What CNBC’s Rick Santelli referred to as a “mouse trap” Friday morning is a growing concern for banks. The “mouse trap” is the Federal Reserve’s quantitative easing, which means it is buying $85 billion of long-term bonds each month. How the Fed will taper off those long-term bond purchases without tanking both the stock market and the banks is the “mouse trap” it will have to try to escape from.
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When the Fed slows and then stops buying long-term bonds, bond prices will fall and banks will face capitalization losses.
Stanford University Professor Ronald I. McKinnon also used the trap metaphor in a July 30 column in the Wall Street Journal: “The problem here is that as banks and other financial institutions get used to near-zero interest rates and accumulate low-interest bonds for some years, they end up in a trap from which escape is difficult, and this trap has negative implications even for corporations that seek direct, long-term financing.
“The trap was revealed for all to see after Fed Chairman Ben Bernanke’s suggestion, in congressional testimony on May 22, that the central bank might slow down its huge purchases of long-term treasury bonds and other long-term securities — purchases designed to keep long-term interest rates low.”
Bernanke’s tapering talk led long-term bond rates to spike 1.5-2.5 percentage points in four days and stock markets crashed around the world. It took a whole lot of jawboning from Bernanke and various other Federal Reserve Board members to calm stock markets.
The yield on 10-year U.S. bonds Friday morning was 2.62 — down from about 2.75 at the start of the day — and the 30-year mortgage was 4.59. The weekly chart for the 10-year bond shows significant variability.
“Now, after a low-interest rate ‘equilibrium’ for some years, the potential for exiting its quantitative-easing means high volatility in bond markets — a volatility that inhibits new bond offerings for domestic investment,” wrote McKinnon, later adding, “The misnamed monetary stimuli are actually holding the economy back.”
McKinnon’s prescription is for all central banks to increase short-term interest rates in a coordinated way and phase out long-term bond purchases.
Coordination seems like the best course, but slowly and discreetly. A top official at the Bank of England talking about that bank’s policy noted it has created “the biggest bond bubble in history.”
It’s time to change, but it’s going to be a challenge to avoid the mouse trap.