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Economic Insights

Extraordinary measures helped end the financial crisis, but are there unintended consequences?

 

In Brief

  • New policies announced by the European Central Bank are unlikely to boost lending and economic growth as intended. But a form of quantitative easing, which would involve the purchasing of asset-backed securities, could have some effect.
  • Quantitative easing by the U.S. Federal Reserve has not re-created a credit bubble similar to that which led to the crisis. Today, there is much less leverage in the financial system than there was in 2007. Some asset classes, however, may be in a bubble, while others are still reasonably valued.
  • Quantitative easing was an appropriate response to the financial crisis, and extending it boosted asset prices, resulting in greater consumer confidence. But extended QE also may have allowed politicians to delay necessary structural reforms that could lead to stronger economic growth.  
  • Ultimately, QE is likely to result in higher inflation and higher interest rates, though the Fed may hold its securities portfolio to maturity, avoiding the problem of how to sell those securities without disrupting the market.

 

Anemic economic growth and a growing fear of deflation prompted the European Central Bank (ECB) to launch four new policies in June 2014 that are intended to jumpstart lending to small businesses and to end the recession that began in 2011. The ECB is also considering a form of quantitative easing that would involve purchasing asset-backed securities instead of sovereign debt. These extraordinary measures highlight the large role that central banks continue to play in the recoveries of developed market economies, which began with the Federal Reserve’s emergency measures at the height of the crisis. Increasingly, investors and policymakers are beginning to assess more critically the effectiveness of these policies and to gauge their long-term impact.

Have historically loose monetary policies in developed markets been effective or are they potentially reflating the credit bubbles that led to the crisis in the first place? Could the Fed’s quantitative easing policy be hindering the recovery rather than helping it? What is the likely long-term effect of easy money in major developed markets, and how should investors prepare for it? Addressing these topics are Lord Abbett Partners Milton Ezrati, Senior Economist and Market Strategist; Zane Brown, Fixed Income Strategist; Harold Sharon, International Strategist; and David Linsen, Director of Domestic Equity Research.   

Q: The ECB has announced new policies designed to boost economic growth. In addition to cutting its official interest rate by 10 basis points (bps), the central bank will impose a negative interest rate on excess bank funds deposited at the ECB and will offer four-year loans to banks to encourage them to lend to small businesses. How effective are these policies likely to be?  

Zane Brown: These policies are more likely to result in lower interest rates than they are to produce greater lending and economic growth. Banks are already concerned about the bad debts on their balance sheets and about their leverage. And they will be soon undergoing stress tests by the ECB. So, they have little interest in any lending that would jeopardize their capital-adequacy ratios.

The ECB’s four-year lending program, known as Targeted Long-Term Refinancing Operations [TLTRO], will make loans available to banks at a rate of 25 basis points (bps). But the banks won’t have to demonstrate that they’ve done any lending for the first two years. So, some are likely to obtain this cheap funding and invest it instead of lending it. And in two years, they’ll just give it back. But in the meantime, the profits they earn on the investment will help them recapitalize. But this policy will do little to boost lending or economic growth. 

The other new policy—negative interest rates on deposits at the ECB—also won’t do much to stimulate lending. The idea is that a negative interest rate will encourage banks to lend that money instead of keeping it on deposit with the ECB. But the banks may just move those deposits to other vehicles that don’t charge them a negative interest rate. As a result, those banks may bid up short-term investments, reducing short-term rates, which could in turn hurt the euro.

The possibility of currency risk could then make international investors less likely to want to hold those securities, encouraging them to look elsewhere for higher-yielding opportunities. As a result, short-duration securities in the United States and higher-yielding opportunities in emerging markets may look more attractive.

Milton Ezrati: There’s also a question of demand. These economies are sinking or stagnant, and their governments have implemented policies of fiscal austerity. So, there isn’t a lot of demand for loans.

Q: The ECB is also considering a form of quantitative easing [QE] that would involve the purchasing of asset-backed securities instead of sovereign debt. What’s the likely impact of this program?

