This page has been archived and commenting is disabled.
Global Deflation & Credit Spreads
Here is our latest macro note. The results of the FOMC meeting confirm that most of the media and investor communities don't get the joke on Fed policy since the crisis. The narrative is about jobs and inflation, but the actions are all about spreads. This is a no-win scenario for Chair Yellen, thus no action. Our guess is no change in rates this year. Link is on the bottom if you want to see the footnotes or the chart. Best, Chris
"Turn him to any cause of policy,
The Gordian Knot of it he will unloose,
Familiar as his garter"
(Shakespeare, Henry V, Act 1 Scene 1. 45–47)
Discussion
The debate among investors as to when and how much the Federal Open Market Committee (FOMC) will raise short-term interest rates is following a familiar pattern seen over the past several years. At first, a number of analysts predicted that the FOMC would raise rates in the first quarter of the year, this optimistic view based on the promise of an economic “lift off.” With a number of disappointing economic statistics and the end of the first month of Q2, the analyst community is quickly retreating, revising estimates of when a rake hike will occur into the second half of 2015 and beyond.
Kroll Bond Rating Agency (KBRA) believes that the FOMC is facing an impossible and increasingly untenable situation. On the one hand, economic indicators such as employment, inflation, GDP and particularly credit demand do not justify an interest rate increase. Based upon the indicators publicly identified by Chair Janet Yellen and other committee members, the U.S. economy is not yet close to a lift off.
On the other hand, the U.S. central bank must soon allow rates to rise to restore market function and avoid further damage to investors, financial institutions and the economy as a whole. As we have noted in previous comments, the wasting effect of low interest rates and the burden of uncollectible debt are depriving the global economy of trillions of dollars in income annually.
We believe that the decrease in income for savers and investors that is part of the FOMC policy mix is making it increasingly difficult to achieve the committee’s stated job and inflation targets and is, in fact, driving global deflation. The FOMC has been able to successfully stave off a liquidity crisis and also manipulate asset prices for equities, debt and other asset classes, yet there has not been a commensurate increase in personal or aggregate income. KBRA believes that the Fed and other agencies in Washington must now shift focus from ensuring market liquidity to increasing investment, and thereby income and growth.
Low Rates are Driving Deflation
As illustrated in the chart that follows, the Federal Funds rate was close to zero from 2001 through 2004. The FOMC then increased short-term rates as the mortgage market peaked at the end of that year, but was forced to again reduce rates down to present levels as the 2008 crisis exploded, sending credit spreads soaring as market liquidity disappeared.
During that terrible year, credit spreads exploded to crisis levels, with the high-yield minus investment grade spread over 1,500 basis points (bps). When this indicator exceeds 500 bps, this indicates that financial intermediation has broken down and the economy is destroying value. The low rate policy put back into place by former Fed Chairman Benjamin Bernanke in 2008 was meant to counteract the negative effects of the financial crisis by focusing on reducing credit spreads.
Thanks to Chairman Bernanke’s genius in understanding the significance of credit spreads in a deflationary environment, low interest rates were used successfully to address the run on liquidity that followed. In his 1983 analysis of the cost of credit intermediation (CCI), Bernanke noted that a rise of CCI from 250 bps to 800 bps, between 1929 and 1932, explained all the damage done during the Great Depression. He also observed that the less than 200 bp rise caused the recession of 1920-22 which preceded the Crash of 1929.
The media and the FOMC both have adopted a public narrative that describes the Fed’s low interest rate policies as being focused on creating jobs and increasing inflation. In fact, what the FOMC has primarily achieved is the lowering of credit spreads. Low interest rates and credit spreads by themselves, however, are not sufficient to restore economic health and have also led to the creation of new asset bubbles. Although low interest rates did stave off calamity in 2008 and thereafter, the diminution of income for consumers and investors alike is retarding economic growth and job creation, and is arguably driving down demand for globally traded commodities.
