What does it mean when the Fed and other central banks jointly bemoan the effects of their own policies? Worried about not being able to keep all the plates spinning?
This is the transcript from my podcast last Sunday, THE WOLF STREET REPORT:
The Federal Reserve, the ECB, the individual central banks of Eurozone countries, such as the Bundesbank and the Bank of France, the central banks of negative-interest-rate countries outside the Eurozone, such as in Switzerland and Sweden, they’re all now lamenting, bemoaning, and begroaning one of the consequences of low and negative interest rates, the ballooning record-breaking pile of business debts.
This is ironic because these outfits that are now lamenting, bemoaning, and begroaning the pileup of business debts are the ones that manipulated interest rates down via their radical and experimental monetary policies, thereby triggering the pileup of business debts.
This debt pileup isn’t an unintended consequence of their policies. It was one of the purposes of their policies.
But central banks also know from history that this historically high level of business debts is a powder keg waiting to explode – company by company at first, and then as contagion spreads, all at once.
The Fed is a superb example. In its most recent “Financial Stability Report,” released in November, the Fed warns about the historic record-breaking pileup of business debts in the US, as a consequence of low interest rates, and it considers this business debt the biggest risk to financial stability in the US.
But this warning came after the Fed had just cut its policy interest rates three times, and after it had begun to bail out the repo market with over $200 billion so far, and after it had begun buying $60 billion a month in T-bills, in total printing over $300 billion in less than three months, to repress short term rates in the repo market and to bail out its crybaby-cronies on Wall Street – and not necessarily banks – that had become hooked on these low interest rates.
In its Financial Stability Report, the Fed warns about the ballooning debts of non-financial businesses. These are businesses that are not lenders. Excluding lenders from the tally prevents double counting of debts, since lenders borrow money to lend money. So this is money that non-financial companies owe, and they range from mom-and-pop restaurants to Apple.
The Fed measures this debt in several ways. In absolute dollars, these debts have skyrocketed from record to record and have hit $18 trillion. And as a percent of GDP, these debts have reached historic highs. The Fed says that “the most rapid increases in debt are concentrated among the riskiest firms amid weak credit standards.”
So we’ve got historically high debt levels, especially among the most leveraged companies with negative cash flows, amid loosey-goosey underwriting standards.
And the Fed warns about, laments, and bemoans the speed of this debt pileup, with business debts jumping by 5.1% over the past 12 months, much faster than the economy grew.
The Fed warns that “excessive borrowing” leaves businesses “vulnerable to distress,” in which case they will need to “cut back in spending,” which means layoffs and lower spending on other stuff and cutting back on investments. This ricochets through the overall economy. And it comes with a decline in overvalued asset prices, and suddenly the collateral for those debts begins to vanish.
So the Fed says: “These vulnerabilities often interact with each other. For example, elevated valuation pressures” – meaning high asset prices – “tend to be associated with excessive borrowing because both borrowers and lenders are more willing to accept higher degrees of risk and leverage when asset prices are appreciating rapidly. The associated debt and leverage, in turn, make the risk of outsized declines in asset prices more likely and more damaging.”
In terms of high asset prices, the Fed puts commercial real estate at the top of its list, after massive price increases over the past seven years due to low interest rates. But rents on commercial properties have risen more slowly, and as a result, the Fed says, “capitalization rates, which measure annual rental income relative to prices for recently transacted commercial properties, have moved down over the past decade and are at historically low levels.”
The Fed laments not only the high quantity of debt, but also its lousy quality.
In addition to the $2.4 trillion in junk-rated bonds and loans, about half of investment-grade debt outstanding is currently rated triple-B, the lowest category of investment-grade. This is “near an all-time high,” groans the Fed.
And it warns that in an economic downturn, widespread downgrades of bonds to junk, could “lead investors to sell the downgraded bonds rapidly, increasing market illiquidity and downward price pressures in a segment of the corporate bond market known already to exhibit relatively low liquidity.”
And the Fed warns that a broad indicator of corporate leverage – the ratio of debt to assets for publicly traded non-financial companies – is at its highest level in 20 years. OK, 20 years ago was the end of 1999, just months before a phenomenal stock-market crash began.