Brown: This is actually a pretty clever idea. The difficulty with a QE program that buys sovereign debt is that the ECB must buy a proportionate amount from each eurozone member country. This means that to provide help to Greece, Spain, or Italy, for example, the ECB would have to purchase a large amount of Greek, Spanish, or Italian debt. But to do that, it would have to purchase an even larger amount of German debt. But Germany doesn’t need that help. By buying asset-backed securities instead of sovereign debt, the ECB avoids that problem.

Harold Sharon: The main issue I see is that while the ECB can implement some of these auxiliary monetary programs, like targeted loans and private asset purchases, they can’t actually control the extent to which these are pushed down into the real economy. There’s no guarantee the lending programs will be taken up fully. If trying to rectify the transmission mechanism of monetary policy into the real economy is the stumbling block, these programs offer up partial solutions, but they can only succeed if economic participants believe there will be better growth. 

So maybe the next set of actions will not be by the ECB but instead will be the EU [European Union] Commission loosening the fiscal deficit compact in which it targets a maximum deficit of 3% of GDP [gross domestic product]. Perhaps the Commission will let the target deficit slip to 4% for a transitional period. 

Brown: Even if demand for loans is weak, buying asset-backed securities would put more money into the economy and help the banks. If a bank, say, has €100 million in loans on its books and sells them to be securitized, it gets them off the books and improves its capital ratios. It can then take the €100 million in proceeds, keep €50 million, and lend out €50 million. That would improve its capital ratios and still put an additional €50 million into the economy.

Ezrati: What Zane is describing is important because the ECB has been thwarted in its attempts to reliquefy the banks, so this is a backdoor way to do that. The ECB is not allowed to lend directly to banks or to buy bank debt; it is allowed to lend only to sovereigns. But this way, it would be reliquefying the banks, even though it’s not allowed to do that.

The other problem with these new policies is that they’re not appropriate for the largest economy in the eurozone, Germany. Germany is now complaining about a bubble in its economy because interest rates are too low.

Sharon: One stark difference between the U.S. and European credit markets is that in Europe 80% of credit funding goes through the fragmented banking system and only 20% through credit capital markets. In the United States, the bond markets are massively larger than those in Europe. So the focus on increasing bank liquidity and clearing up capital levels is crucial.

David Linsen: Even with the new lower interest rate, the eurozone’s monetary policy is still tighter, in real terms, than U.S. policy. The fed funds rate is essentially zero, and we have approximately a 2% rate of inflation, giving us a real short-term interest rate of about -2.0% [nominal interest rate – inflation rate = real interest rate]. But the eurozone has an official interest rate of near zero and an inflation rate of less than 1%, giving the eurozone a real interest rate somewhere between 0 and -1.0% .

Ezrati: That’s right. Two years ago, the eurozone’s official rate was higher, 1.5%, but inflation was 2.5%. So, the eurozone’s real interest rate was -1.0% [1.5% - 2.5% = -1.0%]. Today, despite the lower nominal interest rate, the eurozone’s policy is tighter because its real, inflation-adjusted interest rate is higher [less negative]. 

This is important, because extremely low inflation means the ECB’s job has become much harder than it was last year. As inflation falls, even low interest rates look less appealing in real terms. The ECB is just trying to buy time for everybody to get their balance sheets in order. But if the eurozone is on the verge of deflation, then the window of opportunity to allow that to happen is closing quickly, and any excess debt on corporate, consumer, or government balance sheets could begin to look more and more burdensome.

Q: Is there any danger that by keeping rates low, central banks are just reflating the credit bubble that led to the credit crisis?

Brown: There’s not as much leverage in the system today as there was in 2007. In addition, much of the new financing that is occurring today is re-financing, which is enabling many companies to lower their interest costs, and to lock those lower interest costs in for a long period of time. As a result, these companies are even better-positioned to withstand periods of slow growth in the future. So, we’re certainly not in a [credit] bubble.

