Special thanks to our friend, macro maven Brian Yelvington for his contribution to this piece
On the seventh anniversary of the implosion of Lehman Brothers, an event that rocked the global economy, it’s more than ironic that the main topic of global financial discussion has been a rate hike by the Federal Reserve. Behind the scenes, more interesting is the growing list of risks which may be tying the FOMC’s hands behind their back.
The Fed should have hiked rates in 2012, but every day they put off the rate raise, Lehman-like systemic risk is lurking and rising. It’s a Colossal Failure of Common Sense all over again.
With all the debate about what exactly the Federal Reserve should do with short-term interest rates, historical perspective is something that’s being left behind.
The U.S. has had near zero short-term interest rates before. The period of 1932 to 1953 was defined by rates that were between zero and 2.1%. The last time we hit the zero bound, we stayed very close to it for upwards of 21 years. This is not something you hear often from economists these days.
The main reason central banks raise and lower rates is to shift consumption around and smooth out periods of stagnation. The Fed’s dual mandate of non-accelerating inflation and full employment defines the characteristics of the smoothing that society wants to see. Low rates pull consumption and investment forward and allow projects to be undertaken that otherwise would have to wait. Some people call this stealing economic activity from the future, but we must keep our eye on the incentives created by Fed policy.
On the other hand, higher rates make debt more expensive and push consumption and investment out. This year, most economist have felt the Fed is looking to “tap the brakes” on the improving U.S. economy.
Excessive Debt: Handcuffs Or A Noose?
The other pressing issue is high debt levels. The Fed is in no hurry to hike rates with debt levels so high in the post-Lehman era. The U.S. hit its debt ceiling in March, at $18.1 trillion, but the devil is in the details, or what’s called interest costs as a percentage of federal spending. As you can see below, net interest outlays are on course to more than double by 2017 from 2005 levels. Interest costs on the staggering U.S. debt load, added together with government entitlement spending, is nearing 71% of Federal spending, compared to 26% in the early 1960s. Is this sustainable?
U.S. Government Net Interest Outlays
|*Data from CBO|
Central Banks and Rising Debt Levels
There’s a price to pay for six years of a zero interest rate policy, it’s not free. As the world’s most influential central bank has kept interest rates so low for so long, debt has piled up in all kinds of global pockets, especially in emerging markets.
According to the Bank of International Settlements, emerging markets’ total debt to GDP ratio has surged to nearly 170%, up from 100% just before Lehman’s failure. Even more disturbing, according to Bloomberg data: there’s a strong correlation between the surge in emerging market debt levels and the cost of credit default protection. Investors wanting to insure themselves against the risk of EM defaults are paying up for the privilege these days.
Global Credit Explosion, Debt Denominated in US Dollars*
*Easy Money Fed policy has enticed countries and companies around the world to borrow in dollars. We have witnessed a colossal leverage expansion. A substantially stronger dollar makes these debts even larger, much harder to repay.
The dollar index has surged nearly 30% over the last 14 months. The ugly side effects are twofold. First, China’s currency, the yuan is pegged to the dollar, putting substantial negative pressure on their $10 trillion economy as exports have become much more expensive globally. Second, the $50 trillion debt load globally just got a lot larger with so much of it denominated in dollars. This ugly combination is putting tremendous economic pressure on emerging markets and commodities.
Popping Asset Bubbles
There are two broad schools of thought as to why the Fed is seeking to raise interest rates. One involves a traditional bubble bursting of asset prices. Although no one has uttered the “irrational exuberance” line that Fed Chair Greenspan did in December 1996, it is generally felt that certain markets (like the debt markets) are irrationally priced. As we learned in 2007, the risk that some corner of the world could pose a yet-undiagnosed financial cancer if left unchecked, is real.
It’s interesting to note, as all the new debt has piled up in recent years, we’ve seen record after record in terms of issuance. Specifically, if we look at new U.S. corporate bond deals, there’s been more than $100B a month fired into the market for five months running through July, the longest streak above that mark all time. While at the same time, this year U.S. high-yield companies posted two consecutive quarters without earnings growth for the first time since the ’08 crisis, per Bloomberg. Total U.S. corporate debt excluding financial firms stands at $4.2 trillion this year, according to Societe Generale, up from $1.9 trillion in 2009.
More disturbing, U.S. corporate credit rating downgrades and defaults are now at their highest since 2009, per S&P. Not exactly the type of data you want to see prior to a Fed rate hike. It’s clear that central banks around the world have taken a torch to the traditional relationship between credit quality and debt issuance. Once again, the thirst for yield amid excessively low interest rates has enticed investors to look the other way when it comes to credit quality selection. Buy, Buy, Buy.
