The headline summarizing the Fed Minutes on Wednesday is laughable. It reads "hawks worry delay in rate hike could cause recession." There cannot be a more absurd statement. Firstly, the idea that there are any hawks left at the Fed isn't true. The Fed has left rates near zero for about eight years. The differences at the Fed are over who can be more dovish, not about hawkishness. A true hawk wouldn't express a wonder about whether the Fed should raise rates by 25 basis points. A true hawk would want the Fed to raise rates 100-200 basis points immediately.
Secondly, the concept that low interest rates could cause a recession is antithetical to Fed policy over the past few decades. The Fed always cuts rates when it discovers the economy is in a recession. The Fed believes low rates are stimulative, so the concept that low interest rates would cause a recession doesn't make sense. The narrative to raising rates previously has been that the economy is strong enough to handle a rate hike. The Fed seems to be confused about the effects of its policies, so I will explain it to them. In this article, investors will see the bubbles the Fed has produced.
Low interest rates create bubbles in assets. This is because investors are forced into riskier assets to receive a decent return. Pension funds can no longer buy government bonds to achieve the returns they need. As you can see below, low interest rates have caused pension funds to be in a worse position to meet their obligations than in 2008 when the market crashed.
Low interest rates also lower the savings rate. Savings is what drives investment. Business investment has been declining in the past few quarters as you can see from the chart below. If private businesses aren't investing in new initiatives, there is no way for productivity to increase. This has been borne out by the numbers as productivity has been decelerating. The Fed has been keeping rates low to help the economy, but all it has done is increase borrowing to buy back stock which pads management's pay, but does little to drive long-term growth.
The chart below shows the productivity growth over the past few decades. We are currently experiencing extremely low productivity growth. The chart breaks down the sources of productivity growth. Capital deepening is the amount of capital available to each worker. Labor composition is changes in education and experience of the workforce. MFP (multifactor productivity) is improvements in technology. As you can see the MFP growth and capital deepening are the lowest for the most recent period. With interest rates this low business investment has declined, which is the reason capital deepening is weak. Business investment lowering causes technology to improve at a slower rate.
The chart below emphasizes the point that real business investment has declined while commercial and industrial loans are increasing. The leverage in the system is the highest ever as cheap money is not going to the right places. Businesses will only invest in new initiatives if they see sales growth in the future. Low interest rates will not cause a manager to invest in a new initiative. However, managers are still tempted to take the free money, so they pile it into the easiest place: dividends and buybacks.
As you can see, the total payout ratio of dividends and buybacks has exceeded 100% for the past two years. Usually, this borrowing to fund buybacks and dividends doesn't last this long and it has never lasted three years, so leverage is near its brink.
The chart below shows how levered the balance sheets of corporations are. The leverage on investment-grade balance sheets is at a record high. The three bubbles that you can see in the chart below have all been created by the Federal Reserve's easy money policies.
Another reason why I find the headline I started this article with to be absurd is the Fed already missed its opportunity to raise rates. It's not surprising the Fed has missed its opportunity to raise rates because the average recovery is 59 months and this one has lasted 87 months. The chart below emphasizes this point. While on an absolute basis commercial bankruptcies are still low, on a relative basis commercial bankruptcies bottomed and started moving higher in November of 2015. This signals the economic recovery is ending. The chart above which has the C&I lending shows a similar perspective as the rate of growth has slowed to a standstill.
Fed policy has created many bubbles. The two I will highlight below is the bubble in junk bonds (NYSEARCA:JNK) and the bubble in stocks. The first chart below shows the recent increase in default rates. I do not separate out energy and mining when looking at this chart because there is always an industry which leads the economy lower. Excluding housing and financials when looking at the 2008 crisis seems silly to me. While energy and mining will not be the cause of the next recession, given the length of the recovery and the leverage on corporations' balance sheets, it makes sense the stress part of the default cycle is beginning now.
The default cycle rolling over is what makes the chart below so illogical. High yield bond spreads have been decreasing just as default rates have increased. The yield spread was tracking default rates by increasing until February. It was when coordinated central bank action ended the correction in stocks and the increase in yield spreads. Considering the Fed wasn't able to lower default rates, all it did was create a junk bond bubble.
The chart below shows this bubble by combining the two charts above. It shows the actual high yield bond spread minus what the estimated spread should be based on fundamentals such as default rates. On September 8th this difference reached two standard deviations, which qualifies junk bonds to be at bubble valuations.
Another chart that shows the bubble in junk bonds is shown below. The investment in high yield bonds has caused yields to fall even as recovery rates are the lowest ever. Recovery rates are the percentage of the debt recovered in the event of a default. The difference between the market price of high yield bonds and recovery rates is at a record-high. This is why I describe junk bonds as being in a bubble.
The second bubble I will discuss in this article is the bubble in stocks. The bubble is being caused by the same issues I have discussed in this article. Sales have not increased to a level which would spur business investment. When sales growth is weak along with investors moving up the risk curve into stocks, you get the chart below. The median price to revenue ratio of the S&P 500 (NYSEARCA:SPY) is at a record-high.
My favorite chart which shows the over-valuation of the stock market was created by Jesse Felder of The Felder Report. This chart below is the enterprise value to gross value added. This is the third generation of ways to measure valuation. The first was the Buffet Yardstick which measures the total market cap of the U.S. stock market relative to GDP. This is akin to the price to sales ratio shown above. Dr. John Hussman improved on this by looking at the market cap to gross value added, which includes the foreign revenues earned by domestic firms. As I have said earlier, there has been an unprecedented amount of debt added to corporate balance sheets. This new valuation metric created by Felder includes debt. It shows stocks are near the bubble valuations of the late 1990s. Valuations are two standard deviations higher than normal, signaling they are in a bubble.
It is absurd the Fed is only now concerned about its policies because the time for worry should have been when the decision to put interest rates near zero and do three rounds of quantitative easing were being considered. At this point, the business cycle is already near its end and junk bonds and stocks are in bubbles. There is no Fed policy which can prevent the carnage that will occur when these bubbles burst. Investors must be aware of these bubbles when they consider asset allocation. Investors also must recognize the poor track record of the Fed to make sure they don't listen to the Fed's forecasts.
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.