Ezrati: The same is true in the household sector. Consumers have reduced the cash flow burden of their debt and they’ve improved their balance sheets.

Brown: Certainly, investors need to be aware of risks on particular securities, but we don’t see the same subprime risk, where lending standards had been lowered to ridiculous levels. So, the quality of the lending is better today, and even though there has been an increase in covenant-light loans, the credit quality of companies is better today than in 2007.

Ezrati: The question is, then, where is the bubble? If you look at asset pricing, the bubble is in all the asset classes that historically have been high quality, and low risk. The only bubble I can see is in Treasuries, agencies, and high-grade paper. Stocks certainly are not in a bubble. Yields are low in the high-yield market, too, but the spread over Treasuries is nowhere near where it was prior to the crisis.

Brown: High-yield spreads relative to Treasuries are narrower than they have been historically, and recently [as of June 20] that spread went below 400 bps. But in 2007, it got down to 266 bps. So, we have a long way to go before we get to that level.2

I think it’s also important to think about the yield spread in the context of the underlying Treasury yield. So, if the spread of high-yield bonds over Treasuries is 400 bps when Treasuries are yielding 2.5%, that’s proportionately greater than if that spread is 400 bps and Treasuries are yielding 5%. I think the spread that an investor demands from high-yield bonds depends to some extent on how much the underlying Treasuries are yielding.

Often, when high-yield spreads narrow, they can stay at that level for years. And we have found that when Treasury yields go up, high-yield spreads compress further. So, when the yield on the 10-year Treasury goes from around 2.6% [as of June 20] to 3%, we may see no movement at all in the yield on high-yield bonds, resulting in a narrower spread.  

Sharon: You could argue that the decade of low interest rates did create some bubbles in various emerging market economies, as seen, for example, through real estate in Asia, consumer prices in Brazil, etc. There also has been relatively rapid price appreciation in some of the northern European asset markets, but perhaps not yet into bubble territory. Some economies still need low rates to repair household balance sheets and to stimulate growth. The hard part is that the low rates are everywhere and, in time, they may lead to more mispriced assets.

Q: Some economists have raised the question whether quantitative easing [QE] is part of the problem instead of the solution. Most economists would agree that it has been disruptive to emerging markets. But some also believe that by turning on the monetary stimulus every time the economy appears to struggle, central banks are stealing growth from the future and not permitting the business cycle to run its normal course. Is QE part of the problem?

Brown: To the extent that QE has kept interest rates low here, it has encouraged investors to search for yield in emerging markets. Last year, when the Fed began to talk about tapering the QE program, our interest rates began to rise, and some of the funds that had flowed to emerging markets came back here. So, yes, QE has had global effects.

Linsen: The question is, is QE better than the alternative? Every policy decision has consequences, and although there may be negative consequences to QE, the consequences of not doing QE would have been worse. That was [former Fed chairman Ben] Bernanke’s argument in support of QE.

Ezrati: To put it another way, there was nothing else the Fed could have done, because to let the cycle run its course would have caused so much economic harm. Has QE gone on too long and should it have been extended beyond the immediate crisis period? We could debate that endlessly.

Sharon: Right, it has been a useful response to eliminate the worst-case economic collapse, but if pursued too long, it eliminates not just the natural economic cycle but also weakens the fortitude of politicians to do their part through structural economic reforms that enhance productivity and growth. We’ve seen a real lack of political follow-through around the world, and I wonder if we missed the chance to truly restructure obsolete and uneconomic rules and regulations around the world.

Linsen: QE, however, also led to higher asset prices, which led to higher business and consumer confidence. Higher confidence and greater investment lead to job creation. Just this month, the U.S. economy exceeded the pre-crisis peak in jobs. What would the U.S. economy have looked like without these positive impacts of QE?

Ezrati: Some researchers at the Fed studied the effects of QE3 and concluded it had no effect because the stimulus didn’t reach the real economy. It got bottled up in the banks and never reached Main Street, which is what the Fed was trying to accomplish. The researchers also found that QE3 didn’t keep long-term interest rates down much. They concluded that short-term rates were low because the fed funds rate was kept low, not because the Fed was buying long-term debt.