Seen in a realistic light, the Fed’s low rate policy has merely been a palliative remedy for addressing the alarming level of public and private debt accumulated over the past decade and more, but is now hurting growth. Michael Lewitt, publisher of The Credit Strategist, states the case succinctly:
“It is becoming increasingly clear to me that just like everyone was wrong about the effects of lower interest rates – they suppress growth not stimulate it – they are likely wrong about the impact of higher rates (modestly higher rates not radically higher rates) – they would promote economic growth by imposing more discipline and giving banks more incentive to lend. Basically consensus thinking is upside-down. Until it gets right side-up we are doomed to a bevy of serious problems.”
By subsidizing debtors at the expense of savers via low interest rates, the FOMC has put off the day of reckoning with respect to excessive debt, but has not solved the underlying problems of flat income and weak job creation that are the result of decades of debt fueled “growth” in the major industrial nations. Should credit spreads start to widen with even a modest change in Fed rate policy, the FOMC would be forced to quickly reverse course. This is a key reason, KBRA believes, that the FOMC has been so reluctant to actually make a change in policy.
Since 2008, the overall indebtedness of the industrialized world increased by $57 trillion, according to McKinsey & Co., encouraged by the low rate environment maintained by the Fed. McKinsey notes that this “raises the ratio of debt to GDP by 17 percentage points. That poses new risks to financial stability and may undermine global economic growth.” Even as markets have issued trillions of dollars’ worth of new public and private debt, financial institutions continue to see their income from earning assets decline. Industry leader BB&T (NYSE:BBT) is the latest major U.S. bank to report lower earnings due to the FOMC’s “rate squeeze.”
KBRA believes that investors and policy makers need to reconsider the basic assumptions driving U.S monetary policy and appreciate that low interest rates are part of the problem, not the solution, when it comes to avoiding deflation and restoring growth. We believe that the FOMC needs to embrace a shift in policy away from subsidizing debtors and toward restoring income for both consumers and investors. Such shift will necessarily require governments and policy makers to focus on resolving bad debts and slow the accumulation of new obligations that are not focused on investment.
Part of the solution to the global threat of deflation is to allow for a gradual and relatively modest increase in interest rates, starting with an immediate increase in the rate the Fed pays on bank reserves. By hiking the interest rate paid on bank reserves from 0.25% to 0.5%, the Fed will slow the deflationary wave now threatening U.S. financial institutions, pension funds and the global banking system as a whole.
This change will also reduce the regressive transfer of resources from the Fed to the U.S. Treasury. Instead of transferring to the Treasury the spread earned on bank reserves via FOMC investments in government debt and mortgage securities, the Fed should instead leave these earnings in the banking system. By enhancing the profitability of bank assets, the Fed will avoid the dangerous compression of bank interest margins.
Another part of the solution must come from fiscal authorities in the form of policies to encourage both private and public sector investment, and loosen laws and regulations that impede prudent credit creation. The political reaction to the 2008 credit bubble, an orgy of ill-considered risk taking that was fueled by the very same low interest rate polices of the FOMC, has been to constrain lending for legitimate risk taking in a way that harkens back to the 1930s. One of the great ironies that confront investors and policy makers, KBRA believes, is that prolonging low interest rates and increased regulation have combined to create the very deflationary environment that the FOMC has fought so valiantly to avoid.
KBRA believes that policy makers need to re-learn the key lessons of the 1930s and appreciate that simply lowering the cost of credit and boosting asset prices is not sufficient to address the damage done by the 2008 crisis. We must also boost income and cash flow to validate these enhanced asset prices, otherwise the efforts by the FOMC over the past five years have been for naught.
Chair Yellen and the other members of the FOMC need to address the need for a fiscal response in their public statements and make the case the U.S. central bank cannot alone fix the problem of uncollectible debt, mounting deflation, falling consumption and stagnant income. A combination of debt restructuring, increased public infrastructure spending and private tax initiatives are needed to complete the task.
In 1932, when John Maynard Keynes saw economies deflating with 0% government borrowing rates, his visceral reaction was that of any good real estate developer – borrow and build until the credit markets re-price the cost of the debt. Keynes told Congress and FDR that their responsibility in a zero-bound rate environment was to borrow and spend until investors caused them to change their priorities. There are many tens of billions of dollars’ worth of badly needed infrastructure projects in the U.S. and EU that could be easily justified at today’s interest rates.
