In the recession of 2008 and 2009, the U.S. economy faced its biggest financial crisis since the great depression. The U.S. Federal Reserve stepped in with dramatic responses to quell the damage.
One of the most powerful tools the Fed has is its capacity to set interest rates banks charge each other to borrow and lend money held at the Federal Reserve. This is known as the Federal funds target rate. The actual rate banks lend to one another is known as the effective Federal funds rate.
Here is a chart of the effective Federal funds rate since the mid 1950s:
As you can tell, the rate has been close to zero since 2009.
The financial fires have been put out with the help of this policy.
Take a look at the following charts of delinquency rates of loans at commercial banks.
Business loans at all commercial banks had a delinquency rate of 1.08% in Q1 of 2013, the lowest since October of 2006 when it was 1.15%.
Consumer loans at all commercial banks had a delinquency rate of 2.53% in Q1 of 2013, also the lowest since it was 2.69% in October of 2005.
While business loans and consumer loans are showing outstanding performance, the same can't be said of real estate related loans at both the residential (BLUE) and commercial (Red) side. Here is a chart of the delinquency rate of both residential and commercial loans booked in domestic offices.
(click to enlarge)
The efforts to save the real estate loans on banks have caused perhaps too great of a performance of non real estate related loans.
I'm not so sure this is a good thing. I can't help but think of the "Wallow Fire."
The Wallow Fire was the largest wildfire recorded in Arizona. It occurred in June of 2011, and burned 841 square miles.
Why the Fed policies remind me of the Wallow Fire is because of what made the Wallow Fire so devastating: Too much intervention.
Like any natural forest, there needs to be occasional wildfires to burn up the dead wood and thicket. An economy needs healthy doses of recessions to clean out the dead wood businesses and malinvestments, be it government or private. This is to allow sunlight to reach the floor of the forest or economy and provide new plant life or new businesses. It also helps to keep the amount of dead wood build up from becoming too large. Too much dead wood build up simply brings about more fuel for the next fire and too much fuel could cause the fire to become so great, the entire forest gets burned to a crisp.
That wasn't the case in Arizona. A 90-year old rancher in Arizona put it like this:
All of this is a result of overprotection of our natural resources, timber and grass that has grown into a dog hair thicket that cannot be contained...
In an article written in June of 2011, describing the reasons for the wildfire, the author puts it like this:
Under the disguise of non-profit organizations and saviors of the environment and endangers species, groups like the Sierra Club, Friends of the Forest Guardians and the Center for Biological Diversity have been strong advocates against logging, the burning of small natural fires, and grazing on Federally held forest land. Excessive Forest Service regulation, Endangered Species Act regulations, clean water regulations and more, prevent the salvaging of dead trees and clean up of excess dead vegetation. This has resulted in a dangerous and large build up of extremely dry dead trees, excess brush and thick vegetation undergrowth. A ticking time bomb waiting for a single lightening strike to set it off.
Fed officials met this past May 17, for their Meeting of the Federal Advisory Council and the Board of Governors. A question was posed about the effects of current monetary policy, the ongoing impacts of the Federal Reserve's portfolio and how security purchases are influencing financial markets.
Some of the statements made were as follows:
There are potential risks associated with current policy. The Fed's securities purchases have reduced mortgage yields and, to a lesser extent, Treasury yields. Current low bond yields are disruptive to management of fixed-income portfolios, retirement funds, consumer savings, and retirement planning. They may encourage unsophisticated investors to take on undue risk to achieve better returns. MBS purchases account for over 70% of gross issuance, causing price distortion and volatility in the MBS market. Fixed-income investors worry that attractive mortgage-backed securities are in very tight supply. Higher premium coupons carry too much exposure to prepayments, potentially led by new government support programs for housing. Many are concerned about the Fed's significant presence in the market. They have underweighted MBS in favor of corporate, municipal,and emerging-market bonds. There is also concern about the possibility of a breakout of inflation, although current inflation risk is not considered unmanageable, and of an unsustainable bubble in equity and fixed-income markets given current prices.
Uncertainty exists about how markets will reestablish normal valuations when the Fed withdraws from the market. It will likely be difficult to unwind policy accommodation, and the end of monetary easing may be painful for consumers and businesses. Given the Fed's balance sheet increase of approximately $2.5 trillion since 2008, the Fed may now be perceived as integral to the housing finance system
Think about this in terms of the economy being a forest. Given the extremely low delinquency rates of both consumer and business loans, perhaps the Fed policy has allowed too much dead wood to sit on the floor of the economy.
Too much dead wood on the floor of a forest would prevent sunlight from reaching the floor of the forest too.
Another comment from the minutes was this:
Uncertainty about fiscal and monetary policy is deterring business investment that would spur growth, and despite policy accommodation, economic growth has remained sluggish and uneven.
Note: Emphasis mine
The Fed may have done too much and has made the conditions such that in the next recession, the "economic fire is uncontrollable" and burns down much of the entire forest.
A healthy wildfire may look something like this:
The deadwood would burn up, but the large trees would remain.
Aftermath of such a healthy wildfire would look like this:
Too much dead wood and thicket in a forest looks like this:
So that when the spark is lit, the wildfire becomes something like this:
Conclusion: While this article serves as an observation on monetary policy, investors need to be aware of the risks both banks and the economy face.
Aggregate debt in the U.S. economy is $57 trillion as of Q1 of 2013:
As a percent of GDP, aggregate debt is still very high.
I recon a good deal of this debt is deadwood. Here is a great example of deadwood in the U.S. economy. In 1964, a $25 million bond was issued in Philadelphia, to pay for a new sports stadium, the Veterans Stadium. The stadium was demolished in 2004, yet taxpayers in Philadelphia are still trying to pay off this $25 million bond issued nearly 50 years ago. The good news is, it's expected to be paid off next year.
For the greater good, it may be in the best long-term interest of the U.S. economy if we get a large wildfire that burns up all this dead wood. The longer we wait for such a fire, the greater the fire will eventually become.
I can appreciate Andrew Mellon's advise to Herbert Hoover soon after the stock market crash of 1929: "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate..purge the rottenness out of the system." In essence, he was calling for a clearing of all the deadwood.
The great risk ahead is rising interest rates coupled with a declining economy as that would be the spark and wind that brings about the next economic wildfire.
This is why investors and households for that matter, should hedge against such worst-case scenarios by owning tangible and private assets. Gold (NYSEARCA:GLD) and Silver (NYSEARCA:SLV) may well prove to be such an asset. Owning assets like cars, real estate and appliances outright instead of having loans on them will also act as a hedge against such a scenario to avoid the repo man or foreclosure sheriff.
As for stocks, stick with low-leveraged companies with little to no debt. For bonds, stick with private corporate debt with high credit ratings and low duration to avoid higher interest rate risk. Holding cash I believe is prudent as well while you wait for the "fire sale" of assets to go on.