Thursday, December 13, 2012

The Great Wealth Transfer: Coming to a Bond Market Near You

Attempt to pull off a bank heist, chances are you go to jail. If someone has a habit of burglarizing homes, eventually he’ll have an address in the state pen. If an online con man convinces you to send thousands of dollars to facilitate an overseas estate transaction, he’ll remain scot-free as he’s likely operating out of a Moscow café. Plus you would deserve to lose the money for falling for such a scam. If the government institutes policies that gut the assets of a country’s savers for the sake of alleviating the burden of the indebted…..namely the government itself….then one gets a cushy corner office in D.C.

Yet this cynical transfer of wealth from savers (the responsible) to debtors (the irresponsible) is exactly what current U.S. monetary policy is facilitating, the most recent iteration being yesterday’s Fed announcement to continue purchasing $45 billion of U.S. Treasuries on top of the $40 billion in mortgage securities it resumed buying this autumn. Yes, the Fed has already been sopping up this amount of Treasuries monthly, but that was part of Operation Twist, which included the sale of an equal amount of shorter dated debt, zeroing out the value of the transaction. The new policy once again cranks up the printing press, quickly sending the Fed’s balance sheet over $3 trillion, well above its pre-crisis norm of sub $1 trillion. The rationale for such dovish policy is that high unemployment remains sticky and inflation is under control, thus enabling a dramatic expansion of money supply without fear of sparking a rapid rise in prices. And they may indeed have a point as banks have yet to deploy these massive reserves, choosing instead to keep them parked at the Fed. Some good that does.

Yesterday’s Fed announcement was overshadowed in the mainstream media by the fiscal cliff negotiations, which suddenly have captured the nation’s attention much like the way a salacious reality TV show would: Survivor, Obama vs. Boehner: Who Gets Chucked Off the Cliff. The real reality is that this crisis has been decades in the making and nothing will make it go away overnight, especially when taking into account how the meat of the problem….runaway entitlement spending….has been cleverly extracted from the conversation. Of the recent news emanating from the Beltway, the Fed’s decision will likely cast a longer shadow than any Band-Aid fiscal fixes that get cobbled together before the holidays. In the Fed’s defense, a key reason it continues to go down this untested path of extraordinarily dovish policy is government’s unwillingness or inability to address the country’s fiscal imbalances. If chronic deficits are not resolved in a manner which is conducive to growing the economy, thus increasing government revenue without the hazardous effects of tax hikes on income and investment, then the recovery will continue to sputter along at sub 2%, justifying the Fed’s drastic steps.

More Distortion; Just What the Treasury Market (and Broader Economy) Needs
The goal of monetary policy is to eventually affect the real economy. Since the mechanism used to achieve its ends is the bond market, the most immediate manifestation of these actions can be seen bond prices. For anyone with exposure to fixed income instruments….and we all should have some in our allocation soup, the Fed’s impact on bond markets is literally a matter of dollars and cents, namely those you’ve allotted for a comfy retirement. From early 2008 through Spring 2010, with the exception of the crisis nadir, 10-Year Treasury yields remained near 4%. After the Fed got serious about catalyzing a stagnant economy, yields fell to current low levels on the back of Fed purchases.
The Fed’s shenanigans are also evidenced in the shape of the Treasury yield curve. As seen below, shorter-dated notes are stapled to the floor thanks to the 0% Fed Funds rate. Fearing the inflationary effects of loose monetary policy (QE v1.0), investors initially shied away from longer dated Treasuries, sending yields up, which added yet another headwind to the fragile economy. Since then the Fed has become the market heavyweight, buying up longer dated instruments…along with foreign buyers recycling export profits into safe assets and hoping to buoy the value of their existing portfolios. Presently, the spread between the 10-Year and 2-Year Note is 147 basis points (bps or 1/100 of a percent), down from a recent record of 275+ bps. Usually such a flat curve would signal weak growth and low inflation expectations....which may indeed be the case….but given market distortions, one must hesitate before drawing such conclusions.

Since this week’s FOMC announcement, the yield on the 10-Year has sold off 9 bps to 1.74%. Granted there are other factors moving prices and the expectation was that the Fed would continue its purchases, thus the news was priced in, but one could expect that with such an open-ended commitment to be active in the market until joblessness creeps down to 6.5%, even with an inflation overshoot (to 2.5%), Treasury prices would rally, sending yields lower. Some analysts have even hinted that Bund-type yields of 1.4% could be on the horizon. Instead the slight sell-off could be interpreted that investors expect the measures will ultimately result in sustainable growth……or that the Fed, by attaching hard numbers to its dual mandate, will inevitably get behind the curve on controlling inflation. As seen below, since the autumn announcement of the twist extension and MBS purchases, the level of inflation inferred in the TIPs market has ticked up, with inflation for the 2017 to 2022 period expected to be near 3%, well above the target threshold of 2%.

