miércoles, 13 de febrero de 2013

miércoles, febrero 13, 2013

A credit vigilante arrives at the Fed

February 10, 2013 4:31 pm

by Gavyn Davies
 
 


The speech, which is nicely summarised here by Matthew Klein at The Economist, deserves to be read in full by all market participants. (One member of the FOMC told me last week that the speech was “geeky”, but that was intended, and taken, as a high compliment!)


In summary, the speech argues that the credit markets have recently beenreaching for yield”, much as they did prior to the financial crash. Although not yet as dangerous as in the period from 2004-2007, this behaviour is shown by the rapid expansion of the junk bond market, flows into high-yield mutual funds and real estate investment trusts and the duration of bond portfolios held by banks.


Governor Stein suggests (hypothetically) that this may become a policy headache within 18 months and, in a break with the Bernanke/Greenspan doctrine, he indicates that the right weapon to deal with this might well be to raise interest rates, rather than relying solely on regulatory and other prudential policy to control the process. This would obviously come as a big surprise to the markets, which have tended to view the Fed’s stated concerns about the “costs of QE” as so much hot air.


It is clear that the economic staff at the Fed has been doing a great deal of empirical work in identifying financial market bubbles rather earlier than they have managed to do in the past.


The fruits of that work are shown in the empirical benchmarks introduced in the Stein speech. In the past, investors have tended to measure risk appetite by observing risk premia in bonds and equities, and especially credit spreads on corporate debt. These spreads have dropped sharply during the reach for yield in 2011-2012, but they have not yet dropped much below the average levels reached in the decade that preceded the crash, as the first graph shows. This is a common pattern among global credit spreads at present, and it also applies to equities as well.
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Why, then, is Governor Stein becoming concerned? One reason is that he is not just worried about spreads, but also about the quantities of investments being made in risky assets. This is illustrated by these graphs taken from his paper:
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Governor Stein points out that the quantity of high-yield bonds being issued, or the share of high yield in the total, is an important indicator of future returns on these investments: more high-yield issuance leads to more defaults and lower returns, at any given spread. He also argues that non-price variables, like the degree of subordination in the capital structure, can vary a lot through the cycle, making investments far more risky than they appear at first sight.


Governor Stein believes that the rising shares of high yield in total issuance, and increased amounts of subordination at any given credit spread, suggest that markets are over-reaching for yield, with dangers that a bubble might soon develop. A mitigating factor is that there does not seem to be as much maturity mismatch in credit products as there was before 2008, which makes a sudden implosion from deleveraging and fire sales less likely, but there are some sectors (mentioned above) where a maturity mismatch is already developing.


The conclusion, which seems right to me, is that a credit bubble may already be building, but it has not yet reached a point where it poses a systemic threat to the financial system. In Fed language, that would mean that the “costs” of quantitative easing have not yet risen too far. But Governor Stein is much more worried about this than any of his colleagues (apart from Esther George at Kansas City), and he will be following his new set of dials very carefully. His real concern is that they could be flashing red by 2014.


If so, the FOMC will be faced with a big decision, which is whether to respond to signs of a credit bubble by raising rates (or ending QE) when the rest of the economy points in the other direction. The received wisdom at the Fed is that this should not happen. According to the Bernanke/Greenspan doctrine, interest rates, and balance sheet expansion, should be directed towards inflation and unemployment, while regulation and prudential policy should be used to prevent bubbles in the financial system. (This all stems from a paper written by academics Ben Bernanke and Mark Gertler in 1999.)


We do not know whether Chairman Bernanke continues to believe this, though he defended the proposition as recently as in 2010 and, after all, his current policy is intended to drive investors into risk assets. What we do know is that governor Stein is very doubtful about it. This is what he said last week:

If the underlying economic environment creates a strong incentive for financial institutions to, say, take on more credit risk in a reach for yield, it is unlikely that regulatory tools can completely contain this behavior While monetary policy may not be quite the right tool for the job… it gets in all of the cracksChanges in rates may reach into corners of the market that supervision and regulation cannot.
 
“It gets in all of the cracks” could be a phrase that sticks. It implies the Fed may need to change interest rates to contain a credit bubble, even when economic factors suggest the opposite. Even if Governor Stein is at the hawkish end of the FOMC on the possible need to raise rates, which he likely is at present, the arrival of new regulatory and prudential controls in the next couple of years would, on their own, be enough to truncate the bull market in credit.


The Fed’s new credit vigilante is clearly a man worth watching.

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