Monday, April 28, 2014

Unintended Consequences

Two weeks ago we wrote about a bear flattening and discussed the especially vulnerable short end of the curve. Since that writing, 5 year Treasuries have moved from 1.58% up to 1.74%. The 30 year has gone from 3.48% to 3.49%. The curve is flattening and it is flattening from the most manipulated end: The short end.

So what is causing the slow rise in interest rates when everyone expects a slightly faster rise? And if the banks have lots of cash available, why do there continue to be complaints about access to borrowing? Any time there is government intervention in the markets, there is most likely to be unintended consequences. One unintended consequence of the increased liquidity standards forced upon banks is the lack of liquidity for borrowers.

Banks have been forced to strengthen their balance sheets as a result of the 2008 financial crisis. A liquidity coverage ratio has been established for the banks and only cash and Treasuries and Agencies count fully in that ratio calculation. The result? Banks need to keep more assets on hand to cover times of  "stress" and the best instruments that banks can use happen to be Treasuries and Agencies. So, once again, we have an unnatural demand for Treasuries on the short end of the curve, which is why on days like today we had 10 Year Treasuries briefly at 2.67%. Also, since banks need to keep more cash on hand to prevent a similar fiasco to 2008, banks cannot lend in the way that they used to. As a result, there are now businesses and individuals that historically looked like good candidates for lending, but now cannot be lent to due to the banks' need to beef up their own balance sheets.

If the economy keeps growing, and when banks reach the ratios that are acceptable, we expect that the short end of the yield curve could move up in yield faster than we've seen recently. Again, the short end most likely has the most risk and needs to be approached very cautiously.

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