In the process of reaching and stooping, prices on financial assets have soared and central banks have temporarily averted a debt deflation reminiscent of the Great Depression. Their near-zero-based interest rates and QEs that have lowered carry and risk premiums have stabilized real economies, but not returned them to old normal growth rates. History will likely record that these policies were necessary oxygen generators. But the misunderstood after effects of this chemotherapy may also one day find their way into economic annals or even accepted economic theory. Central banks — including today’s superquant, Kuroda, leading the Bank of Japan — seem to believe that higher and higher asset prices produced necessarily by more and more QE check writing will inevitably stimulate real economic growth via the spillover wealth effect into consumption and real investment. That theory requires challenge if only because it doesn’t seem to be working very well.
Why it might not be working is fairly clear at least to this author. Once yields, risk spreads, volatility or liquidity premiums get so low, there is less and less incentive to take risk. Granted, some investors may switch from fixed income assets to higher “yielding” stocks, or from domestic to global alternatives, but much of the investment universe is segmented by accounting, demographic or personal risk preferences and only marginal amounts of money appear to shift into what seem to most are slam dunk comparisons, such as Apple stock with a 3% dividend vs. Apple bonds at 1%-2% yield levels. Because of historical and demographic asset market segmentation, then, the Fed and other central banks operative model is highly inefficient. Blood is being transfused into the system, but it lacks necessary oxygen.
In addition, there are several other important coagulants that seem to block the financial system’s arteries at zero-bound interest rates and unacceptably narrow “carry” spreads:
- Zero-bound yields deprive savers of their ability to generate income, which in turn limits consumption and economic growth.
- Reduced carry via duration extension or spread actually destroys business models and real economic growth. If banks, insurance and investment management companies can no longer generate sufficient “carry” to support employment infrastructures, then personnel layoffs quickly follow. With banks, net interest margins (NIM) are lowered because of “carry” compression, and then nationwide retail branches previously serving as depository magnets are closed one by one. In the U.K. for instance, Britain’s four biggest banks will have eliminated 189,000 jobs by the end of this year compared to peak staffing levels, reports Bloomberg News. Investment banking, insurance, indeed the entire financial industry is now similarly threatened, which is leading to layoffs and the obsolescence of real estate office structures as well which housed a surfeit of employees.
- Zombie corporations are allowed to survive. Reminiscent of the zero-bound carry-less Japanese economy over the past few decades, low interest rates, compressed risk spreads, historically low volatility and ultra-liquidity allow marginal corporations to keep on living. Schumpeter would be shocked at this perversion of capitalism, which is allowing profits to be more than “temporary” at zombie institutions. Real growth is stunted in the process.
- When ROIs or carry in the real economy are too low, corporations resort to financial engineering as opposed to R&D and productive investment. This idea is far too complicated for an Investment Outlook footnote — it deserves expansion in future editions — but in the meantime, look at it this way: Apple has hundreds of billions of cash that is not being invested in future production, but returned via dividends and stock buybacks. Apple is not unique as shown in Chart 1. Western corporations seem focused more on returning capital as opposed to investing it. Low ROIs fostered by central bank policies in financial markets seem to have increasingly negative influences on investment and real growth.
- Credit expansion in the private economy is restricted by an expanding Fed balance sheet and the limits on Treasury “repo.” Again, too complicated for a sidebar Investment Outlook discussion, but the ability of private credit markets to deliver oxygen to the real economy is being hampered because most new Treasuries wind up in the dungeon of the Fed’s balance sheet where they cannot be expanded, lent out and rehypothecated to foster private credit growth. I have previously suggested that the Fed (and other central banks) is where bad bonds go to die. Low yielding Treasuries fit that description and once there, they expire, being no longer available for credit expansion in the private economy.