Thomas D. Higgins, PhD | Chief Economist, Standish Mellon Asset Management Company LLC
"It is reasonable to ask whether systemic risks can in fact be reliably identified in advance; after all, neither the Federal Reserve nor economists in general predicted the past crisis." — Ben Bernanke
The flood of liquidity from the global central banks has lowered systemic risk and fueled a rally in world capital markets. However, quantitative easing (QE) seems to be exhibiting diminishing returns when it comes to generating real economic activity. Furthermore, there are growing concerns that such policies may have long-term consequences, which could increase financial instability in the future.
Indeed, Federal Reserve Chairman Ben Bernanke1 recently cautioned that a prolonged period of low interest rates may encourage a "reach for yield" by investors. This yield-seeking behavior can push asset prices beyond their fundamental value and create bubbles in financial markets. Ironically, U.S. Treasuries are probably the furthest from fundamental value of any major asset class due to Fed intervention. Yet, the Fed views this as a necessary by-product of its efforts to support aggregate demand.
Setting Treasury valuations aside, we do not see evidence of imminent overheating in the broader fixed income markets today. Despite the absolute low levels of yields, our models suggest that investment grade and high yield spreads versus U.S. Treasuries are fair based on current fundamentals. Nevertheless, certain trends bear watching including the easing in financing terms and the rising share of issuance being used to fund special dividends and share buybacks, which are detrimental to bond holders. We are closely monitoring these trends and avoiding areas of the market where we do not believe we are being compensated for the associated risks.
The Fed has pursued three rounds of QE since the onset of the financial crisis in 2008. The first round of QE, which ran from October 2008 to March 2010, was largely successful at restoring market functioning and reducing tail risks especially during the most acute phase of the crisis. There is also evidence that QE1 brought down long-term Treasury yields, which supported U.S. economic growth and staved off the threat of deflation. Indeed, by the time the first round of asset purchases was completed, the U.S. economy had emerged from recession and was expanding 2.1% year-to-year.
However, the economic benefits of the second and third rounds of Fed asset purchases are more ambiguous. Despite further declines in U.S. Treasury yields, U.S. economic growth remains stuck at around 2%. Although home value and stock prices have risen since the implementation of QE3 in September 2012, there is little evidence that this has translated into a faster pace of consumer or business spending. In fact, year-to-year growth in retail sales and new orders for durable goods has actually slowed over the past nine months.
Some of this may be due to the lags associated with monetary policy or the external factors such as the deterioration in the European economy and the U.S. fiscal drag. Indeed, it is difficult to prove what might have happened without central bank intervention. Nevertheless, the economic numbers generally suggest diminishing returns to QE.
At the same time, the potential costs of QE may be increasing as central bank balance sheets expand globally. Increased liquidity may raise credit risks by compromising bank underwriting standards or discouraging necessary balance sheet repair and deleveraging as we have seen in Europe.2 Low interest rates may also encourage a reach for yield as portfolio managers dissatisfied with low returns take on more credit risk, duration risk, or leverage.
Several Fed officials have recently spent time discussing yield-seeking behavior and how best to address potential credit market overheating3 should it emerge. Fed Governor Jeremy Stein has been the most vocal arguing that annualized rates of payment in kind and covenant-lite issuance in the high yield market are evidence of a fairly significant pattern of reaching for yield.
From Stein's perspective, the Fed should be open to using its macroprudential supervisory and regulatory tools as well as monetary policy to address potential overheating. However, it is not clear how much support this view has from the rest of his colleagues at the Fed. Traditionally, monetary policy has restricted its attention to the dual mandate of price stability and maximum employment.
What is clear from recent communications is that Fed officials are thinking more about the risk of asset bubbles and their role in propagating them. This may be why Fed officials have indicated that the end of QE is unlikely to be the steady and uniform process like their approach from 2003-2006 when they raised short-term interest rates in a series of 25 basis point increments over 17 straight meetings. That methodical approach has been partly blamed for fueling the housing bubble which eventually led to the 2008 financial crisis.
Nevertheless, we do not see signs of an imminent overheating in U.S. credit markets today. While the absolute level of yields is low due to the Fed's manipulation of the U.S. Treasury market, investment grade credit spreads remain in line with their historical averages at around 140 basis points and they are significantly above the tights of the last two cycles. High yield spreads do look a little rich compared to historical averages, but they are still well above the troughs in the 250 basis range experienced over the last two economic cycles.
