Page 1 of 5 THE FOLLY OF INTERVENTION, Part 1 The zero interest rate trap
By Henry C K Liu
John Maynard Keynes formulated the phenomenon of absolute cash preference in a
distressed market as a liquidity trap that can neutralize the stimulative
effect of quantitative easing (increasing the money supply by changing the
quantity of bank reserves) by the central bank.
Japan's two-decade-long recession is a manifestation of a zero interest rate
trap that can also neutralize the stimulative effect of credit easing (lowering
the cost of credit) by the central bank.
Federal Reserve board chairman Ben Bernanke, in the Stamp Lecture at London
School of Economics, London, England on
January 13 this year, defined the difference between quantitative easing and
credit easing as follows:
The Federal Reserve's approach to supporting
credit markets is conceptually distinct from quantitative easing (QE), the
policy approach used by the Bank of Japan from 2001 to 2006. Our approach -
which could be described as "credit easing" - resembles quantitative easing in
one respect: It involves an expansion of the central bank's balance sheet.
However, in a pure QE regime, the focus of policy is the quantity of bank
reserves, which are liabilities of the central bank; the composition of loans
and securities on the asset side of the central bank's balance sheet is
incidental. Indeed, although the Bank of Japan's policy approach during the QE
period was quite multifaceted, the overall stance of its policy was gauged
primarily in terms of its target for bank reserves. In contrast, the Federal
Reserve's credit easing approach focuses on the mix of loans and securities
that it holds and on how this composition of assets affects credit conditions
for households and businesses.
Each in separate ways, the
liquidity and the zero interest rate traps together demonstrate the futility of
macroeconomic attempts to use both quantitative and credit easing by the
central bank to stimulate an economy contracting from excessive debt and
A liquidity trap can be formed when holders of cash seek safe haven from risk
in a distressed market. They rush to park cash in risk-free financial
instruments until the market stabilizes, causing short-term interest rates on
top-rated fixed-income investments to fall from market forces of supply and
demand. A low short-term rate in such a situation is the result and not the
cause of a slowing economy. Under such conditions, central bank lowering of
federal funds rate targets below that set by market forces can have the effect
of pushing investors towards higher risk in search of better returns in a
risk-averse market in which good investment opportunities are in short supply.
Since central bank power to set interest rates is unevenly concentrated on the
short term, a liquidity trap distorts the term structure of interest rates
which defines the expanding spread between short-term and longer-term interest
rates. This is because the Federal Reserve's influence on the much larger
outstanding long-term credit market is less direct than the short-term credit
market, where the central bank has complete control for rates for loans of
Yet the Federal Reserve is institutionally focused more on the long-term health
of the monetary system as compared to the Treasury, which is institutionally
more concerned with the short-term health of the financial sector. Thus to
achieve the Federal Reserves' long-term goal for the monetary system, a stable
interest rate regime is ideal. Milton Friedman and other monetarist have long
agreed on 3% as the most effective interest rate with up to 6% structural
unemployment for avoiding wide price volatility and destructive business
The "risk structure" of interest rates defines the rising risk premium for a
declining scale of credit ratings. Risk premium is defined as the difference
between the rate of return on risk-free government securities and other
financial instrument of higher risk. The higher the risk, the larger is the
compensatory risk premium. The risk premium, which is calculated from both
historical data and forward-looking estimates, adjusts the required risk/reward
ratio for investments of different risk exposures.
On January 6, 2009, the yield on one-month Treasuries was near zero while a
year earlier it was 3.2%. In one year, the Fed cut the short-term rate by
nearly 320 basis points to stimulate the slowing economy. Again on January 6,
the yield on 10-year Treasuries was 2.5%, while 12 months earlier it was 3.8%.
In one year, the long-term rate fell only 130 basis points from market forces,
less than half of the short-term rate cut of 320 basis points by the Fed.
On January 6, the term structure between federal funds and 10-year Treasury
rates was 250 basis points. A year earlier the term structure was only 60 basis
points. The Fed had pushed the short-term rate down further (by 190 basis
points) than the fall of the long-term rate from market forces, widening the
normal term structure of interest rates by 2.5 times. This means significant
future inflation was being seeded.
In the 16th century, Chinese rice traders observed the intricate relationships
between opening, high, low and closing market prices and represented them
graphically using vertical bars which came to be known nowadays on Wall Street
as Japanese candlesticks because Japanese traders learned it from their Chinese
counterparts and Western traders later learned the technique from Japan during
the Meiji reform era of 1868-1912.
