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Federal Reserve Rate Cuts and US Debt Issuance

The current Fed Funds Target Rate is currently 2.25% (actually it’s a range from 2.00-2.25% but the high end of the range rate is always quoted) and the entire US Treasury Curve is lower than the present Fed Funds rate.

Foreign capital is flowing to the US for numerous reasons, partly because the US has a better regulatory and tax environment for both business and capital investment, but also because the other major/safe country currencies have interest rate levels lower to substantially lower than the US (sometimes this capital movement is called the ‘carry trade’).

Japan has negative interest rates all the way out to their 15-year treasury note and GDP has averaged about 1.5% for the last few years.

In Europe while the Euro$ covers all of the major players except for the UK, Germany and

France also have negative interest rates out to 15 years, Spain is negative out to 9 years and even Italy is negative out to 2 years (then rates rise to 2% or so for most of their yield curve). Europe had major rate cut stimulus a few years ago that created these negative interest rates and led to a temporary bump in GDP but is now sliding back into roughly 1% GDP growth (if that).

The UK, with all the uncertainty being brought by BREXIT has positive rates, but they range from .5-1.1%, and GDP is hovering slightly over 1%.

The current higher interest rate differential in the US is drawing foreign capital to the US exacerbating the flattening of the US yield curve and causing inversions due to short term financing costs tied to the Fed Funds rate. Should the US Federal Reserve continue to cut rates even if rate cuts haven’t led to increased long-term growth in other countries?

Here’s a modified approach, the Federal Reserve could cut the Fed Funds rate while simultaneously selling its longer-dated securities. At the same time, the US Treasury could shift some of the issuance of its debt to later-dated maturities (like the 10yr and 30yr) and take advantage of locking in low interest rates for the long term in the financing of US debt. This should take care of the yield curve inversions, help long term with interest on the debt as a function of the government budget, lessen the likelihood of a rise in the US$ helping US exports, and increase the spreads for US banks in the issuance of new loans.

A strengthened banking system is essential for fluid capital movement in US capital markets where one of our big competitive advantages is our free flow of capital. Spreads have contracted so far that making loans is becoming increasingly risky for banks. When this happens banks are forced to tighten credit requirements because they make less on every loan (versus their cost of capital) so they must reduce default risk and that leads to a credit contraction. Often banks end up denying loans to people who would otherwise receive loans under normal conditions lowering home, vehicle, and other purchases.

Maybe the Federal Reserve and the US Treasury should coordinate monetary policy. While foreign nations have created negative interest yield curves, they have not created sustained long-term growth acceleration. Maybe we should take a different route.

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