Lorenzo Bini Smaghi, a former member of the ECB’s executive board, raised some ire last month when he was quoted at the IMF’s spring meeting saying, “We don’t fully understand what is happening in advanced economies.” Such a statement drew so much attention largely because a significant number and proportion of investors, observers and professionals highly agree with him. Central banks are running a series of immense ad hoc experiments outside of their comfort with historical case studies – there simply aren’t any analogs in human history for what we have now (outside of Weimar Germany, but that case is dismissed immediately as “impossible”).
The lingering questions are driven by the conspicuous lack of results. These monetary measures were brought into existence with discrete goals attached, and none have been fully met. Indeed, the standards of success change with time.
Central banks are incapable of diagnosing the problem because they are a full part of it. Capital cannot be substituted for simple money or credit money. There is a far more nuanced and complex relationship between capital and economic health that is beyond the grasp of monetarism.
However, monetary policy, despite academic protestations, is not neutral. It has very real impacts, including those that we have become all too familiar with – asset bubbles. When Mr. Smaghi spoke his truthiness, he was basically saying that central banks were perplexed that credit was not flowing into the real economy, instead moving into asset prices. There is a bit of disingenuousness on this part, particularly since a primary goal of 21st century monetarism is asset price inflation.
While attention in asset inflation is fixated on stocks, rightfully so, and more than passing attention is paid to the “bond bubble”, it is often exclusive to the government bond sphere. Left out of the inflation concerns is the corporate credit bubble, particularly high yield, low quality credits. If JC Penney bonds can continue to trade at a premium after running down every line of credit in their hands, something may be more than slightly askew.
Through the end of April, $136 billion in junk bonds have been issued this year, a record amount. That was 12% more than the same period in 2012. Yet, despite the deluge of supply, junk rates are the lowest we have ever seen. Clearly, it is the case of supply meeting (or still failing to meet) excessive demand.
The yield on Barclay’s US High Yield Index fell below 5% in the past few days, a level that the US Treasury 10-year paid only six years ago. The Bank of America Merrill Lynch High Yield Master II Index was yielding 7% in May 2012, now only 5.31%.
But as is pointed out over and over, the bond optimists and central bank apologists “helpfully” note that junk spreads remain relatively wide to equivalent treasury yields. Because central banks are holding government yields in record low ranges, the junk bond market is simply reacting in accordance with “market” perceptions of relative risk levels, or so this thinking goes. Again, that is by design since central banks wish to use “risk-free” yields to “set” the rates on risky credit, including junk. The end result is exactly what we see – a lot of new debt and borrowing. Where this fails is the transition from borrowing to meaningful economic activity, and that is a direct warning.
That begs the question of what exactly junk yields reflect currently, the “market” perception or the “managed” perception. There is a world of difference between the two.
While spreads are useful for measuring relative risk across different classes, there still exists nominal risk. At that IMF spring conference, the fund also reportedly warned that it sees lax corporate credit standards in the US, standards more associated with the “late stage in a boom-bust credit cycle.” Default rates typically rise shortly after these late stages, but with nominal yields at these levels, regardless of spreads, there is not enough yield paid out to compensate for that change in cycle.
To drive this point home, the volume of covenant-lite loans in corporate junk bonds in 2012 was moving back to 2007 levels, with predictions that 2013 will see even more.
While bond investors are highly complacent, that is the case with investors in every single asset bubble. All it takes is a minor change in perceptions for the herd to begin to reassess valuations and absolutes (not spreads), and it’s not like there aren’t storms on the horizon. Record prices are essentially the indication of the crowded trade, and when the crowd reverses there are no bids to catch all the falling knives.
It is never different ‘this time’ though we can convince ourselves otherwise, soothed by the sweet sounds of “managed” perceptions of risk and “fairly valued” spreads. After all, even the central banks largely admit, through both word and deed, that they don’t really know what is going on.