The Gravitational Pull of the Lower Bound

The idea of this is not to say the world is ending, or that this is an economic forecast in any way. The point of this note is to offer a different perspective on what is currently weighing on the bond market as the broader context of these under-appreciated technicals seems very important. Also, if these factors are right, and continue to push yields lower, it will end up being very supportive for asset prices, especially in the US.

We are at a critical stage in monetary policy in the US. Three key themes. 

1) When r* is this low, there is an innate bimodal distribution for the funds rate, you are either close to neutral or close to 0. And this is the exact setup the market is facing now, does 50 do the job or does 0 beckon. Did the Fed adjust to a shifting goal post in terms of neutral, or is this part of a "natural" move to 0. We will soon find out and it should create real two way action in Eurodollars going forward.

2) There is considerable research to suggest the ZLB is binding a significant percentage of the time when r* is low. Ben Bernanke has made this point multiple times over the past year, most recently in his keynote speech at the AEA conference in January. Bernanke's point was, assuming r* in the US of 1%, there are Lower for Longer (L4L) policies the Fed can do to add policy space and minimize ZLB episodes. His forecasts show that under a traditional Taylor rule with 2% inflation target and r* of 1%, the lower bound is binding 30% of the time. Even assuming L4L policies, that number is still around 20%. The point is, ZLB episodes are extremely difficult to avoid when r* is this low, that's just the nature of the beast.

3) The other source of this gravitational pull towards 0 is, divergent interest rate levels are innately unsustainable. The Fed wants to react domestic factors in line with their dual mandate of price stability and maximum employment. However, too much of the policy setting is set abroad. As we learned in Jackson Hole this year from the terrific Riders on a Storm paper, around 50% of the of the monetary policy stance comes from global factors. This goes a long way in explaining that despite 50 year lows in unemployment and inflation not far from target, the Fed has now cut 125bps in less than a year.

Conclusion: 

The market and FOMC are entering a critical phase which seems bimodal in an outcome sense. Either, the Fed was able to instill enough accommodation to reduce ZLB risks, as their research suggests, when close to 0 act swiftly, or, the natural forces of this very low r* world are exerting their natural forces and bringing down the funds rate to its lower bound. Said another way, will the Fed be able to adjust for lower r* and tighter financial conditions, as they did in 2019 in response to tariffs. Or, have we reached the point of no return in terms of the immense pull of a binding lower bound.

The Fed is in no mans land between neutral and 0, the power of the zero lower bound pull

One of the things that is most interesting at the moment is the sheer speed at which the market priced Fed rate cuts. There is a cascading feeling to US bond yields at the moment and the reason is deeper than just uncertainty about the current shock.

The problem the Fed has, and why the market has gone so fast in pricing implieds, the Fed is is no mans land. As we have seen in research from places like DE Shaw, when r* is low, there is an innate bimodal distribution to the funds rate.

The sum of it is, you are close to neutral or at zero.

As the shock has evolved the, market has transitioned from pricing natural negative permia of an asymmetric reaction function, to the pressing need for rate cuts to arrest the decline in financial conditions. As the market prices a lower policy rate, the gravity of the lower bound begins to kick in and this vicious rally in bonds begins.

One of the reasons the Fed was relatively aggressive last year in lowering the policy rate was because of the well known research that when you are close to the lower bound, you have to be aggressive to minimize the chances of hitting it. This is why the research topic du jour in the Fed framework review has been about creating policy space in a low r* world. The problem now is, this shock is different than tariffs via the exchange rate channel (limiting USD upside), and the Fed has already played the insurance card. The gravity of the ZLB is, 125bps in rate cuts over the course of the year is no longer insurance. I.e. part of the reason this move in rates has been so swift is, the market has to consider that the "adjustment" period is over and zero beckons. The idea that Fed can continue to recalibrate policy relative to their celestial stars is getting exhausted. That doesn't mean they cant cut 100bps and say job done, but the real message of this move in market pricing is, the Fed is caught in no mans land and "gravity" or the binding ZLB will continue to pull them to zero in the case of shocks.

This chart is Bernanke's estimates for ZLB frequency under a traditional Taylor rule model and 2% inflation target. As we know from his work with Kiley and Roberts last year, that under assumption that r* = 1, the ZLB is binding around 30% of the time. Even with some lower for longer (L4L) policies like QE and forward guidance, the ZLB is still binding around 20% of the time. The point is, especially under more traditional monetary policy settings, it doesn't take much to push the Fed back to zero.




So what do we know so far, 2 things:

1) When r* is low, the bindingness of the ZLB bites and is like gravity pulling interest rates to zero

2) When r* is low, there is innate bimodal distribution, you are either at neutral or zero

Now, this is pretty powerful on its own, but what if r* is even lower. Both the DE Shaw chart and much of Bernanke/Kily/Roberts, have base assumption that r* is 1. What if its 0....

