For a relatively brief period in antiquity, about four decades ago, US financial markets traded freely without overt interference from the central bank. The market was allowed to set even the most basic interest rate – overnight federal funds – while Paul Volcker’s Federal Reserve aimed to control the money supply to beat double-digit inflation. Bond yields hit record highs and the dollar soared, while stocks were at the end of a secular bear market in which the
Dow Jones Industrial Average
slipped below the level of 1000 first reached in the 1960s.
Fast forward 40 years, and it’s hard to find a market that the Fed doesn’t participate in. In response to the near collapse of markets due to the coronavirus crisis, the central bank bought massive volumes of mortgage-backed securities from the Treasury and agencies. Then it took the unprecedented step of also supporting the credit markets for businesses and municipalities with measures including purchases of exchange traded funds.
Other measures taken by other central banks are also reportedly under discussion, including ‘controlling the yield curve’, as the longer-term Treasury bond anchor has been dubbed. Other once radical programs adopted by central banks abroad, such as buying stocks or imposing negative interest rates, are long-standing.
“Price fixing” is how Peter Fisher, who previously headed the Fed’s Open Market office, describes all of these operations. Intervening in so many areas of the financial markets means that prices no longer mean what they once did.
Of course, equity investors who have benefited from the marked improvement in the markets for high-quality, high-yield corporate bonds are not complaining. But the Fed’s narrowing of credit spreads not only skews the outlook for the economy to recover; it also reduces the efficiency of the capital market. Former zombie businesses are funded, which could mean less creative destruction in the post-Covid-19 economy, said Fisher, now a clinical professor at the Tuck School of Business at Dartmouth College, in a
webinar last week.
A corner of the credit market that has not been touched by the Fed is leveraged loans, our former colleague Jim Grant writes in the current edition of Grant’s Interest Rate Observer. The loan market has an excellent track record when it comes to forecasting a turnaround in the business cycle, he notes, citing Standard & Poor’s LCD Global lending unit. During the financial crisis and its recovery from 2007 to 2010, the S & P / LSTA Leveraged Loan index dominated the
S&P 500 Index
on the downside and on the upside, overtaking its counterpart in equities.
However, since the equity nadir on March 23, loans have recovered about 15%, less than half of the rally in equities. This may reflect the decline in loan quality due to “the last 10 years of ultra-low interest rates, consequent ultra-easy credit, and rapid private equity activity,” Grant writes. Without the Fed’s involvement, loan prices would be left to “the primary forces of supply and demand.”
Fisher, for his part, is not convinced of the effectiveness of policies practiced abroad. the
Bank of Japan
recovered much of that country’s government bond and fixed yield market, while buying ETFs. Still, there is little evidence that it has boosted domestic demand there, he said.
who uses them, is frank in saying that his objective is to prevent his currency from rising. (In the process, the SNB prints more Swiss francs, than it exchanges for dollars, and buys US stocks, a trick beyond the wildest imagination of medieval alchemists.)
Negative rates set by the European Central Bank and the BoJ may also have capped their currencies. In Sweden, instead of stimulating spending, as economic theory suggests, these rates would have boosted savings to make up for the lack of interest income, he added. (In December, Sweden therefore abandoned negative rates.)
Virtually all of the Fed officials questioned about imposing negative interest rates expressed their distaste for the policy, which would effectively kill the money market fund industry. Fisher further warned that they could jeopardize the dollar’s status as the world’s primary reserve currency. Global investors would have little incentive to hold non-paying Treasury securities. The Fed wants to maintain the liquidity of the Treasury market, the other key attraction of holding assets in greenbacks. Negative rates would make this more difficult.
As for buying stocks, which Fed officials say they won’t do, Fisher advises monitoring how the central bank will stop buying corporate debt and ETFs once the crisis hits. past. In the next crisis, stocks could be added to the Fed’s shopping list despite the lack of evidence of the effectiveness of this tool.
In the short term, the Fed is expected to revert to its more traditional asset purchases, buying between $ 80 billion and $ 120 billion in treasury bills and $ 25 billion to $ 35 billion in mortgage-backed securities per month, writes the economist. by Goldman Sachs David Mericle in a study. Note.
The central bank is also expected to declare that it will keep interest rates close to zero until the economy hits its 2% inflation target and full employment. Additionally, Goldman expects the Fed to introduce some control on the short end of the yield curve to underscore its intention to hold its policy rate target stable.
Doing whatever it takes, to use the famous phrase of former ECB President Mario Draghi, shouldn’t mean everything goes, Fisher observed. So far, the Fed’s pricing has boosted asset values. The cost of distorting the market may not appear until much later.
Write to Randall W. Forsyth at [email protected]