In addition to valuations, we also consider trends related to the investor behavior, the quality of issuance and financial leverage when assessing whether the markets have run too far. According to our analysis, issuance quality has deteriorated at the margin, but nearly two-thirds of funds raised in the high yield market are still being used for refinancing existing debt at lower interest rates or fund capital expenditures, which is generally positive. And it would be a stretch to say there is irrational exuberance in the bond market given the near universal scorn investors heap on the diminutive yields in the fixed income markets. Leverage is beginning to make a comeback, but it is nowhere near the levels we witnessed in 2007. One reason is tighter regulation has constrained the balance sheets of banks and broker-dealers.
Even so, we expect the debate over the efficacy of QE to intensify and this may weigh on risk assets especially given the rally we have seen since the latter half of 2012. Unfortunately, as the 2001 technology bubble and the 2007 housing bubble demonstrate, the Fed has a poor track record when it comes to identifying and addressing asset bubbles. Moreover, even if they can develop an early warning system, there seems to be disagreement amongst the Board of Governors about the appropriate policy prescriptions that would follow. In our opinion, traditional monetary policy is a rather blunt instrument for countering excesses in financial markets. Instead, increased surveillance and macroprudential oversight are better suited to cooling overheating markets.
1 Ben S. Bernanke, "Monitoring the Financial System," The 49th Annual Bank Structure Competition sponsored by the Federal Reserve Bank of Chicago, May 10, 2013.
2 World Economic Outlook April 2013, "Chapter 3: Do Central Bank Policies Since the Crisis Carry Risks to Financial Stability?" The International Monetary Fund.
3 Jeremy Stein, "Overheating in Credit Markets: Origins, Measurement, and Policy Responses," Research Symposium sponsored by the Federal Reserve Bank of St. Louis, February 7, 2013.
BNY Mellon Investment Management is one of the world's leading investment management organizations and one of the top U.S. wealth managers, encompassing BNY Mellon's affiliated investment management firms, wealth management services and global distribution companies. BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation and may also be used as a generic term to reference the Corporation as a whole or its various subsidiaries generally. · The statements and opinions expressed in this document are those of the authors as of the date of the article, are subject to change as economic and market conditions dictate, and do not necessarily represent the views of BNY Mellon, BNY Mellon Asset Management International or any of their respective affiliates. This document is of general nature, does not constitute legal, tax, accounting or other professional counsel or investment advice, is not predictive of future performance, and should not be construed as an offer to sell or a solicitation to buy any security or make an offer where otherwise unlawful. The information has been provided without taking into account the investment objective, financial situation or needs of any particular person. BNY Mellon Asset Management International Limited and its affiliates are not responsible for any subsequent investment advice given based on the information supplied.
Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and can fall as well as rise due to stock market and currency movements. When you sell your investment you may get back less than you originally invested. · While the information in this document is not intended to be investment advice, it may be deemed a financial promotion in non-U.S. jurisdictions. Accordingly, where this document is used or distributed in any non-U.S. jurisdiction, the information provided is for use by professional and wholesale investors only and not for onward distribution to, or to be relied upon by, retail investors. · Products or services described in this document are provided by BNY Mellon, its subsidiaries, affiliates or related companies and may be provided in various countries by one or more of these companies where authorized and regulated as required within each jurisdiction. This document is not intended for distribution to, or use by, any person or entity in any jurisdiction or country in which such distribution or use would be contrary to local law or regulation. This document may not be distributed or used for the purpose of offers or solicitations in any jurisdiction or in any circumstances in which such offers or solicitations are unlawful or not authorized, or where there would be, by virtue of such distribution, new or additional registration requirements. Persons into whose possession this document comes are required to inform themselves about and to observe any restrictions that apply to the distribution of this document in their jurisdiction. The investment products and services mentioned here are not insured by the FDIC (or any other state or federal agency), are not deposits of or guaranteed by any bank, and may lose value. · This document should not be published in hard copy, electronic form, via the web or in any other medium accessible to the public, unless authorized by BNY Mellon Investment Management International Limited.