Today, candlestick traders look for recognizable patterns with repeating
"highs" as good probabilities for profitable trades. They do this by
determining entry and exit points to meet profit targets and stop loss targets.
These trading points can be located by looking at historical moving averages,
Bollinger bands, or other technical indicators to evaluate probable support and
In the 1980s, John Bollinger developed the Bollinger Bands as a technical
analysis tool from the concept of trading bands. Bollinger Bands can be used to
provide a relative definition of high and low and to measure the highness or
lowness of a price relative to previous trades. By definition, prices are high
at the upper band and low at the lower band. This definition can enhance rigor
in pattern recognition and is useful in comparing price action to indicator
movements to arrive at disciplined trading decisions.
Some stock traders seek profit by buying when price touches the lower Bollinger
Band and selling when price touches the moving average in the center of the
bands. Other traders buy when the price breaks above the upper Bollinger Band
and sell when the price falls below the lower Bollinger Band. Options traders,
most notably implied volatility traders, often sell options when Bollinger
Bands are far apart by historical standards, and buy options when the Bollinger
Bands are close together, expecting volatility to revert back towards the
average historical volatility level. When the bands lie close together, a
period of low volatility in stock price is indicated; and when far apart, a
period of high volatility in price is indicated. When the bands have only a
slight slope and lie approximately parallel for an extended time, the price of
a stock will be found to oscillate up and down between the bands as though in a
As an illustration, a stock with a per share entry price of $20.35 can be
assigned by the trader a profit target of $21.35 and a stop loss target of
$19.85. The risk of loss is $20.35 minus $19.85, or $0.50. The reward is $21.35
minus $20.35, or $1. The trade is risking 50 cents to make $1, with a
risk/reward ratio of 1:2. The return on capital of $20.35 is around 20:1, or 5%
for the open duration of the trade, which could be minutes, hours, days or
months. If the trade is closed out by the stop loss target, the return on
capital is negative 40:1, or -2.5%. Trading and financing cost has not been
included in the calculations. A long open period will reduce the positive
return on capital as financing cost rises over time.
It is necessary to bear in mind that rational quantitative trading models,
while giving an unemotional framework for decision making, are not guarantees
for achieving targets. Models are by definitions abstractions of reality, which
is infinitely more complex. One can fail rationally as well as intuitively.
Often, rationality can prolong the denial phase unconstructively even when
intuition suggests something is wrong.
There is another problem of modeling reality. Most model builders assume
reality to be rational and orderly. In fact, life is full of misinformation,
disinformation, errors of judgment, miscalculations, communication breakdowns,
ill will, legalized fraud, unwarranted optimism, prematurely throwing in the
towel, and so forth. One view of the business world is that it is a snake pit.
Very few economic models reflect that perspective.
The risk-reward ratio provides a non-intuitive quantitative evaluation of risk
decisions. It does not say anything about the qualitative evaluation of the
decision, which is the surmised probability of achieving the profit target,
which when missed, will produce a loss of $0.50 per share plus transaction and
financing cost. Price reward ratios are merely quantitative justification for
taking manageable risk. High risk only means high probability of loss but it is
not synonymous with certainty of loss.
Good management of risk must include a probability/impact ratio. A low
probability event with high impact is more dangerous or profitable than a high
probability event with low impact, which may fall into the "not worth the
bother" category unless it can be exploited in large volume with high leverage.
The net capital rule created by the SEC in 1975 required broker-dealers to
limit their debt-to-net-capital ratio to 12-to-1. After the rule was exempted
in 2004 for five big firms, many hedge funds increased their leverage to
40-to-1 to maximize profit by enlarging the risk profile.
Both risk and profit magnified by leverage The five big investment
banking firms wanted for their brokerage units an exemption from the 1975
regulation that had limited the amount of debt they could take on to $12 for
every dollar of equity. The debt-to-net-capital ratio exemption would unshackle
billions of dollars held in reserve as a cushion against potential losses on
their investments and trades. The released equity funds from higher leverage
could then flow up to the parent company, enabling it to speculate in the fast
growing but opaque world of mortgage-backed securities, credit derivatives, and
credit default swaps (a form of insurance for bond holders), and other exotic
structured finance instruments.
In 2004, the European Union, responding to financial globalization and to
attract profitable finance operations to financial centers in