By Robert P. Murphy of Mises Institute

The Fed Can't Save Us

In December, the Fed hiked its target for the federal funds rate, which is the interest rate banks charge each other for overnight loans of reserves. Since 2008 the Fed’s target for the Fed Funds Rate had been a range of 0 percent – 0.25 percent (or what is referred to as zero to 25 “basis points”). But last month they moved that target range up to 0.25 – 0.50 percent. Ending a seven-year period of effectively zero percent interest rates.

From our vantage point, we already see carnage in the financial markets, with the worst opening week in US history. This of course lines up neatly with standard Austrian business cycle theory, which says that the central bank can give an appearance of prosperity for a while with cheap credit, but that this only sets the economy up for a crash once rates begin rising.

However, there is something new in the present cycle. The Fed is trying to raise rates while simultaneously maintaining its bloated balance sheet. It is attempting to pull off a magic trick whereby it can keep all of the “benefits” of its earlier rounds of monetary expansion (i.e., “quantitative easing” or “QE”) while removing the artificial stimulus of ultra-low interest rates. As we’ll see, this attempt will not end well, for the Fed officials or for the rest of us. In the meantime, Ben Bernanke will look on with concern, writing the occasional blog post and perhaps giving a speech about poor Janet Yellen’s tough predicament.

Austrian Business Cycle Theory

One of the seminal contributions of Ludwig von Mises was what he called the circulation credit theory of the trade cycle. In our times, we simply call it Austrian business cycle theory, sometimes abbreviated as ABCT. The Misesian theory was subsequently elaborated by Friedrich Hayek, and it was partly for this work that Hayek won the Nobel Prize in 1974.

In the Mises/Hayek view, interest rates are market prices that perform a definite social function. They communicate vital information about consumer preferences regarding the timing of consumption. Entrepreneurs must decide which projects to start, and they can be of varying length. Intuitively, a high interest rate is a signal that consumers are “impatient,” meaning that entrepreneurs should not tie resources up in long projects unless there are large gains to be had in output from the delay. On the other hand, a low interest rate reduces the penalty on longer investments, and thus acts as a green light to tie capital up in lengthy projects.

So long as the interest rate is set by genuine market forces, it gives the correct guidance to entrepreneurs. If consumers are willing to defer immediate gratification, they save large amounts of their income, and this pushes down interest rates. The high savings frees up real resources from current consumption — things like restaurants and movie theaters — and allows more factories and oil wells to be developed.

However, if the interest rate drops not because of genuine saving, but instead because the central bank electronically buys assets with money created “out of thin air,” then entrepreneurs are given a false signal. They go ahead and take out loans at the artificially cheap rate, but now society embarks on an unsustainable trajectory. It is physically impossible for all of the entrepreneurs to complete the long-term projects they begin.

In the beginning, the unsustainable expansion appears prosperous. Every industry is growing, trying to bid away workers and other resources from each other. Wages and commodity prices shoot up; unemployment and spare capacity drop. The economy is humming, and the citizens are happy.

Yet it all must come crashing down. In a typical cycle, price inflation eventually rises to the level that the banks become nervous. They halt their credit expansion, allowing interest rates to start rising to a more correct level. The tightening in the credit markets causes pain initially for the most leveraged operations, but gradually more and more businesses are in trouble. A wave of layoffs ensues, with large numbers of entrepreneurs suddenly realizing they were too ambitious. The painful “bust,” or recession, sets in.

This Time Is Different (Sort of)

Since the financial crisis of 2008, the stock market’s surges have coincided with rounds of QE, and the market has faltered whenever the expansion came to a temporary halt. The sharp sell-off in August 2015 occurred when investors thought the first rate hike was imminent (it had been scheduled for September 2015). That particular hike was postponed, but after it went into effect in December, we soon saw the market tank to 2014 levels.

As we would expect in times of Fed tightening, the official monetary base has fallen sharply in recent months, but this doesn’t mean that the Fed is selling off assets (as it would in a textbook tightening cycle). Indeed the Fed’s assets have been constant since the end of the so-called taper in late 2014.

