The Fed is buying corporate bonds now…what’s next, stocks?

Now the fed is looking at corporate bond purchases through exchange traded funds. Welcome the new world of yield curve control. But what does that mean for you, your portfolio and the economy at large? Yield curve control. Nice, fancy word. It’s largely focused on keeping interest rates low, primarily at the long bond end. Because let’s face it, we’re borrowing a lot of money. And to the extent that that money being borrowed is long-term debt, it does behoove the government to keep the cost of that debt down. But not just for the government. It also affects the economy and industry at large. With low corporate rates right now, there is the question, is this even necessary? When we talked about buying corporate bonds back in April, the spread between corporate bonds and treasuries was rather large. But now that spread’s fairly narrow, and that suggests the corporate bond market’s working fine.

So whatever they’re doing next, it’s got nothing to do with making sure the corporate bond market doesn’t fail. What they’re trying to do is cap yields at specific maturities. It’s never been done in this country before. It’s only twice been done before once in Japan and once in Australia. But there were some interesting results which may be warrant to test. Let’s see how this works. We will find out. In Japan, it was discovered, that less bond buying in aggregate was needed to manage the yield curve. Then with the shotgun approach, quantitative easing has adopted since 2007, 2008, and in this recession today. So that could actually be a good thing. What’s the challenge though? Well, the biggest challenge is this is a distortion. This will cause a distortion of the markets. A purist and economic purists would say, well, distortions are bad thing, period. But really is the medicine worse than the illness in this case? Very probably not.

One thing they’re not going to be doing anytime soon is buying equities. There’s no point in buying equities. If yield curve management is what you’re trying to do. It’s also arguable that there’s no point buying equities, anyway. The problem with equities is it’s they are savings. And when you buy equities you’re not pouring money into the economy, you’re just pouring money into the market. And the money being poured into the economy – already a lot of it has found its way itself into the market. In fact, the interesting thing is, as they turn the spigot off in the coming year, beginning as soon as October, how will the market be supported at its current price-earnings ratios?

There is one downside to corporate bond purchases and that they tend to support all companies equally. But some companies don’t need support. What I mean by that is not what you think. Healthy companies that are being unusually stressed may or may not need support, but a certain slice of the economy in a traditional recession would result in certain companies – a good example would be Hertz rent-a-car – they just need to go out of business. Or go through the bankruptcy process and reorganize because they’re not well-managed. They have too much debt. Something was wrong anyway. And when you engage in this corporate bond buying policy, what you’re doing is you’re actually saving sick companies. They’re called zombie companies. Europe is famous for this. Alitalia is probably the poster child of saving a zombie company. The problem with that is that zombie company is reducing the profitability and increasing the pricing stress for all the remaining companies. It’s not cleaning house. Recessions do actually have a useful function in terms of cleaning house. So that is the one concern, the biggest concern probably, of buying corporate ETFs. It could actually, while saving specific companies, hurt the recovery of an entire industry.

One thing I don’t think you’re going to see is negative interest rates. At least not as a deliberate policy. They’ve been tried in Germany, specifically, through most of the world. In the Western world there’s been some tinkering that either deliberately or inadvertently has led to negative interest rates. And we’re beginning to see that they’re destabilizing. So though they can happen and may in fact happen, at least slightly negative, it’s not likely that it will become the formal policy of the Fed to engage in quantitative easing and yield curve management to the extent you have negative interest rates. This is all costing money. It’s make believe money. It’s Fiat currency. It’s being printed. Though in the short term, it has done a lot to stop the country from falling into depression, there is a limit to how far this can go. Despite the proponents of modern monetary theory – which I might add is getting a real-world stress test right now – there’s a line drawn in the sand beyond which you can’t go without doing more harm than good. I don’t think we’re there yet, but the way this is going, we may yet find that line. We wish you the best of investing success.

Sources:

Yield Curve Control Could Prove a Useful Tool – The Economist

Financial Times – Latest News