I'm Jason Stipp for Morningstar. Eric Jacobson, our director of fixed-income research, recently visited the offices of TCW-Met West and sat down with Tad Rivelle, a founding partner and chief investment officer of Metropolitan West, to discuss the credit markets, the macroeconomic situation, and some of the issues that are on investors' minds.
Eric Jacobson: So, Tad, thank you very much for joining us this morning.
Tad Rivelle: Thank you. It's good to be here.
Jacobson: So, Tad, if you would, give us a sense of what your current thinking is on the macroeconomic situation and Fed policy?
Rivelle: Well, indeed, the whole macro situation, I think, can only be understood through the lens of understanding what the policy responses, which have been draconian in the post-2008 world. The Federal Reserve, of course, has intervened in the market in a number of different fundamental ways. Two of the more visible ones--and two that I think are very significant to investors and I think investors need to understand them--is the zero rate policy that currently underpins much of the pricing in the capital markets, particularly in the bond market, as well as the quantitative easing practices.
The zero rate policy to a very large degree effectively provides financial intermediaries, banks and so forth, the ability to draw on their line of credit, in effect, with the Federal Reserve and finance the ownership of securities that might not otherwise be justified. And one quick example of that is, short two-year Treasury maturity instruments have yielded anywhere between 50 basis points at a low maybe last fall, to maybe 75 basis points, that's three quarters of 1%.
It's less than the rate of inflation and would not, in and of itself, appear to make any sense. It does make sense I think to the financial intermediary that gets to finance the three quarters of a percent asset with the zero percent loan. So it's one example of the many factors, and the way we would characterize it, really economic distortions, that have entered into pricing of bonds in general, and in this case, Treasuries in particular.
Jacobson: So what is the implication for that, in your mind, in terms of where we stand on inflation and the future direction of, shall we just say, interest rate in bond markets?
Rivelle: Well there are many of course, but one of the most direct things, I think, to consider as an investor or as a pundit, is to recognize that first of all, the rate level that exists in Treasuries is in all probability significantly lower than it would be without the zero rate financing. Because of this, in effect, there is the ability for many other borrowers, because many borrowers and corporations and even mortgages to a large degree, are benchmarked against existing Treasury rates, that in effect corporations get to borrow at a spread to Treasuries.
So, if the Treasury level is unduly low, it suggests that the borrowing rates that are available to many other actors in society are also distortedly low or unduly low. What this ultimately amounts to is that there is a subsidized flow of capital that is having a long-term inflationary consequence for the economy. Our take on and our belief is that in order to achieve a clear exit from the economic weakness and the problems that came up in 2008 and 2009, the Federal Reserve is doing this in a very deliberate manner. They are in effect engaged in a practice of holding down market rates not just for the U.S. government, but for many other actors as well. The longer that they hold these rates down, the longer the likely upward consequences are going to be for inflation.
Jacobson: And that's another way of saying, if I understand it correctly, in your opinion, that they are in effect holding rates down longer than they probably would need to in order to make sure that by the time they do go about the practice of raising them back up, we're going to be absolutely certain that we are out of the woods in terms of an economic recovery. And if that's the case--and forgive me for putting words in your mouth--but, that they are running the risk of overshooting.
Rivelle: No, I think that's absolutely right. Everyone knows, of course, that markets are forward-looking, and the Fed knows that markets are forward-looking, and so to a certain degree, even if there's a certain amount of economic strength that is coming back into the economy--and it certainly appears that way; there are a number of indicators and signs that the economy is gradually beginning to claw its way out of the doldrums that it found itself in--but the Fed's problem is a little bit broader than that, which is that they need to consider what the impact would be on interest rates generally when they signal or announce the end of a zero rate policy regime. They recognize, I believe and as do we, that the likelihood is that we are going to see a rather extreme, very significant rise in interest rates in the Treasury market, particularly at the short end, and it will probably or perhaps be somewhat reminiscent of what investors saw in 1994 when the Fed abandoned what was then considered a low rate policy at a 3% rate environment. But once we move from 3% to 3.25% on a short rate environment, it very quickly turned into a pandemonium, a market panic, because markets were clever enough to realize that we are not going from 3% to 3.25% in 1994, and indeed we ended up at 6% when it was all said and done 12 or 13 months later.
I believe the expectation is the same today, and the Fed knows it. As we move from zero rates, this is not a case of moving from 0% to 0.5% or to 1%--we're ultimately going to have to normalize rates in a hurry. So, the Fed has to be clear that as the rate environment normalizes itself, that the U.S. economy in effect will be able to withstand the restraining impact of higher interest rates on the overall economy.
And so, as you say, perhaps the Fed needs to overstay its welcome in real time in order to be able to withstand the pro forma rise in rates that will occur the moment that we do exit.