By Sam Triantafillopoulos
Out of the frying pan…
Since 2008, the Fed has injected close to $4 trillion into asset markets, largely by purchasing US treasuries and government sponsored mortgage bonds; before a pandemic was a factor. Once more, the world’s most pivotal central bank has begun to grow its balance sheet; yet this had already begun prior to Covid-19. This is with Jerome Powell announcing, in September 2019 last year, the formal end of the Fed’s quantitative tightening policy and the subsequent addition of $400 billion to the balance sheet amid a slowing economy.
It is for this reason that we already know how central banks will respond to perhaps the most economically consequential pandemic since 1348. The almost 2-year-old policy of quantitative tightening, an attempt to slowly unwind the assets purchased by the federal reserve since 2008, had been largely reversed in under three months. This is even before the estimated $1.5 trillion in the form of immediate monetary easing as a result of the coronavirus.
The Federal Reserve has since been approved to inject an additional and unprecedented $4 trillion into capital markets as part of the monetary component of the third round of congressional stimulus bills. The ills of the last decade will only be amplified by this capitulation to markets, and the willingness of central banks to appease the indignant shouting, both in times of prosperity and crisis, should be alarming. Young people should be especially incensed as their futures are quietly brushed aside while the populace is distracted by sovereign debt which will surely grow during this period. Those concerned with government debt should shudder at the recklessness which will flourish in corporate debt as governments milk this crisis for all it has.
And it only gets worse…
In Europe, it seems the more things change the more they stay the same. When Mario Draghi was appointed as the head of the European Central Bank (ECB), he was considered a somewhat balanced central banker. His successor, Christine Lagarde, is an open dove who is willing to drive down sovereign yields and flood capital markets with cheap credit, far beyond the implicit role of central banks, namely liquidity management. The man famed for promising “whatever it takes” in response to the question of the ECB’s responsibilities was driven by a financial crisis that rocked Europe to its core and threatened the structure of lending practices in the Eurozone.
Lagarde had indicated such willingness in lieu of any semblance of duress, which spurs one to think about what Frankfurt could feasibly enact when armed with a crisis. For all the criticism unconventional monetary policy garnered for its acceleration of wealth inequality, the policy provided cheap credit at the cost of chronic inflation. This, seemed to be the great magic trick performed by central bankers such that both bond and equity markets were buoyed and banks had the advantage of access to money before it entered circulation, at the cost of depressed margins.
Today, the trade-off has barely been explored and as a result monetary easing measures have gone ahead with a fraction of the dispute which ensued in 2008. Central banks went into this crisis with conventional monetary ammunition effectively depleted, and so the floodgates were already half open to allow bond purchases up the maturity curve almost immediately. The policy before the crisis was essentially “lower for longer”; an assurance by central banks that policy rates would remain near zero for an extended period of time, but to allow for a standard maturity curve at longer tenors.
What will occur instead is “lower for longer” coupled with essentially the same policy for longer dated securities and swap rates; not only will the cash rate, effectively an overnight rate, remain incredibly low, but so will 3 month swap rates, 3 year corporate bonds, 10 year bank hybrids and 30 year government bonds. What this ultimately means is that the trends of the past 12 years, after a brief interruption, will resume and indeed accelerate: banks, which lend for the long term and borrow in the short term, will continue to lose profitability as maturity premiums collapse; companies will increasingly buy back stock on cheap debt and continue to lever up their balance sheet; the rich will benefit from yet another equity recovery and enjoy inflated prices into perpetuity.
Yet, perhaps the most insidious effect of an increasingly interventionist global monetary regime will not be recognized until long after this deflationary period ends. While the large-scale purchases of fixed interest securities depress rates and therefore reduce the cost of borrowing, they do not necessarily extend the capacity of the economy. For every deficit agent that requires money, there is a surplus agent offering their capital to the deficit agent. Rate cuts are ultimately a thumb (or an anvil) on the scales in favour of deficit agents, as every dollar saved by those repaying debt is a dollar lost by those lending for interest. This is why low rates have a tendency to misallocate capital, while not actually increasing economic capacity as per the zero-sum nature of debt payments.
Proponents would argue that debt holders would not necessarily apply the extra proceeds in a manner that increases output and hence expansionary monetary policy is that which supports borrowers, thought to be firms and individuals in desperate need of capital to fund productive pursuits. However at this point, with rates already so low, it is hard to fathom a business which is dead in the water at interest rates of 3% but a dynamo at 0.5% (for more on the subject of these firms, see zombie companies).
Break the lower bound in the event of an emergency…
When corporate bonds are issued, they are first the property of institutional banks which have underwritten the instrument. From there they are usually purchased by a range of institutional clients; hedge funds, asset managers and mutual funds. Yet by far the largest purchaser of fixed income securities in Australia is the superannuation fund industry, which will be forced up the maturity curve in order to preserve yields. In doing this the duration risk, the risk posed by changes in interest rates in relation to the maturity of a bond, will increase, leaving funds vulnerable when interest rates eventually rise and the value of bonds plummets.
The only other alternatives are to search far and wide for riskier debt instruments or creditors with riskier metrics, or indeed reduce fixed income exposure altogether and submit to the mercy of equity markets. This is still a position somewhat more favourable than that of the United States, where pension funds and 401ks are supplemented by government pensions, notably in sectors such as education, healthcare, municipal and emergency services and public administration. These public-private pension funds operate in the same way conventional pension funds do, except that retirement benefits, which are invested and drawn down upon retirement, are determined by state budgets.
By far the greatest contributor to increases in government service costs has been the burgeoning growth of pensions as fund managers accept lower yields for the same risk, hence needing more capital to invest in order to secure the same income. As conventional monetary policy has dried up, policymakers have increasingly explored alternatives to fiscal stimulus, fearing the immediate costs and the potential for inflation to sour the recovery.
Generally, the solutions which gain favour tend to accentuate their benefits and conceal their detriments. This is partly the reason quantitative easing passed through the arteries of the world’s financial system in the last cycle with relatively little bad press, in comparison to the infamous Troubled Asset Relief Program, the Rudd Stimulus and the string of European bailouts which roiled the populace.
It seems nothing shortens our memory like a good crisis.
Disclaimer: The views expressed in this article are solely that of the author’s, and do not necessarily reflect the position of UNIT nor the University of Melbourne. Transacting off this information is done so at one’s own risk, and individuals are encouraged to consult a finance professional before making investment decisions based off of this article.