Other central banks have chimed in, warning about record business indebtedness in their country, and about other fallout from their negative-interest-rate policies, just after having pushed interest rates further into the negative.
While this is clearly a case of central-bank doublespeak, it’s also a case of central banks getting worried about the effects of their handiwork that could end in a crisis at the business level that would hit the financial system, with not-hard-to-imagine consequences for the real economy.
The German Bundesbank laments in its Financial Stability Report that the “risks to financial stability have continued to build up in Germany.” If the current economic slowdown in Germany, now close to a recession despite negative interest rates, turns into an actual downturn, the Bundesbank says, it could trigger a “deterioration in the debt sustainability of enterprises and households,” which in turn could trigger waves of defaults and credit write-downs. This would hit German banks.
These banks, the Bundesbank says, have significantly expanded their lending to “relatively high-risk businesses” while reducing their loan-loss provisions. And the report says, “that banks’ lending portfolios now include a higher share of enterprises whose credit ratings could deteriorate the most in the event of an economic downturn.”
In addition, housing bubbles have sprung up in Germany. The Bundesbank considers home prices in many cities to be overvalued by 15% to 30%. German banks are heavily exposed to these housing bubbles.
The Bundesbank notes that low interest rates not only help mask the deterioration of Germany’s macroeconomic situation, they provide ideal conditions for the financial vulnerabilities to grow further.
The ECB’s own Financial Stability Review warned, lamented, and bemoaned that “very low interest rates,” and the search for yield among investors and “signs of excessive financial risk-taking,” are leading to “higher leverage among riskier firms,” and these companies are more likely to get downgraded during downturns, and this downgrade risk has increased “in view of a deteriorating economic outlook, indicating higher funding costs and possible rollover risks going forward, primarily for the very large lower-rated investment-grade segment” – so this is the very large pile of near-junk-rated debt that would be downgraded to junk. This “could exacerbate potential losses,” the report says.
And the Bank of France warned about, lamented, bemoaned, and begroaned the huge debt levels of large French non-financial corporations, many of them part- or majority-owned by the state. They have been using the era of negative interest rates and ECB corporate bond purchases to take on debt, not to invest in France and move the economy forward, but mostly to acquire other companies, many of them overseas.
The Bank of France points out that “the burden of this debt will have to be covered by the future revenues released from these acquisitions.” And it says, there is a risk that “anticipated future revenues may be overvalued.”
In the US, in Europe, in China for crying out loud, or anywhere, these business debts don’t go away on their own. They only go away in a debt restructuring or bankruptcy – at a big cost for lenders and investors or taxpayers.
Many of these debts were incurred to fund share buybacks, and to fund acquisitions that don’t produce cash flows for the acquiring company, and to fund cash-burning operations. And these debts just balloon and they need to be refinanced when they come due, and interest payments need to be made. And central banks are getting nervous about the effects of their own policies.
So their lamentations and warnings could be just more central-bank CYA – and later they could say to these companies and the public, we told you so, you shouldn’t have borrowed so much, and now look what kind of mess you’ve made.
Or their lamentations and warnings could mean that they’re going to let inflation run hot, to burn through this debt. But one entity’s debt is another entity’s asset. And in this scenario, everyone who holds these assets – pension funds, social security systems, retail investors, bond funds, banks, and the like – will see the purchasing power of their assets get crushed.
Normally you’d expect inflation to be priced into debt, but central banks manipulate the credit markets with an iron fist, and if rates spike in an effort at price discovery – such as in the repo market – the central banks step in with all their might and push those rates back down. So current interest rates neither reflect current inflation rates nor future inflation risk. Nothing is priced in.
Or their lamentations and moans and groans about debt levels could mean that central banks are struggling with a change of mind. The central bank of Sweden has already indicated that it would exit its negative-interest-rate policies soon. There is considerable jabbering among ECB officials that QE and negative interest rates would need to end. Draghi is gone, and there is now a reevaluation of monetary policy going on at the ECB. All these warnings, lamentations, and moans and groans about corporate debt could be a sign for folks to get ready for the end the negative interest rate era in Europe.
Or their lamentations could be a mix of all these and other elements, as they’re struggling to figure out how to keep all the plates spinning.
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