The Fed’s Freedom to Tighten is a Paper Tiger

All is well, it seems. Stocks have continued their ascent untroubled by, well, much. Part of this is attributable to the risk-free interest rate on ten-year Treasuries below 1.5%. But the other part of it is compression of the risk premium, which is supposed to compensate equity investors for multiple potential risks. This is primarily a product of the history lesson that the Federal Reserve has repeatedly come roaring to the rescue when the ground begins to shake. In the apparent absence of such tremors, it appears to most observers that things are somnolent.

But it pays to look for signs that that may not persist for as long as the crowd believes. The salient development of recent decades is the persistent increase in debt across multiple sectors of the economy, and of the world. Debt accumulation rose to excessive levels in the first decade of the millennium, ending with the global financial crisis and the deleveraging of the household sector in the U.S. But debt has continued to grow elsewhere.

Corporate debt is the most directly relevant sector for stocks, since it is senior to equity on business balance sheets. The following chart shows the recent history:

Graph showing increase in U.S. corporate debt to GDP

Despite the persistence of debt accumulation, financial markets are positively buoyant. Chart 2 shows the laxity of the bond market in pricing below investment grade debt, despite the past lessons of overuse of leverage:

Graph showing US below investment grade spread over treasuries

Credit spreads at rock-bottom levels such as these are asking for trouble. Seasoned observers agree; from a recent Financial Times article:

“So why lend at such low rates when investors know how a default cycle will eventually play out? In a forthcoming paper in the Journal of Portfolio Management, New York University professor Edward Altman and Stanford University lecturer Mike Harmon argue that investors are lending based on expectations that are “aggressive and highly optimistic. By underwriting to a set of possible outcomes at the bullish end of the probability curve, investors appear to be making a bet that is highly optimistic to the downside,” they write. (note 1)

Such circumspection has been out of fashion in the presence of persistent stimulus from the Federal Reserve. But there are signs that second thoughts may be appearing. While stocks’ performance has been led by the shares of large firms, particularly the technology aristocracy, the rest of the stock market has started to fade. The Fed’s asset purchases no longer seem to be supporting stocks of smaller firms, or measures of the broader stock market measured by the performance of equalweighted indexes (instead of the capitalization-weighted issues that are so affected by the largest firms):

Graph showing performance of Russell 2000/ S&P 500
Graph showing S&P 500 performance

Both of these two charts show a pattern of declining relative performance among the stock markets’ proletariat. This is despite the Fed’s continued purchasing of $120bn per month of Treasury bonds and mortgage-backed securities. The discussion of the day has become not if, but when they taper down those purchases. If negative performance divergences have appeared within the markets already, one must question what will accompany a decline or cessation in the Fed’s activism. Even more important is the question of what would follow if the curmudgeons had their way, and they tightened policy as in days past. The recent rise in Treasury yields has had very little effect upon credit spreads, at least so far.

So the credit markets, which are the senior securities in corporate capital structures, continue to thrive while broad measures of the equity markets, which are junior, are telling us something different. This is before the Fed actually does anything differently. We continue to suspect that their ability to tighten monetary policy is widely overestimated.

Note 1. Financial Times, September 18, 2021.
These are the views of the author and do not necessarily reflect the views of BFS.

John R. Gilbert

John is a Senior Research Consultant and whose primary responsibilities include contributing differentiated macroeconomic perspectives as well as providing industry and company research.

In addition, he writes investment commentary, which is published on our website.

John has worked in the investment industry for over 45 years. He was formerly our Director of Research. Prior to joining BFS, he was the Chief Investment Officer at New England Asset Management, Inc.

John has achieved the designations of Chartered Financial Analyst® and Certified Public Accountant.


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