“All of these markets saw historic highs during the Fed’s quantitative-easing, near-zero heyday. The Fed wanted investors to lift financial-asset prices, chasing risk along the yield curve. That’s exactly what they did, pouring into the likes of emerging-market debt, commodity plays and riskier corporate bonds…

…The high-yield-bond washout is worth watching in particular, as we note below. Normally junk investors would deserve no special attention because their investments are called junk for a reason. But some investors unaccustomed to the risks may have been enticed into the market when junk spreads narrowed to historic lows against Treasurys while the Fed was urging everybody on.Now the junk bubble is bursting, and the extent of the damage is hard to predict. This is precisely why many of our friends warned about the excesses that near-zero rates might produce in asset markets.”, “The Fed at the Brink”, The Wall Street Journal Editorial Board, December 15, 2015

Opinion

The Fed at the Brink

After seven years of near-zero, financial markets are nervous.

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The Federal Reserve Building in Washington D.C. on October 27, 2014. PHOTO: GETTY IMAGES

What goes down must come up, and so after seven long years the Federal Reserve is finally poised this week to get off its near-zero interest-rate bound. Along with this come the financial tensions of unwinding the Fed’s long gamble with unconventional monetary stimulus.

The big news in financial markets in recent weeks has been the return of anxiety, led by commodities, junk bonds and emerging markets. All of these markets saw historic highs during the Fed’s quantitative-easing, near-zero heyday. The Fed wanted investors to lift financial-asset prices, chasing risk along the yield curve. That’s exactly what they did, pouring into the likes of emerging-market debt, commodity plays and riskier corporate bonds.

The returns were fun while they lasted, but these have been rolling back as the Fed has signaled a gradual return to normalcy. As the dollar has climbed while Japan and Europe devalue and emerging economics like China slow, commodities have plunged.

Crashing oil prices are punishing energy companies, which is also rippling through the credit markets. Chesapeake Energy’s bonds traded below 30 cents on Monday amid a bond swap to reduce debt. Banks have been carrying many energy companies for months in anticipation that oil prices might rebound, but the pain will build the longer prices stay low.

The high-yield-bond washout is worth watching in particular, as we note below. Normally junk investors would deserve no special attention because their investments are called junk for a reason. But some investors unaccustomed to the risks may have been enticed into the market when junk spreads narrowed to historic lows against Treasurys while the Fed was urging everybody on.

Now the junk bubble is bursting, and the extent of the damage is hard to predict. This is precisely why many of our friends warned about the excesses that near-zero rates might produce in asset markets.

One question is whether this case of market nerves is merely an inevitable and temporary adjustment or a sign of deeper credit distress. The former is certainly possible. The markets threw their famous “taper tantrum” of 2013 when the Fed was reducing its monthly bond purchases, only to calm down when the Fed followed through. This expansion had two of its strongest quarters of growth after the Fed purchases ended.

Perhaps the oddest feature of this pending rate hike is how conflicted Fed Chair Janet Yellen and her colleagues seem to be. Even their own leaks to the Fed press corps are full of self-doubt. Fed officials seem to be looking at the economy through the usual Phillips Curve model based on the trade-off between inflation and unemployment. The Fed’s Keynesians see a moderately tight jobs market with a 5% unemployment rate, at least for those still looking for work, and so they worry about wage-push pressure on prices coming around the corner.

We thought the Phillips Curve was discredited amid the stagflation of the 1970s, and our preferred inflation guides are actual prices and price expectations. On that score, nearly every leading commodity market is signaling lower future prices, which suggests lower demand expectations. The rising dollar is a factor here, but these markets could also be signaling slower global growth in 2016.

***

All of which leaves the Fed with a dilemma of its own making. If it stays at zero this week, it will raise more doubts about the economy and cause markets to wonder about the Fed’s competence. If the Fed does follow through and raise rates, it courts catcalls from the political class and Wall Street if the economy slows or there is larger financial turmoil.

Our own view, oft-expressed, is that the Fed would be better positioned now if it had begun raising rates earlier in this expansion, returning to normal amid a stronger, more confident investor outlook. If the fed-funds rate were closer to 2% or 3% now, the Fed would have room to pause its rate increases and might have less financial turmoil to navigate.

Instead, the Ben Bernanke-Yellen Fed argued year after year that a little more time at zero would pave the way for an economic breakout to 3% or faster growth. That faster growth has never arrived, even as the Fed’s rate reckoning apparently has. The transition had to happen sooner or later, and it might be a bumpy ride.

Posted on December 16, 2015, in Postings. Bookmark the permalink. Leave a comment.

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