ZERO RATE ZONE POWERS U.S. STOCK RALLY / THE FINANCIAL TIMES

On Wall Street

December 27, 2013 9:57 am

 

Zero rate zone powers US stocks rally

 

By Henny Sender

 

The Federal Reserve punchbowl is fuller than at first glance

 

 

Since the Federal Reserve announced it was reducing its asset purchases by $10bn a month, the markets have shrugged off the news the long-dreaded tapering had finally begun. That oblivious response to the scaling back of the Fed’s purchases of Treasuries and mortgage securities was in contrast to the global tremors at the mere prospect of tapering Ben Bernanke hinted at last May and June.

 

Sure, the positive response partly reflects some healing in the economy. Housing starts are up – never mind the fact that new mortgage applications are far weaker, suggesting that demand from real end users remains subdued. The jobless rate is down, but that improvement owes much to the fact that the participation rate continues to fall. For 43 consecutive months, more people have left the workforce than entered it, CLSA data show.

But much more of the rally in stocks and riskier debt markets has to do with the Fed’s extended commitment to zero interest rates. A reduction of $10bn a month in asset purchases means far less than the promise to keep rates lower for longer than ever. The punchbowl, which at first appeared to be starting to drain this month, is fuller than at first glance.

The FOMC statement promised the market that the funds rate will be kept near zero “well past” the time when unemployment falls to 6.5 per cent, which “pointed to a rates prediction for 2015 and 2016 that was somewhat lower than forecasts published in September”, JPMorgan economist Michael Feroli noted. “Presumably all these changes were meant to soften the blow from starting the process of winding down Fed balance sheet expansion.” As indeed it did.

That means the Fed is affirming its message to the markets to invest in the riskiest financial assets, preferably with borrowed money. The greatest beneficiaries of easy money are speculators using borrowed money – that isn’t about to change. The war between the liquidity driving the markets up and the far more sombre economic and corporate fundamentals still favours those who invest on the basis of liquidity.

Demand for high-yield debt is so great that the head of high yield at one major bank worries that the biggest problem for next year is supply, after this year’s record of nearly $1tn in combined leveraged loan and high-yield issuance. Virtually every company that needed to refinance and postpone debt payments has done so already. Yet, every day high-yield mutual fund managers have to find a home for the inflows that continue to flow in, leading to tighter spreads and lower yields.

“Interest rate risk is more pertinent than credit risk and historically wide spreads relative to low default risk will again allow high-yield bonds and loans to outperform the majority of fixed income,” analysts at JPMorgan noted in their outlook for those asset classes on December 11. They predicted high-yield spreads would tighten to 415 basis points over Treasuries, a prediction exceeded less than two weeks later.

 

Distressed debt investors have been forced to look to just a few troubled sectors, such as coal, for investment opportunities as owners of virtually all the troubled, over-levered deals from the peak years have managed to postpone the day of reckoning.

In the stock markets, many of the initial listings, especially small, little-known tech names, assumed to be high-growth counters, have seen their share prices rise 60 to 70 per cent on the first day, far outperforming more mature companies with a far more solid track record such as Aramark. Sound familiar?

 

At some point of course that Fed policy will definitively reverse. Inflation would be the obvious trigger but today deflation appears to be a bigger risk than rising prices.

One problem is that the risks of the Fed’s easy money policy are largely invisible. Today, those Fed policies appear costless – just as they did after the last round of easing. The shortfalls in pension funds assuming 8 per cent returns in a zero rate world are barely being acknowledged, yet alone dealt with. Millions of Americans who are postponing their retirements because they aren’t earning enough to finance them don’t seem to have factored into the Fed’s calculations. Sadly, retail investors will be the last to get out of the risk assets they are being driven into now.

Executives at firms such as Apollo Management are not alarmed, though. They know the foundations for the next distressed cycle are being laid today, thanks to the Fed’s generosity.

 

 

Copyright The Financial Times Limited 2013.