'Boneheads' at the Fed and the 'Riskless Rate'

Published 11.09.2019 21:59
Updated 12.09.2019 02:09

After suffering from a bout of jetlag today, I awoke to a paradigm shift in the world of finance. U.S. President Donald Trump had, while I was dreaming of growth and prosperity, floated some controversial ideas in a tweet. "The Federal Reserve should get our interest rates down to ZERO, or less, and we should then start to refinance our debt. INTEREST COST COULD BE BROUGHT WAY DOWN, while at the same time substantially lengthening the term," tweeted Trump. Wow.

While Trump regularly engages in "megaphone monetary policy," to borrow a term Bloomberg often uses, something has changed here. He often calls for lowered interest rates and attacks the U.S. Federal Reserve (Fed) and Jay Powell, the chairman he appointed. Yet the "refinance our debt" idea hadn't been tweeted before. This would mean bondholders would be paid lower yields because interest rates had decreased. How does this work? Well, if you have an auto loan or mortgage that you are paying off at a 20% interest rate when the central bank rate is 15%, you'd pay less interest when the rate went from 15 to 10, for example. In doing so, you borrow at a cheaper rate, pay off your auto loan/mortgage earlier and now pay the reduced rate to the new lender. This is "refinancing" of debt.

The problem here is that banks are aware you will most likely be retiring your mortgage debt when rates decrease and factor that in their calculations when selling their mortgages. This is not what the U.S. Treasury or the investors in its debt do. The U.S. Treasury, by not "refinancing" its debt, gives investors a chance to profit handsomely on the bonds they purchase. This potential upside adds value to its bonds making them more attractive and thus making the interest payments lower on bonds. Declaring that the U.S. can "ad hoc" retire its debt and that investors will be forced to sell their bonds back to the government or accept lower interest payments will make bonds less desirable. Trump also suggests "lengthening the term" or offering longer-term bond issues that would actually help decrease the debt burden in the near term but issuing longer term bonds while simultaneously threatening to refinance debt would be a net negative.

If Trump is serious about this suggestion, and he most probably is not, this will cause investors to add a new risk premium into their bond valuation calculations. This will cause bond prices to increase, ceteris paribus, and ultimately defeat the purpose of "refinancing debt." Trump continues to tweet, "We have the great currency, power, and balance sheet. The U.S. should always be paying the lowest rate. No Inflation! It is only the naivete of Jay Powell and the Federal Reserve that doesn't allow us to do what other countries are already doing. A once in a lifetime opportunity that we are missing because of 'Boneheads'." There's a lot to unpack here. First, calling the Fed and its chair "boneheads" isn't exactly arousing confidence in your government or the Fed. The remainder of what Trump said is actually on balance correct. Unbridled U.S. "power" means it could demand to pay the lowest rates but at what costs?

Trump's ideas are not all bad, but declaring them over Twitter and in such a bellicose manner are not in America's best interest nor are they in the best interest of global financial markets. Finance 101 teaches us that there is no risk associated with U.S. debt, it's literally called the "riskless rate," but Trump has done a lot of damage to this notion, damage that will be difficult to undo.

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