Shortly after the U.S. Federal Reserve held off on further interest-rate increases, the European Central Bank said it would keep record-low interest rates for longer. While investors are celebrating the policy reversal, soon enough, cheap credits may posses another threat to the U.S. economy.
Postponing the inevitable downturn with artificially low rates will indeed buy market an additional year or two. But, the cost of that postponing is a massive credit bubble that has enormous proportions.
Business cycles to be replaced with credit cycles
A chief investment officer of Bleakley Advisory Group, a $3.5 billion wealth-management firm, Peter Boockvar said that we no longer have business cycles. Instead, we now have a different type of cycles – credit cycles.
When it comes to understanding what do business cycles mean, it is important to reach for the definition. The economy is always in either expansion or contraction. A growing economy peaks, contracts to a trough, recovers to enter prosperity and hits a higher peak.
But, the last decade brought an end to this pattern. An especially painful contraction that occurred was followed by an extraordinary weak expansion. GDP (Gross domestic product) has been around 3% at its best since 2008. And it should be at around 5% in the recovery and prosperity phases.
Debt-fueled growth is not good for the economy
As Boockvar explained why we no longer have economic cycles, he underlined the significance of credit rates. “We have credit rates that ebb and flow with monetary policy. After all, when the U.S. Federal Reserve Bank cuts rates to extremes, its only function is to encourage the rest of us to borrow a lot of money and we seem to have been very good at that”.
But, the problem occurs when, over time, debt stops stimulating growth. Debt-fueled growth pulls people toward future spending and boosts asset prices. That is the main reason why real estate and stocks have performed so well.
Since debt drives so much GDP growth, its cost is the main variable defining where we are in the cycle. The U.S. Federal Reserve Bank is trying to control the cost and that is why all of us are occupied by the central bank policy.
High-yield bonds pose as a threat
The last credit crisis came from subprime mortgages. But, the bigger risk that lies ahead is the mere amount of corporate debt, especially high-yield bonds. Past cycles have shown that the current level of corporate debt is not going to have a positive impact on the U.S. economy.
Recessions triggered bear markets in an old-style economic cycle. Consumer spending was slowed, corporate earnings fell and stock prices dropped with the economic contraction. But, the credit cycle does not operate in the same manner.
Lower asset prices cause a recession. Access to credit drives consumer spending and business investment. If you take those credits away, consumer spending and business investment decline.
Market makers who disappear when needed the most
Two related problems appear when it comes to corporate debt issuance. Firstly, corporate debt issuance, especially high-yield debt, has exploded since 2009. And, secondly, tighter regulations discouraged banks from making markets in corporate and high-yield debt.
Many experts agreed on the fact that the Dodd-Frank Wall Street Reform and Consumer Protection Act have reduced major banks’ market-making abilities by around 90 percent. Bond market liquidity is fine so far, mostly because the hedge and other non-bank lenders have filled the gap.
But, nothing requires them to hold inventory or to buy when you want to sell. In a bear market, you sell what you can, not what you want to. On the other hand, this gap that is currently being filled by the hedge and other non-bank leaders means all the bids can “magically” disappear just when you need them most.
Low credit rates could lead to a recession
Many of these lenders bought their corporate bonds with money borrowed at record-low rates. Hence, they are far more leveraged this time. And that trend will continue as long as the central banks keep rates low.
Another thing that makes this matter even worse is the fact that most leveraged corporate bonds are “covenant-lite.” That means that the borrower doesn’t have to repay by conventional means and that can even be forced to take more debt.
While many companies lose their ability to service debt due to the fact that the economy is entering a recession, this would normally be the borrowers’ problem. But, the covenant-lite lenders took it on themselves to service those debts. And this means that the effects of the macroeconomy changes will spread even more widely.