Yellen and her colleagues at the Federal Reserve are desperately trying to wean the economy off their zero interest rate policy. Yet they are rightfully worried about the first interest rate rise causing market turmoil. So they have been slow to raise rates. Some would argue too slow.
Although I have an opinion about the Federal Reserve’s policies, I try to always remember that as traders, it does not matter one iota about what should be. All that matters is what is.
There can be no denying the Fed’s relatively hawkish stance (at least when compared to most other Central Banks) has tightened monetary conditions. The Federal Reserve’s balance sheet has been static since the end of QE3.
And not only that, the Fed has been busy preparing the market for higher rates.
Some might argue the Federal Reserve has not yet tightened. But don’t forget that a lot of monetary policy is a relative game. If the Federal Reserve has a static balance sheet while the ECB and BoJ are expanding like mad, then the US dollar will appreciate, which in turn will slow down the economy and tighten monetary conditions.
The big question is how long can this continue?
I don’t think the US economy can take this pace of monetary tightening for much longer. We are starting to see some serious cracks in the credit markets.
Even though equities are rallying, corporate credit is not joining the party. Over the years I have learned the hard way – when stocks and credit are saying different things, go with the bond traders.
The Federal Reserve’s unwillingness to add liquidity has caused a crunch in the credit markets. One of the more sensitive areas is the leveraged loan market. In the last few months this asset class has experienced a dramatic drop. This morning’s announcement that banks are willing to sell loans of retailer Belk Inc. at a loss is typical of the action (from Bloomeberg):
Banks led by Morgan Stanley are offering investors a deep discount to buy debt backing Sycamore Partners’ acquisition of retailer Belk Inc. after struggling to attract interest in the loan, according to a person with knowledge of the matter.
The $1.5 billion loan is being offered at 89 cents on the dollar, compared with an initial proposed price of 98 cents to 98.5 cents, said the person, asking not to be identified because the information is private. The discount, one of the biggest of the year, is being offered one week after investor commitments were due.
On Tuesday the largest leveraged buyout of the year was shelved because of trouble floating the loans (again from Bloomberg):
The turnabout has caught Wall Street’s biggest banks off guard and is increasingly leaving them on the hook for funding takeovers that investors want little part of. On Tuesday, Bank of America Corp. and Morgan Stanley were forced to shelve the debt package backing the year’s largest leveraged buyout — $5.5 billion meant to fund Carlyle Group LP’s purchase of Veritas, Symantec Corp.’s data-storage business, according to two people familiar with the matter.
“It’s very much a whipsaw market,” said Martin Fridson, chief investment officer at Lehmann Livian Fridson Advisors LLC. “Outside of a recessionary period, this has been pretty brutal.”
This whole rally in risk assets has been fuelled by cheap money. Leveraged loans were one of the more reliable sources of liquidity for companies looking to leverage up their balance sheet.
But what if the price of these loans was artificially juiced by QE? What if the recent decline is a return to pricing that more accurately reflects the real risks?
If that is the case, what is the correct price for these loans? At the end of QE1 and QE2 when the price of financial assets stumbled, the Federal Reserve rushed back in with another QE program. This time there is no such backstop. In fact, the Federal Reserve seems intent on rushing a move off of zero for the Fed Funds rate. No wonder credit markets are struggling.
And let’s not forget that investors were pouring money into these sorts of fixed income asset classes as rates were compressed around zero.
I am not sure if there will be any stabilization until the actual hike (and even then I am not sure). I find it difficult to be bullish with the axe of the first rate hike in nine years dangling over the market’s neck. In the coming few weeks, we will get more and more bad news as loans and other fixed income assets continue to be under pressure.
This tightening of monetary conditions will affect the US economy. It will be interesting to see if it will be enough for the Federal Reserve to once again blink at the last minute. I don’t think so, but you never know.
In the mean time, you shouldn’t expect any rally in credit markets, and by extension the stock market will struggle. With loan deals falling apart, one of the biggest legs of the risk rally’s stool is now wobbling.
Ironically enough, the markets should be hoping for December 16th to come as quickly as possible. If the Fed manages the rate rise properly, it could be a sell the rumour, buy the fact opportunity. And even if it isn’t, over the next month I don’t think we will rally while credit market are going no bid…
Thanks for reading,