Central Bank Orchestras Are Still Playing But Not Everyone Is Still Dancing

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Includes: AGG, IYF
by: Martin Lowy

Summary

Credit conditions have two components: the base rate and the spread over that rate.

Central banks control the base rate but not the spreads.

High yield bond spreads increase significantly as a credit cycle matures.

The U.S. is now at the maturing end of the credit cycle that began as the GFC waned, much of the rest of the world is even more exposed.

Increasing spreads on low-rated bonds may be a leading indicator of decreasing economic activity.

Credit conditions have two components: (1) the base, or risk-free, rate, and (2) the spread over the risk-free rate at which the lending community is willing to lend to a particular borrower at a particular duration. It often is overlooked that the two components react to very different stimuli. This is the second article on this subject. The first was purely theoretical. This version will adduce some data to back up the assertions.

The Fed or any central bank can, within reasonable parameters, set the short-term risk-free rate. The market sets the spread over the risk-free rate on each loan based on its assessment of the perceived likelihood that the borrower will repay the loan in accordance with its terms.

When the central bank sets the risk-free rate at a low point, it can stimulate lenders to seek additional yield by taking greater risk. Spreads on riskier loans therefore contract, as lenders compete to take risks. The central bank intends that to promote economic activity. That process ensued when the Fed lowered the risk-free rate to near zero in 2009 and pledged to keep it there for an extended period of time: Spreads on all kinds of loans narrowed.

QE followed in 2010 and thereafter in the form of the Fed buying longer-dated but still basically credit-riskless securities, which tended to compress the yield curve by lowering the natural premium for longer term lending.

So far good. Maybe.

Spreads, Fed funds, and Economic Activity

Here is an illustration of how the process worked over the last 20 years (as far back as the Merrill Lynch index in the chart goes):

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There are several things to note about this graph. First, spreads over Treasury rate have no correlation with the fed funds rate. They march to some other drummer. Second, what correlates with both (and possibly the driver of both) is GDP growth. The Fed funds rate is lowered in response to GDP weakness. The change in high yield bond spreads also is correlated, but it appears to be a leading, rather than a lagging correlation. Third, is the spread on high yield bonds a reliable leading indicator of economic weakness? This little chart suggests that it might be. And if it is, then the fairly sharply upward slope from 2014 to date suggests economic weakness ahead.

We could construct a dozen or so such charts for various levels of credit risk and interest rate risk in each type of bonds. I invite you to do it on the FRED site, if that interests you. Or you could accept my assertion that the shorter the maturity and the higher the rating of the security, (1) the less variation there is in the spread over Treasury, (2) the more correlation there is between the spread and the fed funds rate, and (3) the less correlation there is as a potential leading indicator of changes in GDP.

All that is logical. What makes the high yield sector the most interesting is that it responds so much more to perceptions of credit risk. And perceptions of credit risk are, quite naturally, based on perceptions of future economic activity. That assertion will be validated, I think, by the discussion of credit rating changes later in this article.

Credit Cycles

The above graph may suggest that riskier securities have begun to show their risk characteristics in 2015. That tends to happen when the up part of the cycle of economic activity, that begins when the last recession ended, begins to turn downward, as it inevitably must do some day. At that time, which in the current case I would argue was around the end of the third quarter of 2015 (though the above graph might suggest an earlier date), the credit risks are taken more seriously by the lending community, and the Fed and other central banks are without power to prevent risk spreads from widening or to force the lending community to roll over the riskier loans.

As the above graph shows, high yield spreads correlate (I think respond) to perceptions of GDP strength and weakness, not to changes in the fed funds rate.

In the past, the process indicated by increasing high-yield spreads at least has been correlated with (I assert resulted in) defaults and in the contraction of economic activity. And as I said, the Fed and other central banks are powerless to entice the lending community to take the additional risks without vastly greater compensation by way of spread over the riskless rate.

That incapacity has not yet been proven by data. There has never before been such a prolonged period of rates so low, so there is no comparable data to look at. But if one thinks logically as (mythical) universal lenders would do, why would you take greater risk when you think you are at the wrong part of the cycle to do that.

Don't take it from me that now is the wrong part of the cycle. Ask the experts at the Office of Financial Research (OFR), the research arm of the Financial Stability Oversight Council (FSOC) credit cycle at the end of 2015, according to their annual report to Congress. As you can see, EM nations were in the bad part of the cycle and Europe and Japan had yet to enter the good part of the cycle-Europe and Japan were not even approaching it, despite years of monetary stimulus. Thus, if the U.S. is slipping from the good part of the cycle to the downturn, the forces of credit tightening will be at work substantially all over the world.

Emerging markets are particularly vulnerable at this time, as the following complex chart from the OFR 2015 annual report shows:

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But the OFR is not very complimentary about U.S. credit, either: "standards for loan underwriting remain weak," the annual report says.

Credit Rating Downgrades

Credit rating downgrades ought to precede downturns in credit quality, but it appears that credit rating agencies cannot anticipate economic downturns any better than most people. Looked at a bit after-the-fact, however, it is clear that ratings downgrades respond to economic forces, not to the fed funds rate. See this Standard & Poor's study, from which the following graphs are copied.

Low-rated securities appear to perform well in their early years. As time goes on (by the fifth year), they default in numbers.

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The defaults correspond to the state of economic activity, as the following chart shows, with the defaults clustered around the recessions of 1991, 2001 and 2008. Monetary policy seems to make no difference, unless it actually causes the economic downturns.

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Credit ratings downgrades do not precede the economic downturn. They react to it, as shown by the following table of downgrades and other data over the period 1981 to 2014. As a leading indicator, the rating changes seem to have little predictive value. Indeed, the years immediately before economic slowdowns had lower than average downgrade activity, a negative correlation with approaching economic weakness.

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What Can Be Done About Credit Cycles?

Coming back to riskier credits in general: At this point in the cycle, the vastly higher interest rate that the lending community demands of the riskier borrowers cannot be afforded by those borrowers, whose businesses, by definition, are not performing as had to have been anticipated to justify the risks that lenders were taking. Lending to such borrowers grinds to a halt, regardless of how low the risk-free base rate may be.

I doubt that negative risk-free rates can restore central banks' power in this regard because the risky borrowers still will be in process of becoming riskier, but no one really knows the impact of widespread negative rates. I am not optimistic.

The position of the major economies in the credit cycle is what now is forcing the global economy to slow. It does not appear that conventional central banking can reverse the process until large amounts of bad loans have been recognized and washed through the bankruptcy system. That process hurts banks and all other lenders, including individuals and their retirement funds. It has to take some time. But at least in the U.S., I am optimistic that we will not see another financial crisis this time around. The banking system is now so much better capitalized and its risks are much better managed than in the Great Financial Crisis of 2007-2009. There are real risks in the central exchange architecture, but they seem to be contained. Real estate in many places is overpriced, but the transmission mechanism to the major institutions appears to have been dampened. And I am convinced that the mutual fund architecture is sound enough that crisis will not come again from that quarter. I am less certain about the financial systems of other nations.

This article is the second in a series. The next in this series will discuss misallocation of resources (I like that term better than malinvestment) that the low rates of 2009-2015 probably caused. Inducing misallocation of resources appears to be an important part of why inducing lenders to take greater risks does not sustain itself for the long term and may be a key to evaluating the longer-term impact of aggressive monetary policies. And that discussion, in turn, may lead to some clues as to how to ameliorate the excesses of the credit cycle.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.