings, investments, existing debt, and positive future outlook are the primary factors in housing demand. Demand is not just dependent on interest rates. In fact, the biggest reason people buy a house is because they want to live in a house.

Echo Boomers (Generation Y) delay every reason to purchase a house.  They delay marriage, delay having children, have little to no savings and investments, have gloomy career prospects, are mired in student debt, move back in with their parents, and perhaps most of all - they work at lower-than-expected wages with little real-wage growth.

So, the Shelves Will Be Overflowing?
Unless the Fed buys treasuries until interest rates resemble an asymptotic curve - infinitesimally approaching zero - the Fed will eventually mandate a low interest rate time table.  As it is, the Fed has such a time table: until the end of 2013...2014...or is it 2015?

The Fed's latest shopping spree pushes back its low interest rate policy by another year to 2015.  30 years ago, the Fed had a great plan to deal with oil supply shock inflation - high interest rates (reduce inflation).  It then had a great plan to grow the economy during the stagflated recession - low interest rates (increase inflation).

Japanese - the economic forecast for the United States.

So They Really Won't Become Eastman Kodak?
Let me be blunt.  Europe sucks right now - perhaps a currency pact with borders just cannot exist.  Russia is far too cold and far too dependent on oil prices to be a US dollar competitor.  India - the world's largest democracy - cannot keep the lights on.
Is there a legit competitor?  Is there a large, swift acting economy with the manufacturing prowess, insatiable appetite for growth, resources, population, and the right amount of national pride to challenge the US dollar global reserve currency?

Probably not.  So I guess the US is good to go for another housing bubble because we will have the Fed and our eager creditors (Japan, United Kingdom, Brazil, Germany, Canada, South Korea, Switzerland, Luxembourg...anyone else?) to again give us a bail-out if things go wrong.