The drugs don’t work any more
James Saft is a Reuters columnist. The opinions expressed are his own.
On one point departing Kansas City Fed President Thomas Hoenig and the high-yield bond market agree: current monetary policy is not helping.
Bonds issued to highly indebted and riskier companies have suffered since the Federal Reserve last Wednesday introduced “Operation Twist,” its attempt to suppress longer-term rates and goose investment and speculation.
This should come as little surprise to Hoenig, who retires from the KC Fed on Oct. 1 after a long career as a central banker and banking supervisor, and who has decried the way monetary policy has encouraged the running up of debts.
“When you encourage consumption by inhibiting your interest rates from rising to their equilibrium level, you will in fact buy problems, and we have in fact bought problems,” Hoenig said on Wednesday in his farewell speech.
The cost of the debts, a drug that isn’t working any more, is becoming clear; from the utterly indifferent reaction in key markets to Fed policy initiatives and from the very poor performance of the economy since the bubble burst.
Hoenig predicts long-term U.S. GDP growth to average around 2.5 percent a year, down from the 3 percent plus the U.S. has enjoyed over the last quarter century. That may sound a slight difference, but if his prediction comes true it will have profound effects. For one thing the same low growth that has been caused by the amassing of debts will make those very debts harder to repay.
Considering that real wages for American workers have been essentially flat for the past 40 years, despite growth in the economy, it is hard to see strong gains in a more growth-starved environment. Something will have to give and neither will be good for risk assets; either the consumer economy suffers or workers will command a bigger slice of the corporate pie, thereby hitting profits and valuations.
The Fed’s new policy slate, under which it will sell shorter-dated Treasuries and buy longer ones as well as additional mortgage bonds, has so far had a decidedly mixed record. While 30-year mortgage rates are lower than they were a week ago, they’ve risen in recent days. That’s partly driven by bets that Europe will contain its financial crisis, but also a lesson in the limits of monetary policy.
The move higher in yields of bonds of sub-investment grade companies is striking. Investors are now getting 8.00 percentage points more than government debt to own high-yield bonds, according to a Bank of America Merrill Lynch index, up 0.40 percentage point since just before the policy was announced. That’s the highest they have been since October 2009.
That’s telling you that investors are worried about growth, worried about whether money will be there for debt refinancings and worried about market stability.
As analysts Bespoke Investment Group point out, high-yield spreads began to perform poorly in early August, just after the budget scare and Standard & Poor’s cut the U.S.’s long-term rating. This too fits in with Hoenig’s thesis, both about the impact of debt on growth and the inability of the Fed to wave a magic wand over things. Investors in corporate debt are recognizing that government spending will drop, which will hurt corporate profits. The further out on a limb a company is — and the high-yield borrowers are out there, the bigger the chance one will take a tumble.
The loss of the AAA rating, which is the result not just of the size of the debt but of the dysfunctional U.S. political system, has made debt investors very nervous. Now that we live in a world where nothing is truly safe or risk-free, investors are, ironically, buying newly downgraded Treasuries in preference to corporate debt. If nothing is safe, better to hold what is relatively safer. That is having, and will have, a far more profound impact on economic conditions than the Fed’s new $400 billion program of bond reallocation.
It may be that Hoenig’s critique of Fed policy is better than his suggested alternative of raising rates, at least if this is done in isolation.
Albert Einstein is supposed to have said “We can’t solve problems by using the same kind of thinking we used when we created them.”
That is exactly what the Fed has done, and largely what is being done in Europe; seeking to ease debts through time, low rates and inflation rather than seeking to destroy them.
That’s not the job of a central bank, it is the job of a government. Destroying debts can also be done by markets; we’re seeing it in Greece and we will see it again.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)