FED HAS GROWN COMPLACENT ON CREDIT MARKET RISK / THE FINANCIAL TIMES MARKETS INSIGHT

Markets Insight

June 30, 2014 6:33 am

Fed has grown complacent on credit market risk

By Alberto Gallo

US central bank’s error now threatens financial stability

“High-yield bonds have certainly caught our attention,” Janet Yellen, Federal Reserve’s 

chairwoman, remarked after the US central bank’s June policy meeting. “There is some evidence of ‘reach for yield’ behaviour.” Yet, the Fed’s broader message to investors was clear: we are not concerned and we will keep interest rates low; keep on dancing.

I believe this is a policy error. The Fed is underestimating a build-up of risk in credit markets which is threatening financial stability.

The International Monetary Fund warned in its last assessment of the US economy that bond markets were becoming vulnerable to a sell-off. “Longer-term treasury yields and the term premia have been compressed to very low levels,” it noted. The IMF cited increased risk-taking by mutual funds and credit exchange traded funds, which are exposed to daily redemptions but invest in illiquid assets (junk bonds or loans), as well as worsening credit standards and low secondary market liquidity. The European Central Bank and Bank of England have also raised red flags.

The worry is that a combination of complacency and illiquidity could turn a snowball into an avalanche when “low-for-long” interest rates come to an end. With US unemployment falling and the Fed’s asset purchase “tapering” ending in the fourth quarter, this moment is getting closer. Markets are unprepared.

Exit strategies

To prevent excess risk-taking and prepare investors for its exit strategy, the Fed has adopted two policies: clear communication and macroprudential regulation. Both are ineffective.

First, providing certainty about the low path of interest rates is self-defeating. It gives an even stronger green light to investors and companies engaged in risk taking. US firms are adding record debt through mergers and acquisitions and share buybacks.

Risk-premium indicators such as the Vix index of US share price volatility and the “spread”, or difference, between high yield US corporate bonds and Treasuries are nearing all-time lows.

Second, macroprudential policy making has a dubious record and may not work. Most existing prudential tools target mortgage lending. In financial markets, investors can generally invent new structures to take risks – and elude regulation. Before leaving the Fed, Jeremy Stein warned policy makers needed to “be realistic” about the limits of regulation. Only monetary policy “gets in all the cracks” of the financial system, he said.

If interest rates remain low, macroprudential policies will fail to stop investors taking irrational risks.

To keep up with competitors, even conservative asset managers are throwing in the towel and buying riskier products, including bank contingent capital (Cocos), CLOs or lower rated junk bonds. Issuers, in turn, are taking advantage of strong demand to finance on terms offering limited protection to creditors, using “cov-lite” loans or “payment-in-kind” bonds.

Finally, bond markets have developed a mismatch in the duration of assets and liabilities. To match daily redemptions, mutual funds or ETFs may be forced to sell illiquid bonds for which there are no buyers. Broker-dealers, who absorbed volatility in the past, have limited ability to do so now: their corporate bond inventory is at a record low of $50bn – or 0.5 per cent of the market.

Endgame

The endgame will not be pretty for bondholders. In an optimistic – but unlikely – scenario in which the Fed changes its forward guidance early, holders of US bonds would be looking at higher yields and some volatility. But policy makers may decide to wait longer, or even try to lock investors into bonds.

The Financial Times has reported that Fed officials have discussed imposing “exit fees on bond funds to avert a potential run by investors”. The irony is that the Fed is becoming trapped by its own policies. QE and low rates have helped to solve the banking crisis, but they have also pushed investors to take on bigger risks.

Systemic risk has moved from banks to financial markets. Fearing a sharp sell-off in bonds, policy makers are delaying a change in guidance, and hoping that clear communication and macroprudential measures will smooth the exit.

This is “just an illusion” to quote the 1980s disco classic. Instead, I believe the only way to stop excessive risk-taking is to signal clearly that interest rates will rise sooner rather than later, and that the music is about to stop.

Behaving like a bond trader, managing volatility to avoid tomorrow’s market correction may ultimately be self-defeating for the Fed. If not policy makers, then bond vigilantes will eventually worry about financial stability, “open up their eyes”, and start selling.


Alberto Gallo is head of macro credit research at RBS

Copyright The Financial Times Limited 2014.