It seems more likely to Morgan Stanley's Gerard Minack that central bankers may win the battle: sustaining recovery in developed economies with extraordinarily loose monetary policy. For a while this would go hand-in-hand with better equity performance. The battle is against a crisis caused by too loose monetary policy, elevated debt and mis-priced risk. Ironically, he notes, central bankers may overcome these problems by running even looser monetary policy, encouraging a new round of levering up, and fresh mis-pricing of risk. However, winning the battle isn't winning the war. If central bankers do win this round, the next downturn could be, in Minack's view, an omnishambles.
It has not been clear to me that central bankers could single-handedly sustain recovery. Fiscal stimulus helped recovery, but its withdrawal contributed to renewed recession in Europe and the UK. Markets now assume that fiscal tightening in the US will not end the same way that it did elsewhere. My economic colleagues also see better times ahead. In short, it may be that extraordinarily loose money policy will work.
This, on a medium-term view, worries me:
First, monetary policy will have succeeded, in part, by driving interest rates to all-time lows. It is not just policy rates at extreme lows: more importantly, the average effective rate paid on debt is exceptionally low. Exhibit 1 shows the average effective interest paid on the entire stock of (public and private) debt in the US.
Second, one measure of policy ‘success’ seems to be rising leverage. It is important to have a functioning credit system. But it’s not clear to me that it’s a good thing to have leverage rise. That is now happening in the US: aggregate non-financial debt/GDP increased in the December quarter, the first rise in four years. The US had been an exception for having seen any decline in leverage in this cycle. Aggregate (non-financial) leverage in the major developed economies is already at all-time highs (Exhibit 2).
Third, there are growing signs that risk is (again) being mis-priced. For example, high yield credit yields are now at all-time lows (Exhibit 3). If the central banks win the battle I suspect the mis-pricing of risk will become more widespread.
In short, it seems more likely that central bankers may add another leg to the credit super-cycle. The super-cycle was 30 years where total leverage ratcheted higher and interest rates ratcheted lower. There were shorter cycles in interest rates, but it was a sequence of lower lows and lower highs through the past 30 years. Exhibit 4 shows US Federal funds target rate.
The trend decline in policy rates led to a trend decline in sovereign borrowing costs (Exhibit 5 shows G7 long-end yields in real and nominal terms). The decline in risk-free rates has over time reduced the effective rate paid by other borrowers. Hence the decline in the average effective interest rate paid by all borrowers, shown in Exhibit 1 (which is for US debt).
The super-cycle will end when policy-makers exhaust their ability to provide cash-flow relief to under-pressure borrowers, ending the trend to rising leverage. I had thought that the crisis of 2008-09 would do this. I now think I may have been wrong. An important test in my view is that ability of the US to cope with fiscal tightening. If low rates and rising leverage offset fiscal tightening, then it seems a new credit leg will have started.
The downside is that in the next downturn – whenever it comes – central banks will find it even more difficult to provide cash-flow relief to borrowers. Borrowers, at that stage, will likely be even more leveraged than now (or in 2008 – financials probably will be exceptions) but paying an effective average interest rate significantly below the average in 2008.
The key question for investors in this scenario is when (and how) this cycle may end. In many respects, this would be a repeat of the TMT bubble aftermath. The question would be whether we are now 2003, with 3-4 good years to go, or 2006, with the cycle end not imminent but not that far over the horizon. I’m not sure: history tends to rhyme, not repeat (Exhibit 6). My hunch, however, is that this cycle is already closer to 2006 than 2003. I’ll explain in another note what I’m looking to as warning that another 2008 is possible.
Source: Morgan Stanley