This Week’s Blogger: Scott D. Heins, CFP®, IAG Chief Investment Officer
The last few weeks have been filled with headlines about unintended consequences.
Reacting to a global pandemic and government-mandated economic shutdowns, Congress and the Federal Reserve unleashed a torrent of money into the economy. The Federal Reserve took interest rates to 0% and started buying bonds to suppress interest rates further. Congress approved spending trillions of dollars to boost consumers, businesses, and governments.
The greatest perceived threat was economic collapse, and no one had an inkling of concern about future inflation. Bond markets reflected this lack of concern with lower yields.
On August 4, 2020, a 10-year U.S. Treasury bond yielded .52% per year. If you bought $1,000 worth of these bonds, the U.S. government promised to pay you a mere $5.20 per year for 10 years and return your $1,000 principal in 10 years.
However, the unintended consequences of trillions of dollars of economic fuel in a supply-chain-constrained world soon created an inflationary fire. Thus, the Federal Reserve began its persistent rate-hike campaign to suppress rising inflation on March 16, 2022.
By March 2, 2023, a 7-year U.S. Treasury bond yielded 4.24% per year. If you bought $1,000 worth of these bonds, the U.S. government promised to pay you $40.80 per year for 7 years and return your $1,000 principal in 7 years.
This relatively rapid change in bond yields fueled by Federal Reserve rate hikes started creating unintended bank headaches which reached the headlines over the last two weeks.
Banks are required to hold high-quality assets to back a portion of their deposits. Because bank customers never pull all of their money out of a bank at the same time (until they do), the bank invests these reserves in mostly high-quality bonds to earn a higher return.
Let’s say a bank happened to buy $1,000 of high-quality 10-year U.S. Treasury bonds on August 4, 2020, for its reserves. By March 2, 2023, that same bond was still on track to mature at $1,000 in about 7 years, but the U.S. Treasury was now issuing brand new 7-year U.S. Treasury notes that yielded 4.24% per year.
If you had a choice between purchasing a 7-year U.S. Treasury note that yielded .52% per year or one that yielded 4.24% per year, which one would you pick? The answer is obvious.
Suddenly that .52% U.S. Treasury note that will mature for $1,000 in 7 years cannot be sold for $1,000 because its yield is horribly unattractive. To find a buyer, the seller must discount the value of the bond so that it provides the buyer with a total return closer to the newly-issued 4.24% notes.
In this case, a .52%-yielding bond maturing in 7 years for $1,000 will find a willing buyer when the price falls to around $775 – a 22.5% discount from its maturity value. This is a significant problem if a bank is forced to sell its high-quality assets to meet withdrawal demands, and withdrawals have risen dramatically.
For some banks, their business customers are drawing down on reserves instead of issuing new more expensive debt. For other banks, consumers are making withdrawals to earn more interest in U.S. Treasury bills or money market accounts instead of low-interest bank accounts.
Now the Federal Reserve must cope with an additional unintended consequence: their rising interest rate policy rapidly increased bank withdrawals while simultaneously (and significantly) decreasing the value of banks’ high-quality assets.
Banks that did not properly manage the risk of higher interest rates and experience significant withdrawals could fail. We have seen that in the headlines recently.
To head off an additional wave of bank withdrawals, the Federal Reserve coordinated an effort to ensure all depositors at failed banks could access their money, even if they exceeded the usual $250,000 FDIC insurance limit. This could create an additional unintended consequence as depositors may move money to more “systematically important” banks which would receive the same treatment if they fail – accelerating withdrawals from smaller banks that are more vulnerable.
In many ways, unintended consequences can have a larger impact on our economy than intended consequences. This makes predicting the future almost impossible and underlines the importance of overall management of risks in your financial plan.
Hopefully the Federal Reserve can find a way to intentionally manage all of the unintended consequences they are creating, but it seems like there is always one more unintended consequence around every corner.
Securities offered through LPL Financial. Member FINRA/SIPC. Investment advice offered through IAG Wealth Partners, LLC, (IAG) a registered investment advisor and separate entity from LPL Financial.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.
Any opinions are those of IAG and not necessarily those of LPL Financial. Expressions of opinion are as of this date and are subject to change without notice. This information is not intended as a solicitation or an offer to buy or sell any security referred to herein. No strategy assures success or protects against loss. Investing involves risk including loss of principal.
Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.
Quote of the week:
Warren Buffett: “The future is never clear; you pay a very high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values.”