Higher Interest Rates and Debt Reduction in 2016? Maybe...

Below is our latest macro note which looks at the conflicted policies being followed by the major central banks. Saying that Chair Yellen & Co are fighting the last war would be polite.  But a key point we need to talk about more in our next macro missive is this: How can a central banker reasonably set a 2% inflation target when the policies being followed are causing a debt-deflation? The whole concept of a 2% inflation target just illustrates that central bankers have no idea how their actions are affecting the financial markets. The boom and subsequent collapse of commodity markets was driven by a debt fueled bubble caused by the Fed and our friends in the Chinese Communist Party.  How is this helpful?

A safe & happy holiday to all.  We'll be celebrating with the people of Paris -- Chris

Review & Outlook: Higher Interest Rates and Debt Reduction in 2016?
Kroll Bond Rating Agency
December 9, 2015

When the European Central Bank (ECB) “only” pushed interest rates down to negative 0.3%, financial markets reacted negatively. Kroll Bond Rating Agency (KBRA) believes that the decision by the ECB not to wade even further into the swamp of negative interest rates was in fact good news for investors and markets. KBRA believes that investors and elected officials alike need to ask whether a continuation of the current economic policy mix is actually supporting the common objectives of job growth and rising incomes. 

As 2015 comes to an end, investors are faced with greater uncertainty than at any time since the 2008 financial crisis, especially when it comes to the impact of monetary policy on global markets and economies. The Federal Open Market Committee (FOMC) has maintained extremely low interest rates for more than a decade. The ECB, after first experimenting with punitive higher interest rates, has embraced the zero rate theology and has gone even further with explicitly negative interest rates. These policies subsidize debtors at the expense of savers, but seemingly have produced little benefit in terms of real growth as measured by jobs or income. Indeed, we believe that zero rates and market manipulation by the Fed have retarded economic growth and are accelerating the menacing deflationary forces visible in commodity markets and sagging GDP growth rates around the world.

In the U.S., growth has lagged and indebtedness has grown, this even as asset prices have soared in many sectors. The Bank for International Settlements (BIS) has warned for years that “unthinkably” low interest rates are fueling instability in global financial markets. As we noted in a previous KBRA comment, credit loss metrics in many asset classes in the U.S. banking sector are at or near zero, suggesting as in 2005 that credit has no cost.  Meanwhile, the U.S. banking industry has begun to rebuild reserves for future losses after seeing a trough in credit costs in 2013.

KBRA believes it’s important for investors to recognize the twin policies of low, or even negative interest rates and open market intervention (aka “quantitative easing” or “QE”), have not produced the promised results in terms of economic expansion. Moreover, these policies may be creating the conditions for the next financial crisis. KBRA views negative interest rates as a sign of policy failure rather than as a positive development. Negative interest rates penalize savers to the benefit of debtors, and lower potential growth by robbing the former group of disposable income. These policies also reduce the private pool of capital that is a necessary foundation for economic expansion. 

ECB President Mario Draghi told the Economic Club of New York in early December that the chance of deflation in Europe has subsided due to accommodative central bank policy, which could be adjusted "at any time" to meet goals. "Thanks to our monetary policy actions, the risk of deflation in the euro area is firmly off the table," he said in prepared remarks. But given the strong deflationary trends that are very visible in the global economy, we wonder if this statement is really true.

If ECB chief Draghi were to propose a negative interest rate of 25% or even 50%, investors and markets would presumably object. Yet somehow slowly confiscating the savings of individual and corporate savers to subsidize debtors is seen as acceptable and even beneficial to the global economy. We think it is fair to ask Draghi and other advocates of current monetary policy: If the income of savers and the overall stock of capital in the private sector is shrinking due to negative interest rates, how does this fight deflation or support growth in income or jobs? 

KBRA believes that the reluctance of the ECB to experiment more aggressively with negative rates is a positive development for investors and illustrates the mounting concerns with the current policy mix. As the Bank Credit Analyst notes: “The benefits of the ECB’s extraordinary easing are rapidly diminishing, while the risks are increasing.” Former Treasury Secretary Lawrence Summers puts the situation into sharp relief in a comment in the Financial Times:

“Central bankers bravely assert that they can always use unconventional tools. But there may be less in the cupboard than they suppose. The efficacy of further quantitative easing in an environment of well-functioning markets and already very low medium-term rates is highly questionable. There are severe limits on how negative rates can become. A central bank forced back to the zero lower bound is not likely to have great credibility if it engages in forward guidance.”

In reality, the twin policies of zero interest rates and market intervention being followed by the Fed, ECB and other major central banks in the industrialized nations are designed to manage and increasingly unmanageable situation with respect to global indebtedness. In view of the increase in debt and the rate of growth in asset prices, KBRA believes that the prolonged experiment by global central banks with zero rates and market intervention needs to come to an end as soon as possible. 

