The Federal Reserve always knew its unprecedented campaign to boost employment could have unsavory side effects. As that campaign comes to an end, those side effects are making themselves felt.
Seven years of near-zero interest rates caused investors to pour money into corporate debt, emerging-market bonds and commercial real estate, all in search of higher returns. Now that money has started to leave, borrowing costs are climbing, and markets have turned treacherous.
The big question is whether this is a transitory disruption, of consequence mostly to Wall Street, or the tip of a more dangerous iceberg.
Right now, the odds are it’s transitory. But history counsels caution: The scale and nature of the distortions brought on by easy monetary policy can take time to show up.
Historically, inflation was the risk the Fed worried about when it held interest rates low. This time, the Fed would actually welcome a rise in inflation, which has consistently undershot its 2% target. Its greater concern in recent years has been that low interest rates would fuel unsustainable asset bubbles. It has concluded that the boost to employment it achieved with easy policy now would outweigh the potential harm of a bursting bubble later.
It’s a calculated bet. The harm from financial disruptions is much less predictable than from inflation, because it involves linkages that are apparent only under stress.
Janet Yellen, the Fed’s chairwoman, is sanguine. Despite the recent bond market turmoil, financial conditions are “supportive” of growth she told reporters Wednesday.
Two precedents offer lessons. In early 1994, the Fed began to raise interest rates after holding them at 3% for more than a year. That soon triggered a big selloff in the bond market that bloodied Wall Street and, by year-end, bankrupted Orange County in California. Yet the broader economy barely noticed.
In 2004, the Fed began to raise interest rates after holding them at 1% for a year. Three years later, the subprime mortgage crisis began, and the economy tumbled into its worst recession since the 1930s.
Both times, the Fed was only one of many factors at work. The 1994 selloff was compounded by a surge in Japanese bond yields and U.S. mortgage hedging that amplified the Fed’s effect on Treasury bonds. In the 2000s, foreign savings, in particular from China, flooded into the U.S., holding down interest rates. The force of lower rates touched off a home-price bubble. Wall Street engineers then went to work making subprime mortgages to ever-riskier borrowers seem safe. The economic consequences didn’t show up until 2007, when the Fed had already finished tightening.
This time, not only is the Fed tightening, but a slowing Chinese economy and unrestrained oil production from the Organization of Petroleum Exporting Countries have also sent commodity prices plunging, hammering emerging economies and U.S. companies that borrowed heavily to pump oil from shale rock in the U.S. No one knows how these factors may interact with whatever imbalances have accumulated over seven years of near-zero rates.
“You can never say a bubble or a mania has a single cause,” says Jim Bianco of Bianco Research, a 30-year veteran of Wall Street’s booms and busts. “But one common theme is a green light for risk taking, and one way you get that green light is the central bank giving you ultra cheap money and encouraging you to do something with it.”
The Fed lowers rates to encourage borrowing and, in turn, to boost employment and prices. But it has little say in who borrows. The flow of credit to less-creditworthy home buyers and small businesses has been hampered by weak demand, increased caution by banks, and new regulations.
By contrast, a gusher of credit has flowed to companies in the U.S. and in emerging markets. Banks’ loans to leveraged companies have been pooled into “collateralized loan obligations.” A large chunk of the leveraged loans held in CLOs are rated just above CCC, at which companies are considered vulnerable to default. If even a fraction is downgraded, the CLOs’ demand for new loans will contract sharply, a report by Ellington Management Group, a hedge-fund manager, recently warned. “Access to credit for weaker companies would be significantly diminished,” says Rob Kinderman of Ellington.
Between 2009 and 2014 investors poured $973 billion into corporate bond mutual funds and $219 billion into exchange-traded funds that hold corporate debt, according to Thomson Reuters Lipper. Some of those flows are now reversing.
Companies have for the most part used the money not to expand their business operations, but to buy one another and their own stock. This year alone, U.S. companies have borrowed $327 billion to finance mergers and acquisitions, according to Thomson Reuters, more than double the previous full-year high in 2012. Business debt now equals 70% of annual gross domestic product, surpassing its pre-recession peak.
This alarms regulators. The Treasury, in its annual financial-stability report released Dec. 15, warned higher rates and widening spreads between corporate and Treasury rates “may create refinancing risks, expose weaknesses in heavily leveraged entities, and potentially precipitate a broader default cycle.” The extent of borrowing since the crisis means “even a modest default rate could lead to larger absolute losses than in previous default cycles.”
Leverage is often fueled by savers’ confidence that their money is safe. A decade ago, they thought triple-A rated securities and secured, overnight “repo” loans would never default, and shares in money market mutual funds would always be worth one dollar. In fact, many of the securities defaulted, there was a run on the repo loans, and a money fund “broke the buck.”
This time, the illusion has been fed by promises from mutual funds and exchange-traded funds that investors can redeem their shares daily or during the day at close to the funds’ underlying value. But those funds hold bonds that are increasingly difficult to trade as dealers become less willing to take such bonds onto their books.
Low rates have had an even bigger impact in emerging markets than the U.S.; their companies have racked up $3.4 trillion of U.S. dollar-denominated debt, more than double the pre-crisis level, according to the Bank for International Settlements. As those countries’ currencies fall, those debts become harder to repay.
These warning signs need to be taken in context. Most violent market gyrations don’t lead to crises. The global financial crisis reflected a rare confluence of factors: not just low rates and financial engineering but also weak regulation and highly leveraged financial institutions. Banks today have much more capital, fickle short-term borrowing is less prevalent and regulators are more vigilant—arguably too vigilant in some cases.
“We have a far more resilient financial system now than we had prior to the financial crisis,” Ms. Yellen said Wednesday. Many companies, she added, have reduced their debt payments and reduced their reliance on short-term debt.
Even if the flow of credit to companies were to abruptly dry up, that may not have much economic fallout. A decade ago mortgage credit financed home buying and a lot of spending elsewhere. By contrast, corporate debt has fueled mergers and share buybacks. A shutoff of credit might thus endanger share prices, which are already relatively richly valued, but not necessarily investment, or the economy.
Moreover, the more stressed the markets become, the more reluctant the Fed will be to raise rates further. Whether it will ultimately regret waiting so long to tighten—or tightening at all—won’t be known until it’s too late.
Write to Greg Ip at greg.ip@wsj.com
http://www.wsj.com/articles/where-the-fed-goes-next-on-interest-rates-1450299396
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