The Yellen Put

The Fed's risky other mandate

The Yellen Put
Traders work as Federal Reserve Chair Janet Yellen announces the Fed's decision to raise interest rates, on the floor of the New York Stock Exchange on June 14. (DREW ANGERER/GETTY IMAGES)

The term “Greenspan put” was coined after the stock market crash of 1987 and the later bailout of LongTerm Capital Management (LTCM) in 1998. The Federal Reserve (Fed), under chair Alan Greenspan, lowered interest rates when the financial system was in trouble, and life continued. The paltry 0.25 percent hike in the Federal Funds Rate on Dec. 13 to 1.5 percent does not change this dynamic.

The idea of the Greenspan put was that lower interest rates would cure the market’s woes. Unfortunately, the Fed has since fallen into a pattern in which longer periods of low or even zero interest rates are used to address yesterday’s errors. But this action also leads us into tomorrow’s financial excess.

As one observer noted, in an exchange on Twitter with Minneapolis Fed President Neel Kashkari: “Central Bankers are much like the U.S. Forest Service of old. Always trying to manage 'nature' and put out the little brush fires of the capitalist system, while they seem incapable of recognizing they are the root cause of major conflagrations as a result.”

When the Fed briefly allowed interest rates to rise above 6 percent in 2000, the U.S. financial system nearly seized up. Citigroup reported an anomalous spike in loan defaults that sent regulators scrambling for cover. The Fed dropped interest rates at the start of 2001—nine months before the 911 terrorist attacks—and kept the proverbial pedal to the metal at 1 percent until June 2004.

Interest rates rose to 5.25 percent by 2006, but missed the previous highs of 2000 by a full point, a long-term trend reflected in lower earnings for banks and other credit market investors. The accompanying chart shows the return on earning assets for all U.S. banks. The good news is that returns for U.S. banks are rising after hitting a 40-year low at 0.75 percent. The bad news is that the peak return on assets will probably be at 0.9 percent for this cycle, 0.05 percent below the levels of 2008 and 0.1 percent below the 2000 peak of 1 percent.

No Deflation

Now, 5/100 of 1 percent may not seem like a big number, but when you are talking about $15.6 trillion in earning assets held by U.S. banks, that number represents almost $8 billion missing from the industry's quarterly net income of $45 billion. The unfortunate dynamic of the Greenspan put has been to slowly erode the earning power of banks, pensions, and other savers in our economy by driving interest rates ever downward.

But following the 2008 financial crisis, chair Ben Bernanke and later Janet Yellen doubled down. Call it the “Yellen put.” Not content with merely driving short-term rates down to near zero, the committee embarked on a fantastic speculative adventure of market manipulation. The Fed supposed that open-market purchases of trillions of dollars in securities, dubbed quantitative easing, would somehow help the economy and get the heavily qualified measures of inflation, like the Consumer Price Index, to rise to a 2 percent target.

Since then, statistical measures of inflation have barely moved, but asset prices for stocks, housing, and commodities have galloped along in the double digits. The true goal of the Fed was not to restore full employment, much less price stability, as required by law. Instead, the U.S. central bank was and is still today fixated on preventing a general debt deflation. Thus, pumping up asset prices seemed the logical idea, even if it did not fit into the Fed's policy narrative.

The fact that overall debt levels have surged thanks to the Fed’s use of low interest rates obviously begs the question of what was really accomplished. It also proves the wisdom that the monthly payment is all that matters, both to consumers and to heavily indebted governments. The global reality for the Fed, the Bank of Japan, and the European Central Bank is the relentless increase in public debt.

The Yellen put has increased the debt load in the United States and globally, but left the financial markets even more fragile than in 2007. A key measure of this danger was noted in Asset Allocation Insights, which states that since 2008, the duration, a rough measure of interest rate risk, of the Bloomberg Barclays U.S. Aggregate Bond Index has increased 62 percent to 6.2 years.

Simple translation: Via manipulation of the credit markets, the Fed has temporarily suppressed growing bond market volatility as measured by duration. The Yellen put means that bond prices will likely move at a brisk pace as and when volatility returns, a pace that will stun complacent investors.

Hidden Risks

Not only have Yellen and her colleagues created a time bomb of volatility in the U.S. bond sector when it comes to market risk, but also the extended period of low interest rates has created a hidden wave of future loan and bond defaults. By suppressing credit spreads and thus the cost of credit, the Fed afforded inferior corporate and individual borrowers access to credit at a low premium to investment grade prices. Now the defaults are starting to accelerate.

"For the first time since January 2017, the default rate for autos, bank cards, and mortgages all rose together," said David Blitzer, managing director and chairman of the index committee at S&P Dow Jones Indices. The net charge-off rate for bank-owned credit card receivables was 3.4 percent, compared to the low of 2.8 percent in 2015 when banking industry credit loss rates troughed.

The magnitude and length of the Fed’s latest rescue for the U.S. economy dwarfs the modest credit support provided to markets after the failure of LTCM. With the advent of bitcoin and other cryptocurrencies, the more independent-minded members of society are voting with their money and fleeing the post-World War II currency system created by Washington at Bretton Woods.

Given that the price tag of the Yellen put stretches into the trillions of dollars, how big will the next Fed intervention need to be? For example, will the Fed stand by and watch the U.S. equity markets correct as China slows in 2018, destroying trillions of dollars in paper wealth? After all, the chief priority of the Federal Open Market Committee, arguably, is not full employment or price stability, but rather preserving the Treasury’s access to the bond markets.

So here’s the question: Does the Yellen put imply an open-ended commitment to support the equity and bond markets, and purchase more Treasury debt in the systemic event? The answer is most definitely “yes.”

Christopher Whalen publishes The Institutional Risk Analyst and is the author of "Ford Men."
This article was first published on

Christopher Whalen is the chairman of Whalen Global Advisors and the author of "Ford Men." This article was first published by the Institutional Risk Analyst.
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