This is unusual since the monetary base and the Fed’s total assets typically move in tandem. Yet since late 2014, there have been three major drops in the monetary base that occurred while the Fed was dutifully rolling over its holdings of mortgage-backed securities and Treasuries, keeping its total assets at a steady level.

The explanation is that the Fed has been testing out new techniques to temporarily suck reserves out of the banking system, while not reducing its total asset holdings.

Meanwhile, the Fed in December bumped up the interest rate that it pays to commercial banks for keeping their reserves parked at the Fed. I like to describe this policy as the Fed paying banks to not make loans to their customers.

What Does It All Mean?

So why is the Fed trying to tighten the money supply without selling off assets as it has done in the past? It boils down to this: In order to bail out the commercial and investment banks — at least the ones who were in good standing with DC officials —as well as greasing the wheels for the federal government to run trillion-dollar deficits, the Federal Reserve in late 2008 began buying trillions of dollars worth of Treasury debt and mortgage-backed securities (MBS). This flooded the banking system with trillions of dollars of reserves, and went hand in hand with a collapse of short-term interest rates to basically zero percent.

Now, the Fed wants to begin raising rates (albeit modestly), but it doesn’t want to sell off its Treasury or MBS holdings, for fear that this would cause a spike in Uncle Sam’s borrowing costs and/or crash the housing sector. So the Fed has increased the amount that it is paying commercial banks to keep their reserves with the Fed (rather than lending them out to customers), and — for those institutions that are not legally eligible for such a policy — the Fed is effectively paying to borrow the reserves itself. By adjusting the interest rate the Fed pays on such transactions, the Fed can move the floor on all interest rates up. No institution would lend to a private sector party at less than it can get from the Fed, since the Fed can create dollars at will and is thus the safest place to park or lend reserves.

We thus have the worst of both worlds. We still get the economic effects of “tighter monetary policy,” because the price of credit is rising as it would in a normal Fed tightening. Yet we don’t get the benefit of a smaller Fed footprint and a return of assets to the private sector. Instead, the US taxpayer is ultimately paying subsidies to lending institutions to induce them to charge more for loans, while the big banks and Treasury still benefit from the effective bailout they’ve been getting for years.

It Can’t Last

Will the Fed be able to keep the game going? In a word, no. We’ve already seen that even the tiniest of interest rate hikes has gone hand in hand with a huge drop in the markets. Furthermore, the Fed’s subsidies to the banks are now on the order of $11 billion annually, but if they want to raise the fed funds rate to, say, 2 percent, then the annual payment would swell to more than $40 billion. That is “real money” in the sense that the Fed’s excess earnings would otherwise be remitted to the Treasury. Therefore, for a given level of federal spending and tax receipts, increased payments to the bankers implies an increased federal budget deficit.

Janet Yellen and her colleagues are stuck with a giant asset bubble that her predecessor inflated. If they begin another round of asset purchases, they might postpone the crash, but only by making the subsequent reckoning that much more painful.

You don’t make the country richer by printing money out of thin air, especially when you then give it to the government and Wall Street. The Fed’s magic trick of raising interest rates without selling assets can’t evade that basic reality.

"cumulative losses over the length of the entire cycle could be worse than we’ve ever seen before"

     - BofA High Yield strategist Michael Contopoulos

While not as quixotic as Morgan Stanley's Adam Parker piece on market-chasing cockroaches, BofA high yield analyst Michael Contopoulos has moved beyond merely bearish and is now outright catastrophic . That may be a little far fetched, but in his latest note - while he doesn't call rally chasers "cockroaches" (yet), he seems at a loss to explain the ongoing junk bond rally. His reasoning: fundamentals just keep getting worse by the day, while price action has completely disconnected from reality, and virtually nobody expects what is about to unfold in the junk bond space.