In Australia, this document is issued by BNY Mellon Investment Management Australia Ltd (ABN 56 102 482 815, AFS License No. 227865) located at Level 6, 7-15 Macquarie Place, Sydney, NSW 2000. Authorized and regulated by the Australian Securities & Investments Commission. · In Brazil, this document is issued by BNY Mellon Serviços Financeiros DTVM S.A., Av. Presidente Wilson, 231, 11th floor, Rio de Janeiro, RJ, Brazil, CEP 20030-905. BNY Mellon Serviços Financeiros DTVM S.A. is a Financial Institution, duly authorized by the Brazilian Central Bank to provide securities distribution and by the Brazilian Securities and Exchange Commission (CVM) to provide securities portfolio managing services under Declaratory Act No. 4.620, issued on December 19, 1997. · Securities in Canada are offered through BNY Mellon Asset Management Canada Ltd., registered as a Portfolio Manager and Exempt Market Dealer in all provinces and territories of Canada, and as an Investment Fund Manager in Ontario. · In Dubai, United Arab Emirates, this document is issued by the Dubai branch of The Bank of New York Mellon, which is regulated by the Dubai Financial Services Authority. · If this document is used or distributed in Hong Kong, it is issued by BNY Mellon Investment Management Hong Kong Limited, whose business address is Suites 1201-5, Level 12, Three Pacific Place, 1 Queen's Road East, Hong Kong. BNY Mellon Investment Management Hong Kong Limited is regulated by the Hong Kong Securities and Futures Commission and its registered office is at 6th floor, Alexandra House, 18 Chater Road, Central, Hong Kong. · In Japan, this document is issued by BNY Mellon Asset Management Japan Limited, Marunouchi Trust Tower Main Building, 1-8-3 Marunouchi Chiyoda-ku, Tokyo 100-0005, Japan. BNY Mellon Asset Management Japan Limited is a Financial Instruments Business Operator with license no 406 (Kinsho) at the Commissioner of Kanto Local Finance Bureau and is a Member of the Investment Trusts Association, Japan and Japan Securities Investment Advisers Association. · In Korea, this document is issued by BNY Mellon AM Korea Limited for presentation to professional investors. BNY Mellon AM Korea Limited, 29F One IFC, 10 Gukegeumyung-ro,Yeongdeungpo-gu, Seoul, 150-945, Korea. Regulated by the Financial Supervisory Service. · In Singapore, this document is issued by The Bank of New York Mellon, Singapore Branch for presentation to professional investors. The Bank of New York Mellon, Singapore Branch, One Temasek Avenue, #02-01 Millenia Tower, Singapore 039192. Regulated by the Monetary Authority of Singapore. In Singapore, this document is to be distributed to Institutional Investors (as defined in the Securities and Futures Act, Chapter 289 of Singapore) only. · This document is issued in the UK and in mainland Europe, by BNY Mellon Asset Management International Limited, 160 Queen Victoria Street, London EC4V 4LA. Registered in England No. 1118580. Authorized and regulated by the Financial Conduct Authority.· This document is issued in the United States by BNY Mellon Investment Management.
BNY Mellon owns over 95% of the parent holding company of The Alcentra Group, which is comprised of the following affiliated investment advisers: Alcentra, Ltd and Alcentra NY, LLC. · BNY Mellon ARX is the brand used to describe the Brazilian investment capabilities of BNY Mellon ARX Investimentos Ltda. · BNY Mellon Western FMC, Insight Investment and Meriten Investment Management do not offer services in the U.S. This presentation does not constitute an offer to sell, or a solicitation of an offer to purchase, any of the firms' services or funds to any U.S. investor, or where otherwise unlawful. · BNY Mellon Cash Investment Strategies is a division of The Dreyfus Corporation. · BNY Mellon Western Fund Management Company Limited is a joint venture between BNY Mellon (49%) and China based Western Securities Company Ltd. (51%). The firm does not offer services outside of the People's Republic of China. · BNY Mellon owns 90% of The Boston Company Asset Management, LLC and the remainder is owned by employees of the firm. · BNY Mellon owns a 19.9% minority interest in The Hamon Investment Group Pte Limited, the parent company of Blackfriars Asset Management Limited and Hamon Asian Advisors Limited both of which offer investment services in the U.S. · Services offered in the US, Canada and Australia by Pareto Investment Management Limited under the Insight Pareto brand. · The Newton Group ("Newton") is comprised of the following affiliated companies: Newton Investment Management Limited, Newton Capital Management Limited (NCM Ltd), Newton Capital Management LLC (NCM LLC), Newton International Investment Management Limited and Newton Fund Managers (C.I.) Limited. NCM LLC personnel are supervised persons of NCM Ltd and NCM LLC does not provide investment advice, all of which is conducted by NCM Ltd. Only NCM LLC and NCM Ltd offer services in the U.S. · BNY Mellon owns a 20% interest in Siguler Guff & Company, LP and certain related entities (including Siguler Guff Advisers LLC). · BNY Mellon Asset Management International Limited and any other BNY Mellon entity mentioned above are all ultimately owned by BNY Mellon, unless otherwise noted.