Debt: still very much in favour

Reports by the Wall Street Journal that officials at the Federal Reserve are drawing up plans for starting to rein in the current programme of QE are worth noting. Jon Hilsenrath, the Journal reporter who wrote the story, is widely held to be the Fed’s favourite unofficial channel for making known its future intentions.  Could it be that even the Fed is starting to get concerned about the runaway effect that its monetary stimulus is having on asset prices? Throw in Mr Bernanke’s warnings about excessive risk-taking last week and it is tempting to suppose that even the Fed would be happy to see a pause in the the advance of risk assets, at least for now.

That would certainly seem to sit quite well with the normal midyear seasonal pullback that we have seen for each of the last three years. The worry with QE has always been that it is easy to get started on it, but very difficult to stop. Now that the Japanese have joined the QE party in an even more dramatic way, the ripples are being felt in financial markets all round the globe, compounding the scale of the eventual problem. Yields in a number of credit markets (eg junk bonds, leveraged loans) have fallen to what look like dangerously complacent levels. Companies such as Apple are obviously happy to take advantage of the ultra-low rates on corporate debt, but whether that achieves any longer term benefit remains to be seen – not so obvious when the purpose of the debt is committed to share repurchases rather than new capital investment. All the while a return to the levels of economic growth we witnessed before the crisis broke in 2008 remains stubbornly distant.

And meanwhile, as Soc Gen’s Andrew Lapthorne points out in a note today, the policy is surely building up problems for the future, as debt levels globally are rising, not falling, as is needed:

Governments worldwide are of course strapped for cash and are therefore incentivised to tilt investors towards bonds over equity. Regulation is forcing institutions to hold ever more bonds than equities and many government bond issues, be it municipal loans in the US or National Insurance inflation-linked bonds in the UK, are tax deductible, giving a gross yield on bonds that the net equivalent available on equity would struggle to match, even with bond yields at incredibly compressed prices. Dividends in many regions suffer from double-taxation.

With bonds, duration is fixed, this reduces volatility and preserves capital in the shorter term, a characteristic equity can only dream of. And of course central banks have committed in large part to buy bonds to maintain their high prices – therefore low yields yes, but with a capital guarantee. So, most agree corporates would be crazy to issue equity. And for the large part in recent years equity issuance has been to either bail out a mistake (Banks), or to allow their owners to cash in (Facebook).

But of course as it cannot be called, equity serves a very valuable purpose in that it insulates both the company and investors against recessions, rises in interest rates and via dividend growth, provides a degree of inflation protection. In times of crisis corporate bond markets dry up, bond covenants are breached and debt engulfs the business. When rates and inflation rise, the bond investor is stuck with a capital loss and a coupon that does not grow. In a world of too many bonds and too little equity, governments, corporates and investors are simply ensuring that the next slump will be even more painful than the last.

Bill Gross, the bond market guru, said on Friday that the great bull market in fixed income may finally be coming to an end (something he also predicted a couple of years ago, rather prematurely). That may be true in the United States, where economic growth is at least positive, and if so it is welcome news. Whatever the Fed may do in the short term, however there is little evidence I can see that the end to unconventional monetary policy is in sight. Indeed, with the new Governor of the Bank of England starting shortly, and the European Central Bank possibly set to join in the QE game when the German elections are out of the way in September, the chances are that it could intensify later in the year, leading to a new round of currency battles and market distortions.