Short Term Gain, Long Term……..?
Perhaps more important than the bond market’s prognostications on future economic conditions, Fed policy has an immediate impact asset valuations, especially for investors such as pension funds and others desiring a steady income stream. It is here that any potential negative consequences of current policy are already being felt. Bonds…both government and corporate…have had a great ride of late. This has benefited investors willing to ride the QE wave and others who are hesitant to reenter the stock market. As seen below, investment grade corporate debt as measured by the Merrill Lynch Corporate Masters index has returned 10.4% this year. The riskier High Yield Masters II index has returned 15.3%, just slightly below the 15.4% total return of the S&P 500. Venturing further out along the risk spectrum….for those who dare…JP Morgan’s USD-denominated Emerging Market Bond Index has delivered 17.5%.

An explicit goal of QE is that demand…and accompanying rich valuations….for risky assets will spur capital investment, M&A activity, and hiring on the corporate side, as well as wealth-effect induced consumption on the part of investors. Neither of those outcomes is  panning out. Instead we may simply be facing yet another asset bubble. As demand for corporate debt has risen, their spreads to the risk-free benchmark have plummeted. The spread over benchmark for AAA credits (the few that remain) is presently 360 bps, nearly half the 20-year average of 621 bps. Slightly riskier BAA credits now have a spread of 460 bps compared to a 718 bps average. What these data show are that investors are willing to put up with historically miniscule risk premiums to get incrementally higher returns over paltry treasury yields.

Happy Days For Corporate Bond Issuers
Corporate treasurers are taking notice of the generous market conditions. Through October, investment grade corporations have issued $836 billion in debt this year. That is a 24% gain over the same period last year and greater than any full year total since 2007’s $991 billion. Speculative grade (i.e. junk) rated firms have increased their YOY issuance through October by 36%, to $270 billion. Not only is this a record-breaking pace, but many bonds are of the notorious covenant-lite variety, which stacks the deck against the investors in the event of rough sailing, further evidence of the risk people are willing to take to earn a respectable yield.

If these funds were being used to invest in new capital and hire workers, the economy would be receiving the benefits of the virtuous circle of investment, job creation and consumption that the Fed so desires. Instead firms are simply exercising sound corporate finance by levering up balance sheets from recently low levels to goose earnings, something that has yet to occur via revenue growth.

Catching a Falling Knife
Whether looking at Treasuries, investment grade corporates or junk, valuations across the bond spectrum appear frothy to say the least. For investors who rode the wave and are willing to cash in now, they can grin all the way to the bank. For those who instead must rely upon the payments attached to these bonds then the situation is less euphoric. Should investors want to cash in on their earnings after the New Year, they’ll likely be greeted with steeper capital gains taxes. Yet the biggest risk may be what the future throws at the fixed income market. Low yields punish savers and let borrowers (e.g. the government) off the hook for past profligacy. Corporate borrowers are only along for the ride, but the result is the same: their investors are not earning returns commensurate to the risks historically associated with this type of debt. 

The Fed can justify this loose policy by pointing out that current inflation is muted. But it dismisses the deleterious effect of printing money on the value of the dollar. This comes back to bite in two ways: first it diminishes the value of debt held by foreign investors, thus pushing them to dump U.S. debt….possibly a slow bleed, but a bleed nonetheless….which in turn would spike interest rates; second, a weaker dollar would increase the price of imported commodities (sorry frackers, we aren’t yet at the point of energy independence). This would spike the type of inflation that the Fed cannot control. In both instances, the economy slows and bonds sell off.  That danger may be down the road. For today’s bond investors, one negative consequence has already arrived. Real yields on the Ten-Year Treasury are slightly negative, when using the headline PCE price index for inflation (and barely positive using the core rate). This means when adjusted for the loss of buying power, the money an investor lends the government will be worth less when ultimately returned. With the complicity of the Fed, the government is able to inflate its liabilities away, while the negative rate creates a disincentive to save. So much for the effort to rebalance the economy away from consumption and towards investment.


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