For a relatively brief period in ancient times, some four decades ago, U.S. financial markets traded freely with no overt central-bank interference. The market was permitted to set even the most basic interest rate—overnight federal funds—while the Federal Reserve under Paul Volcker aimed to control the money supply to vanquish double-digit inflation. Bond yields soared to records and the dollar turned higher, while stocks were at the end of a secular bear market in which the Dow Jones Industrial Average slid below the 1,000 level first reached back in the Swinging ’60s.
Fast-forward 40 years, and it’s tough to find a market the Fed doesn’t participate in. In response to the markets’ near meltdown from the coronavirus crisis, the central bank bought massive volumes of Treasury and agency mortgage-backed securities. Then it took the unprecedented step of also backstopping the corporate and municipal credit markets through measures including purchases of exchange-traded funds.
Further moves taken by other central banks reportedly also are under discussion, notably “yield curve control,” as the pegging of longer-term Treasury yields has been dubbed. Other formerly radical programs adopted by central banks abroad, such as the purchase of equities or the imposition of negative interest rates, are long shots.
“Price-fixing” is how Peter Fisher, who formerly ran the Fed’s Open Market desk, describes all these operations. Intervening in so many financial market sectors means that prices don’t mean what they once did.
Of course, stock investors who have benefited from the marked improvement in the investment-grade and high-yield corporate bond markets aren’t complaining. But the Fed’s narrowing of credit spreads not only distorts prospects for the economy’s recovery; it also reduces the capital market’s efficiency. Old zombie companies get financed, which might mean less creative destruction in the post-Covid-19 economy, Fisher, now a clinical professor at Dartmouth College’s Tuck School of Business, said in a Natixis webinar this past week.
One corner of the credit market left untouched 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 record of forecasting turns in the business cycle, he notes, quoting Standard & Poor’s LCD Global loan unit. In the financial crisis and its recovery from 2007 to 2010, the S&P/LSTA Leveraged Loan Index led the S&P 500 index on the way down and the way up, outpacing its equity counterpart.
However, since stocks’ nadir on March 23, loans have recovered about 15%—less than half the rebound in stocks. That could reflect the decline in loan quality “over the past 10 years of ultralow interest rates, correspondingly ultra-easy credit, and fast-driving private-equity activity,” Grant writes. Without Fed involvement, prices of loans would be left to “the primal forces of supply and demand.”
Fisher, for his part, is unconvinced of the effectiveness of the policies being practiced overseas. The Bank of Japan has hoovered up much of that nation’s government bond market and fixed yields, while also buying ETFs. Yet there is little evidence that this has stimulated domestic demand there, he said.
As for negative interest rates, Fisher said that the Swiss National Bank, which uses them, is forthright in saying that its aim is to keep its currency from rising. (In the process, the SNB prints more Swiss francs, which it exchanges for dollars, and buys U.S. stocks, a trick beyond medieval alchemists’ wildest imagination.)
The negative rates set by the European Central Bank and the BoJ also might have capped their currencies. In Sweden, instead of spurring spending, as economic theory suggests these rates would, they boosted saving, to make up for the lack of interest income, he added. (In December, Sweden abandoned negative rates as a result.)
Virtually all Fed officials asked about imposing negative interest rates express distaste for the policy, which effectively would kill the money-market fund business. Fisher further warned that they could imperil the dollar’s status as the world’s main reserve currency. Global investors would have little incentive to hold Treasury securities yielding nothing. The Fed wants to maintain the Treasury market’s liquidity, the other key attraction to holding greenback assets. Negative rates would make that more difficult.
As for buying stocks, which Fed officials say they won’t do, Fisher advises watching how the central bank exits from buying corporate debt and ETFs after the current crisis passes. In the next crisis, equities could be added to the Fed’s shopping list despite the lack of evidence of the efficacy of that tool.
In the near term, the Fed is likely to revert to its more traditional asset purchases, buying some $80 billion to $120 billion of Treasuries and $25 billion to $35 billion of mortgage-backed securities per month, Goldman Sachs economist David Mericle writes in a research note.
The central bank also is likely to state that it will maintain near-zero interest rates until the economy reaches its 2% inflation target and full employment. In addition, Goldman expects the Fed to introduce some control of the short end of the yield curve to underline its intent to hold its policy rate target steady.
Doing whatever it takes, to invoke the famous phrase of former ECB President Mario Draghi, shouldn’t mean that anything goes, Fisher observed. So far, the Fed’s price-fixing has boosted asset values. The cost of its market distortion might emerge only much later.
Write to Randall W. Forsyth at randall.forsyth@barrons.com
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May 30, 2020 at 01:15AM
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Fed’s Actions Boost Markets Now. But They Might Take a Toll Later. - Barron's
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