First, according to his assessment of deteriorating macro and micro indicators, the recent price move makes little sense:

Despite the strong payroll data the economy still appears to be headed in the wrong direction, as our economist’s tracking model now indicates just 0.6% Q1 GDP growth and a revised 2.0% (from 2.3%) for Q2. Should our team’s figures hold, the period ending March 31st will mark the 3rd consecutive quarterly decline in GDP and the second sub 1% quarter in the last 5. More importantly for high yield investors, however, is that earnings growth continues to be anemic. 2 weeks ago we wrote that too much emphasis has been placed on Adjusted EBITDA, an approximation of cash flow that doesn’t take into account “1-off” charges, working capital, capex, etc. Although we understand the allure of this measure, in our eyes it has the tendency to cover up late cycle problems; namely asset impairments. With the understanding, however, that this measure is likely to be used for some time to come, we highlight the following: Even with 1-off adjustments 6 out of 17 sectors realized negative year-over-year Adjusted EBITDA in Q4, with a 7th sector growing at just 0.5%. On an unadjusted basis, 9 sectors realized negative EBITDA growth for Q4.

Because one quarter doesn’t tell the whole picture of a company’s earnings momentum, we also calculated both Adjusted and Unadjusted EBITDA by weighting the last 5 quarters 30%, 25%, 20%, 15,%, 10% (Q4 2015 having the highest weight Q4 2014 the lowest). What we find is that the commodities sectors are clearly not the only industries to be experiencing troubles as Capital Good, Commercial Services, Consumer Products, Gaming, Media, Retail, Technology and Utilities are all under pressure. Additionally, on an unadjusted basis Healthcare also doesn’t look like the darling some firm’s spreads would suggest.

Then he looks at where in the credit cycle the market currently finds itself:

We’ve written on multiple occasions how the main question mark surrounding the end of this credit cycle is its shape, not whether we’re currently living through it. As mentioned above, fundamentals have been consistently deteriorating even outside of commodities, defaults are rising, new credit creation is becoming difficult, and illiquidity is still a problem. Although technical tailwinds in the form of retail inflows and supportive central bank policies can prolong the market unwind, they do not change its direction as ultimately fundamentals will prevail.

That is a bold assumption with every central bank having become an activist, but yes: ultimately fundamentals will prevail.

In terms of the shape of this cycle, absent a recession we expect the pace of defaults to be much closer to the 1998 experience than the 2007 one. In fact, we have coined the phrase “a rolling blackout” to describe the potential for a period of many years where the market experiences general weakness and moderately high defaults as individual sectors take turns realizing their moment of distress. Whether these moments are based on a deterioration of underlying fundamentals, an unwind of crowded trades, or some sort of series of macro-economic incidents is nearly irrelevant, as the uncertainty and consistent underperformance of the overall market will likely frustrate many investors and asset allocators. In our view this is not unlike the 1998-2002 experience, where the very same scenario could played out: years of high yield underperformance, poor returns and moderately high defaults. Recall in those years, high yield returned 2.9%, 2.5%, -5%, 4.4%, -1.9% (and 3 years in a row of negative excess returns) while the default rate slowly crept up from 2% to 8% over the course of 3.5 years before hitting double digits.

Next, he proceeds to the "apocalyptic part", stating quite clearly that "the losses over the credit cycle could be worse than we've ever seen before." One reason: central bank intervention that keeps kicking the can instead of allowing the disastrous fundamentals to finally reveal themselves.

Should the market realize a mid to high single digit default rate for years cumulative losses over the length of the entire cycle could be worse than we’ve ever seen before. A total of 33% of issuers defaulted over the course of the 1987 and 1999 default cycles, higher than the 25% in 2008 as the latter benefitted from unprecedented central bank intervention. But the very same policies which helped alleviate the pain in the last cycle will likely add to the severity of the next one. This is because many of the companies that should have defaulted 7 years ago but instead received a lifeline will likely shutter doors now. As risk premiums have caused yields to jump nearly 400bp, many of these firm’s business models will now likely be unsustainable; especially given the lack of EBITDA growth we have seen this cycle (Chart 1). When these issuers are then coupled with the newest crop of unsustainable businesses from this credit cycle, we could see cumulative default rates approaching 40% this cycle versus the traditional 33%.

