Four Charts to Make a Rate-Raising Fed Nervous
The Federal Reserve looks poised to affirm its confidence in the economy by raising interest rates on Wednesday, just weeks after the European Central Bank decided the outlook warranted yet more quantitative easing. As the outlook for monetary policy gets fuzzier, weird things are happening in the debt markets. Here, then, are four charts that suggest the Fed's confidence is misplaced.
WHAT'S WRONG WITH THIS PICTURE?
When the U.S. government borrows for one year in the Treasury bill market, it pays about 0.66 percent for its money. Until recently, that was about the same as Germany pays to borrow for a decade -- which is absurd, right? Except in the past few days, Germany's 10-year borrowing cost has dropped below Uncle Sam's one-year rate, which is even crazier:
Quantitative easing -- which has added about $3.5 trillion to the Fed's balance sheet, and will expand the ECB's balance sheet by more than $1 trillion -- has destroyed the valuation mechanisms for government bonds. When central banks are hoovering up huge amounts of debt, prices and yields lose their information value. The prospect of higher Fed rates has driven one-year yields higher, while the possibility of yet more ECB rate cuts is pushing German levels to record lows.
So the question the Fed needs to ask itself is this: If policy actions at its counterpart in Frankfurt suggest the euro zone's contribution to global growth will be negligible in the foreseeable future, should U.S. monetary policy-makers really be tapping on the brakes?
IF HISTORY DOESN'T REPEAT, IT RHYMES
In 2011, with the global economy still struggling in the aftermath of the credit crisis, the ECB decided to raise interest rates -- twice. Just a few months after the second tightening, the central bank was forced to capitulate:
The risk is that the Fed is committing a similar policy error, and will be bounced into an embarrassing reversal next year. Here's economist Jim Grant, writing in his newsletter earlier this month:
The Fed will raise its infernal rate by the widely expected 25 basis points, then sit back and -- as the months pass -- wish it had done nothing of the kind. With as much dignity as it can muster, the Bank of Yellen will reverse itself and implement some next round of stimulus.
The idea that central banks can safely raise interest rates because they can always reverse course later has gained credibility. This close to zero, the argument goes, it might even be a sensible to push rates higher, thus giving more ammunition for later if more stimulus is required.
That strikes me as dangerous talk. The last thing businesses and consumers need at this juncture is more uncertainty. If the Fed has even the slightest doubts about what policy might be required in, say, the second half of next year, it should stay on hold. The worst of all possible worlds would be a premature increase followed by a u-turn.
HIGH-YIELD MARKET IN A FUNK
When UBS announced in October that it would liquidate the Managed High-Yield Plus Fund it had run since 1998, I wrote that the move had worrisome parallels with fund closures that marked the beginning of the credit crisis in 2007. In recent days, Third Avenue Management said it would close its $788 million credit mutual fund, while Stone Lion Capital suspended redemptions from its $400 million high-yield fund, amid tumbling prices for high-yield securities and a rush of investors asking for their money back. And Monday, Lucidus Capital said it has sold its entire high-yield portfolio and will return the $900 million it managed to its investors.
Average borrowing costs for the riskiest companies in the U.S. have risen since the middle of last year, and are now at almost 9 percent, their highest level in more than four years. That's not exactly a vote of confidence in the outlook for the economy:
If those yields are climbing even while the Fed's target interest rate has been held at 0.25 percent since the end of 2008, imagine the potential carnage once official borrowing costs start to increase. Moreover, in the market for leveraged loans, returns have turned negative for the first time this year, according to figures compiled by credit-rating company Standard & Poor's:
Finance is effectively a confidence trick; if investors lose confidence in the likelihood that they'll get repaid, the sequel to the credit crunch could be like many Hollywood repeats -- longer, less lucrative and worse than the original. A Fed misstep could be the most expensive mistake ever made by a central bank.
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