Can the Fed Deflate the Credit Bubble Without a Crash?

Can the Fed Deflate the Credit Bubble Without a Crash?

By Wednesday, 27 November 2019 12:24 PM Current | Bio | Archive

This time a year ago, the federal funds target rate was 2.25% and Federal Reserve Chairman Jerome Powell was intent on raising it to 3% while continuing to shrink the size of the central bank's balance sheet. The massive disruption in the credit markets that followed not only thwarted his aims and catalyzed the “Powell Pivot,” but continues to dictate monetary policy even now.

Economists and academics have debated Powell’s motive for lowering interest rates and whether expanding the Fed's balance sheet again as a way to alleviate pressures in the repo market is just another round of quantitative easing in disguise, but investors are agnostic. To them, easier monetary policy of any form is the only thing that matters when it comes to the stock market and broader economy.

There is another aspect to consider. Monetary policy has come under increased scrutiny for its perceived role in widening the inequality gap via QE by benefiting owners of risky assets at the expense of those without the financial wherewithal to partake. But recent research by T.S. Lombard chief economist Steven Blitz suggests that argument is more nuanced, with economic growth more closely tethered to the stock market than at any time in more than 50 years based on the net worth of U.S. households.

Powell learned this lesson the hard way last December. First, year-end funding strains, such as those we saw play out beginning in mid-September of this year, led to a reduction in liquidity that was essential to a high-yield debt market where redemptions were rising as the collateral underlying the funds was increasingly difficult to trade. This is no small matter, with nonfinancial corporate debt having ballooned to $15.5 trillion, or 74% of gross domestic product, as measured by the Institute of International Finance.

With so much debt that needs serviced, companies are now apt to cut back on share buybacks at the first sign of trouble. It wouldn't be wrong to say that repurchases exceeding more than $5 trillion in the current cycle have gone a long way toward boosting equity values. So, it's not surprising that stocks tumbled, coming within a hair of meeting the definition of a bear market, which is a peak-to-trough decline of 20%.

As the calendar turned to 2019, Powell seemed to suggest that he now understood what needed to be done. At an event with former Fed chairs Ben S. Bernanke and Janet Yellen, Powell indicated that QE could be re-engaged if a recession was seen as likely. “We’ll use the balance sheet,' he said. The promise of more liquidity has propelled the S&P 500 Index up by 24% this year even though corporate earnings growth has stagnated.

Although cynics say the Fed's three rate cuts since July and the $250 billion expansion in its balance sheet assets since mid-September were done to quell criticism of the central bank by President Donald Trump, nothing could be further from the truth. Powell simply has no choice but to maintain order in the credit markets with increased liquidity injections. There’s just no other choice.

The only thing Powell can hope is that the current liquidity measures tamp down the stress that may be beginning to emerge in the corporate bond market. Yields on debt with ratings in the 'CCC' tier, which S&P Global Ratings defines as 'currently vulnerable to nonpayment' and Moody's Investors Services says has 'very poor financial security,' are now 10 percentage points more than Treasuries for the first time in more than three years.

What could prove most problematic for policy makers is mutual and exchange-traded funds having grown their share of the corporate debt market to 19.5% from 11.9%. ETFs alone hold more than $1 trillion in fixed-income assets, which became an issue one year ago when redemptions rose against a backdrop of severely diminished trading in the bonds held by the ETFs.

And these are the most visible parts of the fixed-income market owned by retail investors. The proliferation of covenant-lite corporate loans, which deprive investors of protections and never surpassed 30% when the credit market last peaked, have topped 80% in the current cycle. This playground for private-equity leveraged buyouts saw the multiples of profit at which deals are signed reach 12.9 times in this year’s third quarter, up from 2007’s prior peak of 9.7 times.

If there is one thing Powell knows, it’s that the Fed’s liquidity tools, in all their forms, are blunt instruments. A year ago, the challenges presented by the doubling in size of a structurally altered bond market coupled with unprecedented lax lending standards tested his mettle. Beginning with Alan Greenspan, his predecessors were of the mind that bubbles could only be addressed after they burst. Powell’s best hope is that breaking that intellectual mold by injecting liquidity before the bubble is pricked produces an entirely different outcome.

Danielle DiMartino Booth, a former adviser to the president of the Dallas Fed, is the author of 'Fed Up: An Insider's Take on Why the Federal Reserve Is Bad for America,' and founder of Quill Intelligence.

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Historically reactive, the central bank is finally trying to get ahead of a potential crisis.
Wednesday, 27 November 2019 12:24 PM
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