KBRA also notes that the fixation of central banks with inflation, at least insofar as it is defined by conventional statistical measures, is another aspect of a systemic failure of policy that needs to be reconsidered. While the heavily manipulated government inflation statistics that are used as a benchmark for monetary policy may suggest that inflation is low, other measures such as prices for financial assets and real property are galloping along at growth rates an order or magnitude above visible GDP growth levels. KBRA respectfully suggests to members of the FOMC, that when asset price inflation is considered, inflation targets cited in the “data dependent” policy guidance were in fact achieved years ago.

Outlook 2016: Rising Rates and Debt Restructuring

Looking forward to 2016, it is clear that the intended focus of policy by the FOMC is going to be to move away from zero rates via mechanisms such as repurchase agreements. There is an important video produced by the Federal Reserve Bank of Chicago, “Economic Perspectives: The Overnight Money Market,” which talks about the workings of the overnight funds market, particularly as it exists since the 2008 crisis. At the end of the video, the form of the next round of Fed market manipulation, reverse repurchase agreements or REPOs, is discussed.  

The FOMC is preparing to use higher rates for bank reserves and reverse REPO transactions in an attempt to raise interest rates, but we continue to be skeptical that such a policy prescription is likely to be effective. Simply stated, there is so much liquidity chasing short-term, risk-free assets that we do not believe that the FOMC will be able to raise and maintain higher short-term interest rates in the cash market for U.S. Treasury and agency securities. 

Demand for credit remains anemic and income levels are flat, suggesting that elevated asset prices are not supported by a commensurate increase in aggregate income. Any significant change in the cost of credit is likely to result in deflation of asset bubbles ranging from stocks to commodities to real estate to fine art, yet the FOMC arguably has no choice but to slowly let the air out of the proverbial credit balloon.

We believe that the policy reaction to the 2008 financial crisis is now starting to shift away from an overt effort to subsidize debtors and towards a more balanced approach, where debt restructuring and resolution will become more important goals for policy makers. As we previously noted, the core economic problem confronting the industrial nations is excessive debt. So far, the focus of central bank policy globally has been to avoid the forced liquidation of debt. The only way to restore some measure of growth and positive momentum to the global economy is to deal with the issue of uncollectible debt, yet policy makers remain reluctant to attack this problem because of the painful political choices involved.

For example, Italy is now moving in the direction of setting up a state-sponsored “bad bank” to absorb some of the €300 billion in bad debts that remain on the books of Italian financial institutions. Italy’s “bad bank” proposal has been blocked for years by the European Commission, which considers any governmental involvement in the resolution of bad bank loans as possible state aid. Yet the fact remains that Italian banks are crippled by non-performing assets, making it impossible for them to support existing economic activity much less an expansion. Since 2010, Italian banks has disposed of less than 5% of bad loans, a stark illustration of how much work remains to be done in the EU to recover from the credit boom of the 2000s.

In the U.S., American financial institutions are preparing for an increase in credit costs in a number of sectors, including leveraged loans and especially in the commodity sector. Credits related to oil production and exploration are under particular stress with oil prices hoovering near $40 per barrel. Sectors such as coal, copper and iron ore are also under pressure due to depressed prices. KBRA is also concerned by the degree of competition for assets among global banks and how this intense competitive environment has compressed loan spreads. Simply observing the rate of growth in commercial & industrial loans by U.S. banks, for example, strongly suggests that U.S. banks face future credit problems as interest rates return to levels that could be described as normal. 

One of the striking aspects of the years since the 2008 financial crisis is the degree to which investors and policy makers alike continue to see the present and future in lenses colored by past events. The FOMC’s search for pre-crisis levels of employment, inflation and consumer activity has been thwarted by the fact that many of the data relationships used by policy makers to describe their actions prior to 2008 have broken down. We believe that members of the Fed, ECB and other central banks need to consider that many of the indicators we use to understand economics are not only in flux, but are also effected by other factors. As the great economist Irving Fisher wrote in “The Debt Deflation Theory of Great Depressions” (1933):

“The old and apparently still persistent notion of ‘the’ business cycle, as a single, simple, self-generating cycle (analogous to that of a pendulum swinging under influence of the single force of gravity) and as actually realized historically in regularly recurring crises, is a myth. Instead of one force there are many forces. Specifically, instead of one cycle, there are many co-existing cycles, constantly aggravating or neutralizing each other, as well as co-existing with many non-cyclical forces. In other words, while a cycle, conceived as a fact, or historical event, is non-existent, there are always innumerable cycles, long and short, big and little, conceived as tendencies (as well as numerous noncyclical tendencies), any historical event being the resultant of all the tendencies then at work. Any one cycle, however perfect and like a sine curve it may tend to be, is sure to be interfered with by other tendencies.”

We can all be sure that our colleagues on the FOMC are telling the truth when they say that their decisions are “data dependent,” but we can also be sure that most of the data points which they are using for policy decisions are sending conflicting signals. The one thing we can be sure of, however, is that since 2008 the industrialized world has refused to deal with the problem of bad debt and has only added to the predicament to the tune of tens of trillions of dollars in new obligations. If the FOMC is truly committed to raising interest rates above the zero bound, then elected officials and other policy makers finally will need to prepare to deal with the tough work of debt restructuring in 2016 and beyond.