The financial economy is like an engine propelling the transaction and bookkeeping side of the overall economy. Similar to issues experienced in the goods-producing economy, imbalances in current capital flows are expected to stymie recovery following the COVID-19 (coronavirus) pandemic.
Dashboard:
- The inflation rate rose to 5.4% in September 2021, as reported by the Federal Reserve.
- The effective federal funds rate (EFFR) currently stands at 0.08%.
- Overnight reverse repossession agreements have stagnated near $1.5 trillion.
- Average 20-year seasoned corporate bond yields fell to 3.23% in September 2021.
Cracks begin to show
Amid the coronavirus pandemic, both the real estate market and the stock market exhibited record gains. The low interest rate environment has diverted capital flows to equities and real estate rather than bonds and other illiquid debt instruments, supercharging prices and returns in those markets. However, due to the rapid increase in the money supply in response to the pandemic-induced recession, further compounded by bottlenecked supply chains, inflation has been creeping upward in 2021. The current dynamic of low interest rates and high inflation is a big problem for the financial economy.
Due to inflation, bonds exhibit asset decay, a process by which inflation outpaces the average returns on bonds. In effect, the dollars used to pay the bond back are weaker than the initial dollars used to purchase the bond. Thus, investors have been flocking to risker bonds in droves. Collateralized loan obligations exhibited the highest return in 2021, at 29.0% in August, outpacing the S&P500 during the same period.
Passing the buck
Mounting uncertainty risk, combined with inflation and low returns on bonds, has caused the value of overnight reverse repossession agreements to rise sharply beginning in April 2021. Reverse repossession markets act similar to a pawnshop, but instead of trading goods for cash, financial instructions can trade the Federal Reserve cash for overnight Treasury bills. However, the current yield on overnight treasuries is less than 0.1%.
So, why are financial institutions bothering with such minuscule returns on overnight Treasury bills when all but the riskiest bonds are not keeping up with inflation? Simply put, they are waiting for an interest rate hike. Rising interest rates set by the Federal Reserve will likely trickle down and boost returns on fixed debt instruments. Concurrently, capital will likely be drawn away from equities markets to the more lucrative bond market.
Take your medicine
An increase in the federal funds rate is likely impending. It is necessary to prevent the economy from overheating in the post-pandemic expansion environment, and thus, raising interest rates to precipitate slow economic recovery. By reducing the money supply by funneling liquid cash into fixed debt instruments, the United States should begin to see a deceleration in inflation. However, this begs the question, if not now, when?