You don’t need to be an advocate of deficit spending or big government to understand that financing valid infrastructure spending at 0% real interest rates is a good deal for investors and the national interest. Private corporations and financial institutions have already taken advantage of low interest rates to re-price long-term liabilities and reduce funding costs, but lower financing costs are not sufficient to ensure economic health if consumption and national income remains constrained.
Conclusion
Now seven years since the 2008 financial crisis, KBRA believes that it is clear the FOMC needs to end its extraordinary low interest rate policy and restore function to the private money markets. Just as the Federal Reserve System had to win back its independence from the Treasury at the end of WWII, today the U.S. bond market needs to again become independent of active Fed market manipulation. By ending its low interest rate policy, the Fed can make clear that the next step in the process of recovery must come from Congress in the form of policy changes to increase both private and public investment. For example:
* Restoring full funding for the federal Highway Trust Fund, which runs out of money by the end of Q2 2015
* Providing vehicles for the states to finance infrastructure spending
* Lowering or eliminating entirely corporate taxes
* Addressing the plight of the millions of Americans who are still underwater on their home mortgages, and
* Modify the bankruptcy laws to roll back many of the changes made in 2005 and, in particular, allow the holders of delinquent student debt to modify or discharge these obligations.
All of these changes, combined with a gradual and relatively modest increase in interest rates, could help turn the threatening tide of deflation that now threatens the global economy. But the first necessary step is for the Fed to end its extraordinary policy efforts and make clear to the White House and the members of both parties in Congress that it is time for them to get into the game.
»
- advertisements -
"increase public infrastructure spending"?
Brilliant whalen.
In case you haven't checked, we have a union problem when it comes to public infrastructure spending?
Oh yeah. AND CORRUPTION
"Thanks to Chairman Bernanke’s genius"
stopped reading at that point
It goes like this: gov continues to not use monies recieved for highway funds to fix bridges.... Which makes for righ ratings of the forth branch let it bleed branch along with the rest of the make room for disaster economy... So u can get more monies with more taxes which won't be used to fix shit either because there is nothing like slushie funds for a do nothing ambitious to get to 300-350 debt to GDP for more slushie do nothing funds to make sure no one else can get off their ass to fix messes filling slushie funds for gnashing teethers in this make room for disaster economy!
they wont raise rates.
they can not - while the debt will never be repaid, as a practical matter, US debt can not be hit with any kind of interest rate bump and sustain us .gov biz as usual.
The FRN is gliding to earth... gliding doesnt feel like crashing - until it does.
"Such shift will necessarily require governments and policy makers to focus on resolving bad debts and slow the accumulation of new obligations that are not focused on investment."
"Instead of transferring to the Treasury the spread earned on bank reserves via FOMC investments in government debt and mortgage securities, the Fed should instead leave these earnings in the banking system."
Not a chance of this happening. Almost comical to suggest it.
Take this Gordian knot and shove it!
Yea right fund the fed highway funds gov taxes us for on fuel and uses as their slush fund.... that will last a day! Once a tax not used for the purpose it was intended for always a slush fund.
This article is so left wing gov bullshit it isn't even funny.
The only good bankers are bankers in a democrats pocket.
It's all more gnashing teethies garbaldy gook!
"the U.S. central bank must soon allow rates to rise to restore market function and avoid further damage to investors, financial institutions and the economy as a whole."
Note that in the world of 'high finance' the average person is last on the list of who needs to be worried about. In their world, the fact that grandma and grandpa are now eating bugs off the floor in their rest home bathroom doesn't matter. Gotta have that extra zero on the end of my income statement!
In a nutshell - the fed screwed shit up for years, Greenspan really screwed things up with near zero interest rates, then all hell broke loose and the Bernank pulled his finger out of his ass, waved it in the air as though measuring something other than the stench on his finger, and declared that he needed to lower interest rates to zero to 'fix' everything. He then pressed the doomsday button with that stinky finger and held it down with typical financier fervor ...