It's not just the upcoming surge defaults. Contopoulos also e focuses on product-specific issues which we have discussed before, namely the already record low recovery rates, a unique feature of this particular default cycle. These are only going to get worse.

However, not only will defaults be higher than in past cycles, but credit losses are also likely to be worse than ever before. That’s because recoveries, even outside of the commodity space have been paltry in the post crisis years. Given where we are in the default cycle, prevailing recoveries are a full 10 points lower than where they should be. Chart 2 highlights historical time periods characterized by low default rates (inside of 4%). Whereas in the past, recoveries tended to surpass 50% in low default environments, the last few years have seen those averaging 40%. This is telling because it means the pressure on recoveries is not being caused by the abundance of assets for sale in the market, which increases as more companies default, but rather because of the quality of these assets as we have discussed in part 1 of our recovery analysis published last year.

One reason for the collapse in recovery rates: the extensively documented chronic underinvestment in replenishing the asset base, and instead "investing" in buybacks and dividends.

So why are today’s assets garnering less enthusiasm than before? One reason, of course, is that a large portion of defaults today are in the commodity space, which are finishing with sub 10% recoveries as investors try to grapple with a market which may not have hit its bottom. However, problems persist even outside of the commodity industries. Take a look at the YoY growth in capex for non-commodity HY issuers (Chart 3). It’s striking how CEOs have invested much less in their businesses this cycle compared to previous ones. In fact, most of the capex growth since 2010 has come from energy issuers on the back of the US energy independence story in the early part of the decade; and we all know not to count on that going forward. On top of that, asset impairments as a percentage of tangible assets are through the roof, chipping away at valuations of an already low asset base. Not surprisingly, non-commodity recoveries reflect the same extent of erosion post 2010 as does overall HY (Chart 4).

If that wasn't bad enough, it gets worse: "Given that HY companies have seen hardly any organic growth within last few years, it is of little surprise that recoveries today are so low. The bad news is that we think they are going to decline further."

Contopoulos then analyzes various fundamental trends to determine the shape of the upcoming default cycle, and concludes with the following bleak assessment:

So where does this leave us? According to our model, should the default cycle look similar to the 1999 experience (2yr cumulative DR of 25%), and debt-to-asset ratio touch the highs of that cycle (0.51x), recoveries can be as low as 16c on the dollar. There is also a case to made that if there is no catalyst to total capitulation, and we see a longer flatter default cycle, we could see 2yr cumulative default rates much less than 25%. While this is reasonable, one can also argue that debt-to-asset ratio which today already stands at 0.48x, could ultimately go much further past 0.51x. Additionally, as we have seen in the post crisis years, default rates matter less than debt-to-asset ratios, meaning recoveries even under a rolling blackout scenario could even be worse than we expect.

Table 3 presents a scenario analysis of the range of recoveries to expect in the next few years depending on one’s forecast of default rates and debt-to-asset ratios. In almost any scenario recovery rates stand to be well below 30% this cycle.

According to Contopoulos, investors are only slowly starting to appreciate just how bad the future will be for junk bond investors:

While most investors we have talked to appreciate that recoveries will be lower going forward, we think it’s just as important to highlight just how much. Because, 8% yield may sound attractive if your expected credit losses are 400bps (6% DR*70% LGD). But the picture suddenly becomes unappealing knowing these losses could accumulate to 500bps; suddenly leaving you with an unremarkable excess spread cushion.

And it appears that investors have begun to pay attention, at least as seen from the events in the primary market. It’s no surprise that CCC issuance has cratered in the last year as investors are unwilling to extend credit to low quality issuers. Now it seems they are even rewarding BB issuers for using their newly raised debt judiciously, as can be seen from the lower clearing yields for debt being earmarked for capex investment over anything else

Welcome to the brave new world of massive default losses and record low recoveries.

This new world will be one where investors should and will adjust their expected compensation higher to make up for rising defaults, dwindling recoveries, and declining liquidity, all of which are here to stay.

Come to think of it, we almost prefer Adam Parker's incoherent ramblings about cockroaches better: at least it gave some sense that there could be a happy ending. If only for the cockroaches that is....