Cash As % Of Debt On Corporate Balance Sheets
The Fed Needs Dry Powder to Fight the Next Recession
The other reason often stated for the Fed’s desire to exit the zero bound is that it would like to have more arrows in its recession fighting quiver. With near zero percent Fed funds (interest rates), the inability to lower rates further necessitates a return to quantitative easing (or bond buying, or debt monetization, or whatever moniker you wish to use) if the economy takes a turn for the worse. After the lessons of Japan and the US, QE is viewed as politically unsavory as well as being of fiscally questionable utility.
Both lines of reasoning as to why the Fed is in such a hurry to raise rates can be called into question. Nevertheless, the Fed wants to exit zero interest rate policy ZIRP. Further, the important thing about this Fed exit is that it will be very, ploddingly, further- off-than-Christmas-in-February-to-a-nine-year-old, slow.
The Road Ahead
If we look at the Fed’s forecast of where they think their Fed Funds Rate will be at the end of 2016, it’s up at 1.625%. That’s five 25bps hikes over the next year? Look for this number to come down substantially.
Today, there are a few things that separate the U.S. from traditional hiking cycles – and we note per our above chart that we really have not had a hiking cycle since the early 1980s – we have merely had successive easing cycles, each going further than the last.
There’s a myriad of circumstances which make the current landscape different from the 2004 and 1994 rate hiking cycles. The two most important have to do with the market most directly impacted by the repricing of interest rates – the colossal global debt markets. Substantial interest rate hikes make the value of debt and debt look like humpty dumpty after his great fall. We see potential issues with the staggering size of the global debt markets as well as the financial condition of the issuers of that debt.
The Cost of Higher Rates
The global debt markets – especially US credit – have ballooned in the time period since the financial crisis. If you think of the reasons behind a hike (besides reloading the stimulus quiver), they basically boil down to the Fed’s ability to reprice assets and slow capital formation to stave off inflation. The repricing of assets is first felt in the debt markets. The fact that these markets are now larger than they have ever been (having grown at a double digit clip in corporate credit and even faster in government issued bonds), makes the impact of even a modest hike exponentially more powerful than ever before.
It is not hard to calculate the amount of monetary value being repriced by a mere 25 basis point hike and see that it is far more powerful than ever before. The term duration refers to the percentage of gain or loss in bond prices for a given shift in interest rates, usually 100b basis points. So for instance a security or pool of bonds with a duration of 2.5 would have about a 2.5% gain in value for a 100 basis point cut in rates and about a 2.5% loss in value for a 100 basis point hike in rates.
Colossal Losses, Impact of Fed Rate Hike in the Market
One of the most popular bond indices, the Barclay’s U.S. Aggregate, has a market value of $17.9 trillion today. This compares to a market value of $8.3 trillion at the time of the last Fed rate hike on June 29, 2006. A look around the world is an eye opener; the Barclay’s Global Aggregate has a market value of $42.2 trillion versus $21.9 trillion on June 29, 2006. Some of this is already priced in of course, but the quick and dirty calculation tells you that for the U.S. Agg, a 25bps hike has 2.53x the impact of a 2006 era move and for the Global Agg, the impact is around 2.36x a 2006 era move in terms of the value of immediately repriced assets. This gives the adage ”interest rates up, bond prices down” profound new meaning.
Put another way, the amount of losses by global bond investors in percentage terms for a given hike in rates is around 2.5x as powerful as it was the last time the Fed hiked rates over nine years ago. So might 25bps act a bit more like 62.5bps? When will we find out?
The second big issue we have with aggressive hikes is that the world’s balance sheets are in worse shape overall than they were in 2006. That year, world GDP was $51 trillion per the World Bank. Current world GDP is around $78 trillion. So while the global stock of debt doubled, the world’s production only increased by about 50%.
Side Effects Of Easy Money Fed Policy
Further, the source of the growth was largely from emerging economies, many of which are dependent on high oil and commodity prices for growth. Traditionally as rates rise, oil and commodity prices decline. Not a good setup. Most of the advanced economies have pretty bad balance sheets.
Total U.S. debt to GDP has risen to 320% from 250% in the last decade and 125% in the 1950s, according to the Economist. In 2007 only three advanced economies had a debt ratio near or above 100%. There are now eleven countries (and growing) that have a debt ratio above 90% and those countries account for the bulk of the world’s GDP.
There have historically been only about 14 economies in the postwar era that have ever overcome such large deficits. It can be done and the usual recipe is for economies to commit to austerity, monetize debt, cut rates, and devalue currencies. But the history of these prior adjustments has one other glaring ingredient – they were usually fairly isolated incidents. It is much easier for a country to make a large adjustment if the rest of the world is humming along swimmingly. Right now the engines of the world are shouldering a debt level rarely observed in history. As such, the measures that can be employed are harder to employ since everyone is reading from the same playbook. This suggests to us that the adjustments themselves (low rates) are likely to last for a very long time.
It’s not about arguing doom and gloom. In fact, the world’s entrepreneurial spirit will triumph. The message is, the growth needed to overcome massive deleveraging of households and re-leveraging of governments will either need to be huge and short or more likely, low and long. Just like interest rates.