It seems to me that Fed chairperson Janet Yellen may have taken these findings to heart because she seems determined to continue with tapering the QE program.

Brown: In the next year or so, when the Fed begins to raise rates, that could attract investors from other parts of the world, including emerging markets. So, there will be consequences for emerging markets, and they may have to take steps to counter the effects of our tightening.

Linsen: What you’re saying is that a healthy U.S. economy will have a tightening effect on emerging markets.

Sharon: It does appear the decade of low interest rates, which boosted growth in emerging countries, has come to an end. At the same time, we see China, the largest driver of that growth, shifting its economic model from export-driven to one of consumption and likely we will see growth moderate to around the 7% level and not the 10% level as in years past. This clearly will have knock-on effects to all the commodity-based emerging countries.

Q:  What is the end game? How will this unprecedented monetary accommodation work out?

Ezrati: The end game is: watch out for inflation.

Brown: Inflation and higher interest rates. Higher rates are likely, because as the Fed ends its securities purchasing, somebody will have to step in and replace that lending, which the Fed did at lower-than-market rates when it purchased those assets at high prices. So, as we return to market-based interest rates, those rates are likely to be higher.

Linsen: Average hourly earnings are rising by only about 2% per year, and I don’t think rates are likely to go much higher until we see some tightness in the labor market.3

Ezrati: If you believe Bernanke and Yellen, the Fed will act before that occurs. If we’re going to avoid this inflation, the Fed will need to remove the excess stimulus before inflation occurs. That’s what makes this such a delicate environment. Bernanke laid out a multi-step program for doing this, which involved reversing every step in QE before raising short-term interest rates. 

Brown: I think the Fed realizes that it can’t sell these assets even in 2015, because investors would panic.

Ezrati: Right. It would be the “taper tantrum” in spades. But the Fed doesn’t have to sell because a lot of its debt isn’t long term. So it could just let its assets mature. I don’t know what the average maturity is of the assets on the Fed’s balance sheet, but it’s pretty short.

Linsen: The Fed also doesn’t have to sell because the new view at the Fed is that prior to the crisis, its balance sheet may have been too small in relation to the economy; but now, at more than $4 trillion, it’s about the right size.

Q: So, if the Fed is not going to remove the excess monetary stimulus from the economy and investors should count on significant inflation in the future, what would be the investment implications of this scenario?

Brown: The bottom line is that if Fed expectations are realized and the ECB policies meet with some success in the eurozone economic growth in the United States and Europe should improve and equities should do well.

In this environment, a gradual return to normal monetary policy and inflation will push interest rates higher, hurting the price of high-quality fixed income, especially longer-term Treasuries and agencies. An investment strategy designed to address rising inflation expectations would be appropriate. Also, lower-quality securities in the United States and elsewhere are less interest rate-sensitive and more economically sensitive and should, therefore, perform better than their high-quality counterparts.

Sharon: I see the cycle outside the United States as a bit behind the cycle in the other large economies. To wit, Japan and Europe are still expanding their quantitative easing. Given that difference, it makes sense to be exposed to economically sensitive assets, especially where valuations also still make sense. I wrote in our investment blog at the beginning of the year about the attractiveness of European equities, and I still think they are attractive. Corporate profits are improving and should be initially immune from modest inflation if it comes about. I think the inflation threat outside the United States is significantly less at this point, though. As we know, equity markets react to the unpredictable events that are positive, and I would expect that we will see surprise pro-growth policies implemented in Europe and some parts of Asia. Our most economically sensitive strategies are international small cap and our value strategy, which had the added benefit of earning high quarterly cash flows from the large dividends being paid by healthy growing foreign companies.   

Q. Thank you, gentlemen.

 

Data from Bloomberg.
2 Data from Bloomberg.
3 Data from the Bureau of Labor Statistics.

 

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