What the fed has done for the last 8 years is steal the wealth of this nation, which is (was) mostly held by average, working people. There is almost a 1 to 1 relationship to the shit that the fed has inflicted upon us and the reduction in actual wealth in the nation. Here's a concise summary of Whalen's note:
The money people screwed stuff up bad and are now fixing it by stealing wealth from everybody else and that is causing the wealth of the nation to decrease (deflation) and that is causing more of the same problems, and ... oh shit, there's no way out! We're screwed.
There seems to be an assumption that the Natural Rate of Interest, i.e. where rates would be in the absence of central bank intervention, is and will remain at extremely low levels. I strongly disagree.
By flooding the capital markets with illusory capital that comes, not from real savings, but merely from a few computer keystrokes, central banks have artificially pushed down the cost of capital. That in turn discourages saving and encourages borrowing, both of which have the effect of pushing the cost of capital higher. In other words, the more that central banks push down the cost of capital, the greater become the forces of economic nature pushing in the opposite direction. As every schoolboy knows, for every actdion there is an equal and opposite reaction.
I wrote a long piece about this almost 7 years ago. For those who are interested in this stuff it might be worth a look.
http://parcontre.blogspot.com/2008/08/what-is-problem.html
Bingo. Debt is nothing but a claim on future productivy in a future that isn't yours in the first place.
As repeated many times on ZH, the Fed is playing a shell game of enriching their ilk while pretending to address inflation and employment. Did Bernanke take up farming ? Hell no. He is cuddled amongst those who were most enriched by his policies.
All debt/credit and money creation is a claim against current and future income. But real wealth- net income after taxes is on a long term decline as welfare on both ends of the income extreme, including the "government" share of GDP, suck the life out of the real private sector economy.
"Bernanke is a genius". Now that is one sick fucking joke.
"Global deflation"... LMFAO!! Has the real average cost of living globally decreased?
Yes, I can see it now, the relative few remaining humans that are unfortunate enough to survive will literaly be able to pick up whatever they can find and carry it back to their island tribe for free.
"Winning"...
Those preaching free shit for those who vote for me.....still want their (chains) taxes on all freedoms!
So if everything has a price cap on it at zero (for those who vote to enslave the rest as well as themselves) and one must pay the taxes of the almighty who deserve a buck for their lack of effort as chains upon another..... So we can all be forever indebted! Nothing like getting taxed higher than the price caps place upon the item... Call an imposed shortage or crisis for truths stated lies and visa versa..... for Hillary's happy farms of those crazy enough to dare speak truth to power.
"* Addressing the plight of the millions of Americans who are still underwater on their home mortgages, and
* Modify the bankruptcy laws to roll back many of the changes made in 2005 and, in particular, allow the holders of delinquent student debt to modify or discharge these obligations."
So if I saved, didn't take on an unreasonable amount of debt, paid all my bills on time, and generally try to live a prudent lifestyle, where's my bailout?
Yes, moral hazard is a real fucking bitch like that.
The FED works under the assumption that the mega-banks and the traders in the markets are the economy and avoid bringing the general population into the equation except as a footnote. Now they are starting to notice that pesky little things like trade by the normal people is no longer happening and their answer is to flog the proles until morale improves and the government inviting the bottom class of another country to come here and vacuum up resources that are increasingly scarce. It's suicide with an automatic pistol and a full magazine and "lord of the flies" is the likely outcome.....
The policy of the congress to authorize the 3rd national bank, The Federal Reserve, is the crisis. The crisis is not what happens because of the Fed's policies.
In other words,
Life is Beautiful. Acceptance of the Fed's Counterfeiting Policy is akin to the father in the movie amusing his son while surrounded by overlords and barbedwire. The father in this movie truly was stifled. Are we?this is their way of dealing with structural changes to the global economy (congress wont or cant because potus has too much power, and its essentially not potus job, though FDR thought it was his, and we got the new deal out of it - the next new deal could be far more reaching in terms of entitlements, FDR had little progress until W2 which provided the cover of deficits to raise government sponsored economic activity) ZIRP policy extended is stealth QE. what you want to watch is how far behind inflation the lagging interest rate rises are, that is the most important spread number, guessing maybe 50% at low nominal rates. 4% inflation 2% comparable rates, but once that nominal number goes higher all bets are off. at 10% inflation and 5% rates the anger in the investor community goes viral