Deja Vu: The Fed’s Real ‘Policy Error’ Was To Encourage Years Of Speculation

Deja Vu: The Fed’s Real ‘Policy Error’ Was To Encourage Years Of Speculation

Over the past several years, yield-seeking investors, starved for any “pickup” in yield over Treasury securities, have piled into the junk debt and leveraged loan markets. Just as equity valuations have been driven to the second most extreme point in history (and the single most extreme point in history for the median stock, where valuations are well-beyond 2000 levels), risk premiums on speculative debt were compressed to razor-thin levels. By 2014, the spread between junk bond yields and Treasury yields had fallen to less than 2.4%. Since then, years of expected “risk-premiums” have been erased by capital losses, and defaults haven’t even spiked yet (they do so with a lag).

From an economic standpoint, the unfortunate fact is that the proceeds from aggressive issuance of junk debt and leveraged loans in the past few years were channeled into speculation. Excess capacity in energy production was expanded at the cyclical peak in oil prices, and heavy stock buybacks were executed at obscene equity valuations. The end result will be unintended wealth transfers and deadweight losses for the economy. Since the late-1990’s, the Federal Reserve has actively encouraged the channeling of trillions of dollars of savings into speculation. Recurring cycles of malinvestment and crisis have progressively weakened the resilience and long-term growth prospects of the U.S. economy.

Investors repeatedly forget that reaching for yield in speculative securities only works if capital losses don’t wipe out the “pickup” in yield. Since mid-2014, we’ve emphasized the increasing deterioration in market internals and credit spreads, noting that this deterioration has historically been a reliable signal of a shift from risk-seeking to risk-aversion by investors. This risk-aversion is now accelerating. Last week, a number of high-yield bond funds placed delays on redemptions in order to give them time to liquidate holdings into a collapsing market. When a problem is specific to a particular fund, orderly liquidation can protect investors. But in this case, the need for liquidation isn’t specific to those particular funds – it’s driven by selling pressure and illiquidity in the junk debt market as a whole. As a result, these “redemption holds” risk contributing to general panic across the entire high-yield market.

Given the valuation extremes we presently observe in the equity market (seeRarefied Air: Valuations and Subsequent Market Returns), our view is that spiking yields in the junk debt market are a precursor of significant losses in stocks, as we’ve observed in other market cycles across history. At present, the valuation measures we find most tightly correlated (~92%) with actual subsequent 10-12 year S&P 500 total returns are consistent with negativenominal total returns over a 10-year horizon, and roughly 1% annual returns over a 12-year horizon. Razor-thin risk premiums are already baked into equity valuations, even assuming historically normal economic growth over these horizons.

At current valuations, the notion that “There Is No Alternative” (TINA) to zero-interest cash is profoundly incorrect. The only thing that equities offer here is to promise wider extremes of panic, despair, excitement, and hope over the coming 10-12 years, on the way to overall returns no better than safe, liquid cash equivalents are likely to achieve. That’s the unfortunate consequence of the obscene valuations Fed policy has encouraged. Valuations, market internals, and the overall market outlook will change over the completion of this market cycle, but here and now, market conditions pair the second most extreme valuations on record with deteriorating internals and accelerating risk aversion among investors. This is a wicked combination.

The Fed’s Real Policy Error

The Federal Reserve is also in a rather difficult situation. Based on a broad range of economic factors, our economic outlook has shifted to a guarded expectation of recession. Now, if there was historical evidence to demonstrate that activist Fed policy had a significant and reliable impact on the real economy, and didn’t result in ultimately violent side-effects, we would argue that a Fed hike here and now might be a “policy error.” In reality, however, decades of economic evidence demonstrate that activist monetary interventions (e.g. deviations from straightforward rules of thumb like the Taylor Rule) have unreliable, weak, and lagging effects on the real economy.

Moreover, as we should have learned from the global financial crisis, when the Fed holds interest rates down for so long that investors begin reaching for yield by speculating in the financial markets and making low-quality loans, the entire financial system becomes dangerously prone to future crises. Read More:

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