Traditionally,
as the economy heats up, interest rates rise...making it more expensive to
borrow money and possibly more difficult. Conversely, as the economy
cools, interest rates fall...making it cheaper to borrow money and in some
cases less difficult. This can result in unintended
consequences.
Amid
the end of the Internet boom and the shock of 9/11, at the direction of
then-Fed Chairman Alan Greenspan, the Fed turned on an "easy" money
policy to try to combat an economic slowdown. The Fed pumped money into
the US economy and slashed its main interest rate - the Federal Funds Rate -
from 3.5% in August 2001 to 1% by mid-2003. The Fed Funds Rate was held
at 1% for one full year until June 30, 2004 when the target rate started to be
raised. In the opinion of many, the Fed held this rate too low for too
long.
Many
economists now blame Greenspan, in hindsight of course, for the lax bank
supervision during that period as well. Lee Hoskins, former President of
the Cleveland Fed from 1987 to 1991, said that to find
"partial causes" of the credit turmoil, "you have to go back to
the Fed's decision to push the federal funds rate down to 1% and leave it there
for over a year." Short term interest rates tend to be a leading
indicator of longer term interest rates. As the Fed was lowering short
term interest rates during this period, lower longer term interest rates
spurred home buying, while at the same time a minimally regulated financial
services sector was creating mechanisms for those with little to no
creditworthiness to borrow.
On
June 29, 2006, under the leadership of new Fed Chairman "Helicopter"
Ben Bernanke, the Fed Funds Rate peaked at 5.25%. This was then reduced
steadily, culminating at a target rate of 0-0.25%, which was set on December
16, 2008. This near 0% rate has famously been accompanied by several
rounds of Quantitative Easing (QE) and is expected to continue to be held for
the foreseeable future. At its
December 2013 meeting, the Fed Committee indicated that, based on its
assessment of measures of labor market conditions, indicators of inflation
pressures and inflation expectations, and readings on financial developments,
it will likely be appropriate to maintain the current target range for the
Federal Funds Rate well past the time that the unemployment rate declines below
6.5%, especially if projected inflation continues to run below the Committee's
2% longer-run goal.
Throughout
the life of near 0% interest rates, asset prices have generally inflated
strongly across the board. In the example of the Greenspan
experiment, housing was the asset class that soared to record highs and then
collapsed. In the Bernanke zero-rate
experiment, corporate high yield bonds was the asset class that soared to
record highs. We believe that similar to
housing, certain companies will collapse. Additionally, as high yield bonds have increased in price
and tightened in yield to all-time records, bond issuance has been
unprecedented.
2013
PIK Bond issuance, a type of loan that allows the borrower to pay lenders back
in additional loans in lieu of cash, was more than $16.5 B, dwarfing the prior
peak of $11.1 B in 2007. According to the BIS, more than 30% of PIK Bonds
from the last cycle have already defaulted. Nearly 60% of loan volume in
2013 was issued as cov-lite and record paces of high yield issuance has gone on
unmitigated for nearly six years. Combine this with academic studies that show nearly 50% of all CCC-rated
issues default within 4 years of issuance, and we think there is a serious high
yield bubble primed to deflate over the next several years.
Holding
interest rates at 1% for one year had serious unintended consequences that
indirectly helped cause the subprime debacle. Former Fed Chairman
Greenspan handed that mess over to soon-to-be former Fed Chairman Bernanke.
Now, Fed Chairperson-elect Yellen will inherit a situation where there is
no historical data to help predict future results. We think that holding
near 0% interest rates for 5+ years (and counting) will also have serious
unintended consequences and we will be short overvalued, highly levered,
vulnerable US high yield companies while that story plays out.
Richard
Travia
Director of Research
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