“Two and two are four.”
“Sometimes, Winston. Sometimes they are five. Sometimes they are
three. Sometimes they are all of them at once. You must try harder.
It is not easy to become sane.”
– George Orwell, 1984
Few who assume power ever do so
with the intention of relinquishing it.
So long as the Fed maintains the fiction
that without monetary “stimulus,” the
U.S. economy is doomed to recession,
depression, deflation, or maybe to all
three at once, the Fed legitimizes its
role as de facto global central planner
for interest rates.
After eight plus years of ZIRP, the Fed
took its first baby step towards rate
“normalization” in December. Rather
than accept that capital markets will
need to – sooner or later – re-price
themselves to “normal,” the Fed’s
response to Q1’s equity and credit
market volatility was cringe worthy.
January’s clear guidance that rates
would be heading higher was replaced
with Yellen’s March statement that from
now on the Fed’s guidance would be
market dependent. Sorry, but that is not
“guidance” – it is all but a confession
that the Fed, having missed its off-ramp
to raise rates for this cycle, no longer
knows whether rates should go up,
down, or sideways. The Fed has painted
itself into a corner, and knows it.
What are its policy options? Through door
#1 lies the wrecked remains of the bridge
to “normalization.” The “dream” of riding
off into an eventual sunset of 3%+ short
rates is dead. That path won’t be followed
because it can’t be followed. Higher rates
in the U.S. would further strengthen the
dollar, curtail corporate profits, flatten or
invert the yield curve, thereby causing a
recession. That leaves door #2: hope and
pray. In other words, don’t raise rates,
at least not now, raising the specter that
when this cycle finally gives up the ghost,
it does so with the Fed out of ammo. The
Fed full well understands that the legacy
of its eight years of asset price inflation
has not been prosperity but rather an
economic no-man’s land embodied by
an apathetic “recovery.” The Fed sold us
a bottle of monetary Dr. Good but never
did get around to mentioning price. But
economics inherently is about balancing
costs with benefits; it is not about the
procurement of free lunches. Indeed,
if zero rates delivered only benefits,
then I suppose all of us in the asset
management industry ought to call it a
day and just let the central bankers give
credit away, abolish capital charges, and
exhort the borrowers of the world that
they have nothing to lose but their chains.
But we know better: all things economic
have a price because they have
opportunity cost. To use a resource in
a certain way at a certain time precludes
its use in another way at another time.
Facts are indeed stubborn and while an economic good can be priced at zero that does not mean that its cost is zero. And, when
prices are misaligned with costs, resources are sure to be squandered and growth will suffer.
When the Fed decided to misalign rates with economic reality by pivoting to the zero bound, it did so with the expectation that
a reach for yield would ensue and would, in turn, suppress capitalization rates across such diverse markets as real-estate, stocks,
and bonds. The tautological result would be a bull market in risk followed by (or so the Fed thought) a rejuvenation in animal spirits
and a virtuous cycle of spending, credit creation, and output expansion:
The Fed’s Playbook: ZIRP as “Free Lunch”
The Fed must have thought that its monetary innovations would shock and awe us into a state of rapid growth. Alas, growth is
a complex process that happens one business and one innovation at a time. The attempt to socially engineer growth from the
top down by “falsifying” rates and asset prices was bound to fail, and so it has. Did anyone at the Fed ask the question of what
the consequences of an artificial expansion in asset prices really meant?
Apparently not. Quite obviously, inflating asset values tautologically expands the system-wide supply of collateral. Higher real
estate prices means there is more real-estate to borrow against. With more stuff to leverage, more leverage will be added to the
stuff. Of course, had the leverage been used to direct resources efficiently, the happy result would be that boom the Fed promised
was coming our way. Instead, we are saddled with the leverage created by an artificial bull market, hence without the proportionate
increase in incomes needed to service all that newly created leverage:
The Delayed and “Hidden” Costs of ZIRP
Eventually, too little income servicing too much debt can have but a single result. As fixed income investors, how are we to prepare
ourselves for the inevitable? We can start by recognizing that late in the asset cycle bonds naturally organize themselves into three
distinct cohorts: the Safe, the Breakable, and the Bendable:
Safe assets, as the name implies, includes Treasuries, agency MBS, Bunds, and Japanese Government Bonds (JGBs). No one is
going to feather their nest in style with Safe assets, but they can be counted upon to damp down volatility when the de-leveraging
storm hits shore. After it does, selling such “anchor to windward” assets in favor of higher yielding opportunities is de rigueur for
the active manager.
Meanwhile, active management would have little meaning unless it further recognized the inevitable presence of Breakable assets
in every cycle. Last time around, subprime mortgages and high yield debt created as a result of such absurdly overleveraged
transactions as the 2007 TXU buyout constituted the Breakable cohort. This time around, assets have already broken in the
energy and commodities complex and, in time, the breakage will spread to new territories in the high yield and emerging market
landscape. Needless to say, active investors need to avoid the Breakable until they actually break. To do otherwise is to invite
writedowns and principal losses into your portfolio.
Finally, there are the Bendable assets: your investment grade corporates, your top of the capital structure AAA-rated CMBS and
ABS. These assets have the wherewithal to survive a de-leveraging cycle but will most certainly suffer marking-to-market volatility
as the weather turns inclement. The Bendable, by definition, will survive the cycle and should be bought in a disciplined, dollar-cost
averaged manner.
So, while the Fed cannot direct the movement of the clouds, the rest of us earthlings can prepare for the incoming squall.
This means taking counsel from this investor’s playbook: buy Bendable into weakness, sell Safe into strength, and avoid the
Breakable until the break.