One of the biggest differences between 0 and 1 in terms of the level of real neutral rates is, there is more room for L4L policies to contribute at r*=1 in terms of adding policy space and limiting chances of ZLB episodes. Bernanke said, if the nominal neutral interest rate is between 2-3%, which is what is assumed for the US economy, then L4L (lower for longer) policies can add up to 3% of policy space at the lower bound.

However, "if the nominal neutral interest rate is much lower than 2 percent, then the model simulations imply that the new monetary tools—while still providing valuable policy space—can no longer fully compensate for the effects of the lower bound."

So now we have to add a third finding, if the r* is actually closer to 0 than 1, than the Fed even by adopting lower for longer policies, which they will for sure try and do with their strategic review, will still very much struggle in preventing ZLB episodes.

Another factor in pricing the funds rate, so much of r* comes from abroad

One of the more interesting macro themes of the past few year, which continues to prove itself, is that divergence, especially in monetary policy is unsustainable. There have been two key papers from the academic side that encapsulate this message.

1) Something Kristin Forbes has been talking about since Sintra 2018, there is a global Phillips Curve and that has a massive impact on the slope of any local curve. In her latest paper, a couple months ago, "Inflation Dynamics; Dead, Dormant or Determined Abroad?" Dr. Forbes posits that domestic CPI inflation is increasingly determined abroad.

One of the charts from her paper show, that incorporating "global variables" such as commodity prices, world slack, exchange rates, and global value chains, are necessary in forecasting domestic inflation.

"This chart shows the resulting “error” between actual inflation and inflation explained using the rolling estimates. It shows the superior performance of the model with the global variables (in red) relative to that with only the domestic variables (in grey) and with the domestic variables plus import prices (dashed black)."

If global factors lead to reduced model error in expected inflation outcomes, then obviously global variables are having a large impact on domestic prices.

2) Arguably the star paper from Jackson Hole this year, "Riders on a Storm", shows that interest rates are increasingly correlated to moves other than Central Bank reaction functions and domestic mandates.

"Taken together, the average monetary policy stance explains only about half of the variation in interest rates. The other half of the time, interest rates move for reasons other than a central banks response to the economic outlook."

Variance decomposition of real short term interest rates (calculations by Jorda and Taylor)

The point is, inflation and neutral interest rates are increasingly a globalized concept, monetary policy does not exist in a vacuum. Another example of this, from their paper is how synchronized policy rates have become.

Stance of monetary policy is highly synchronized (calculations by Jorda and Taylor)

Global factors are pushing the Fed, despite the FOMC being the closest CB to its mandate.

So to update again, now we have 4 strong factors anchoring front end yields lower

1) When r* is low, the bindingness of the ZLB bites and is like gravity pulling interest rates to zero.

2) When r* is low, there is innate bimodal distribution, you are either at neutral or zero.

3) If r* is below 1%, the ability for the Fed to minimize ZLB episodes is further curtailed.

4) Low r* has large global beta, from the nominal neutral level of interest to inflationary forces.

If the Fed ends up at 0, what comes next, steepeners never work but they may have to this time

A good place to look at how the Fed will likely respond in the case of conventional policy space running out, is Governor Brainard.

One of the reasons steepeners have been a brutal trade since the middle of last year is, despite their approach of preemptive policy, the Fed has not really been cutting to get ahead, they have been cutting relative to shifting goal posts. This is why the dollar has remained strong and the curve flat.

However, this time really could be different, especially with 10y note yields sub 1%. If the market is seriously going to entertain the lower bound, then we know two things.

First, it will stay there a while. Brainard's February speech shows this, once you get to 0, you stay.

"Forward guidance that commits to refrain from lifting the policy rate from its lower bound until full employment and 2 percent inflation are achieved is vital to ensure achievement of our dual mandate goals with compressed conventional policy space." 

Second, as the same Brainard speech shows, the Fed will consider some sort of YCC via caps on interest rates in the short to medium term part of the yield curve.

Conclusion: If the market has to entertain the lower bound, there are two key things that should continue to favor steepeners. 1) the very front end will continue to glide towards 0 while the belly of the curve is running out of room to rally if part of the response mechanism is going to be caps on the belly. 2) If the Fed were to do YCC type thing, 2s are anchored to the ELB, tenors outside the cap have to price a normal distribution + the floor of caps. Basically, if the market wants to price 0, the very front end has plenty of room to rally, that case is less compelling in the outer parts of the curve in a very mechanical sense.

Thanks for reading. best place for comments and feedback is by email, jonturek@gmail.com