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  • Writer's picturecrhyldahl

Spreads and the Fed


The Federal Reserve continues to insert itself in the capital markets. Now they are buying fixed income exchange traded funds (ETF) as well as individual corporate bonds. So, they are now copying the Bank of Japan and the ECB and becoming an outright buyer of publicly traded non-government assets. These policies have led to virtually zero economic growth for decades. Is that the end game here? What is it that they fear for them to do this? We have written about this in earlier commentary, but is this a signal by them that the worst is yet to come?  Are they trying to bridge the gap between economic calamity and sustainable organic growth? Are they desperately hoping that fiscal stimulus will save the day and facilitate equilibrium? Is this equilibrium real? Or is it transitory due to the synthetic exogenous measures taken to arrive there? Stasis only happens at market clearing levels and this market has not cleared. Until policies support organic growth and market efficiencies, we will have to endure markets that are violently stochastic, technical in nature, and almost exclusively behavioral. Again, we preach patience here. Risk remains the primary dimension throughout the investment space.

High yield and lower quality investment grade spreads have contracted precipitously over the past few weeks as a result of the Fed. The magnitude of these spread contractions imply that default risks have dropped by about 50% over that same period. Is that an accurate assessment? As investors we need to be compensated for accepting risk. Has risk really decreased so dramatically over that period? Or, is it because the Fed has inserted itself so impactfully that they have artificially distorted the markets? You know where we lie on this issue. The Fed is impacting the capital markets in ways that dramatically pervert fundamentals and in so doing has made it impossible for the markets to clear and function properly. No informed fixed income investor can possibly defend this reduction in risk in terms of the probability of economic contraction and thus defaults. It is a preposterous notion to even try. Investors and savers continuously lose all opportunity to be rewarded for the risks inherent throughout the fixed income markets disallowing them to generate meaningful income. The Fed is responsible for this outcome. By using massive liquidity insertions and market intrusions they have effectively destroyed these markets.  For anyone buying these bonds you will not be compensated for the significant likelihood of defaults and bankruptcies that are going to happen over the coming quarters. Again, patience.

Wiley CFO’s will certainly be tempted to issue new paper to exploit the Fed’s foolishness. Why not stack up on cheap financing and build up cash knowing that the coming quarters are going to be very challenging for the real economy? After all, the Fed is signaling economic apocalypse by their actions so best to prepare for the worst. This leads to higher leverage and far less attractive fundamentals for the foreseeable future. This will certainly lead to more downgrades and meaningful turnover across bond portfolios. Moreover, it will make security selection throughout the credit markets more difficult and thus credit markets become more speculative and volatile. How can the Fed exit then? They are setting up an impossible scenario for themselves. I doubt any of the Fed governors have even bothered to consider this outcome. They are about today with little regard for tomorrow. This treadmill of short termism is leading to the accumulation of higher and higher pressures that eventually must be released. Will it be gradual or sudden? We are certain that the continued destruction of one asset class (bonds) for the benefit of another (equity) can not last forever. Ironically, the Fed’s attempt to help markets in the short term may be ruining them in the long term.

Stocks and Pop Culture

The popular press has become obsessed with the daily vagaries of the equity markets. The swings from day to day have become the replacement of watching competitive sports. It’s the only thing to write about that is of any interest. I have had conversations with young adults about their desire to start day trading. They believe that the up and downs can be easily gamed. As I try to explain to them the backward-looking delusions of price dynamics creates the illusion that making profits from trading is easy. I further try to dissuade them from such tomfoolery. They make statements that the game isn’t fixed if you buy. “The Fed will never let the market go down,” they say. This is where we are in the market cycle. I think this is not only true amongst these newfound traders but much of the advisory space. For those of us that are old enough to remember the 1999-2001 period, this time may be much worse. Back then valuations were distorted due to the potential of an entirely new technology and like Tulipmania markets became untenable. Now, however, we have unprecedented government intervention destroying valuations. Then you had significant policy ammunition (as you did in 1987, 1989, and 2008-2009) to address economic and capital market problems. Now you don’t. The breaking point now will be the mother of all corrections. The present chaotic nature of prices may be the harbinger of this eventuality.

Individual Investors and Retirement Savings

When will market volatility begin to influence wealth management decisions around retirement investments? Eventually, responsible fiduciaries must advise clients to begin protecting capital and redeploy it more conservatively. Baby boomers will not stand for such wild fluctuations in their wealth as they approach the day when income goes to zero. This selling pressure is going to further influence risk dynamics going forward. Traders will be unable to forestall the selling; they rely on being able to sell to the next idiot and even the Fed has resource limitations. The Fed may be the last practitioner of BTFD!

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