Why QE is doomed to failure
While low yields on government bonds have led more people to invest in blue chips instead, these companies are more likely to hoard this cash until growth picks up than let it trickle down to the rest of the economy, writes L&G’s Ben Bennett.
By Ben Bennett, Credit analyst at Legal & General
Friday August 17, 2012
Macroeconomic risks have rarely been greater. Many economies are at stall-speed if not outright recession, the US is facing the uncertainty of forthcoming elections and a looming fiscal cliff, while the euro crisis appears to be reaching a make-or-break moment.
Despite this uncertainty, money keeps coming into fixed income funds, with investors reacting to the low interest-rate environment by looking for yield. Is this the result of successful non-standard monetary policy, or another bubble waiting to burst?
By cutting interest rates to virtually zero and then buying significant amounts of their own debt, central governments have tried to discourage saving and prompt investment back into the economy via corporate bonds and equity markets.
If the strong retail flows into corporate bond funds, particularly high-yield funds, are anything to go by, this has been achieved. Indeed, many corporate bond markets now trade with a yield at an all-time low and even the relative yield (the extra yield over and above the "risk free" rate) is below the historical average in many cases.
Companies that have benefited from this dynamic can therefore borrow money at very low levels and use the proceeds to buy equipment and hire people. The theory is that such activity will take economies out of their malaise and ultimately reward investors’ risk-taking.
There are two significant problems with this theory. The first is that low borrowing costs have yet to trigger a satisfactory demand for credit. Bank surveys suggest that credit conditions have been loosening, but that loan demand remains very low.
Perhaps this is simply a chicken-and-egg situation and demand will slowly pick up as time progresses. Maybe central banks just need to cut interest rates again or buy some more government debt, and credit demand will gradually follow.
I have my doubts. I think the reluctance to take on more debt is a natural consequence of the credit boom that brought us to this difficult situation in the first place.
Consumers, banks and governments are already laden with significant amounts of debt. Many are actively trying to pay down their debt rather than take on more. Those that don’t need to reduce their debt are reluctant to invest in assets whose value remains boosted by the debt of others (the UK property market springs to mind).
Even if borrowers decide to keep their debt constant, lower yields are helping reduce costs when loans come due and are refinanced. But even this benefit is not universal. Indeed, this brings me to the second problem, namely that not every company or country benefits from a low borrowing rate.
High debt levels can be eroded by defaults or high nominal GDP growth rates, boosted by inflation. Given that nominal GDP growth has been rather disappointing recently, it is natural for investors to be concerned about the threat of default and shun borrowers who seem most susceptible.
With Greece having recently defaulted, the European periphery is an obvious candidate, with Italian and Spanish companies being forced to fund at much higher yields than similar German companies.
Highly indebted banks outside of the core eurozone economies are also struggling to raise funds in the bond market, given their leveraged exposure to weak economic growth.
This has not been helped by policymakers forcing losses onto certain types of bond holders. Unfortunately, the borrowers that struggle to get cheap funding are the very ones that are in desperate need of it. Of even greater concern is that such borrowers are rather large.
If Spain or Italy were to follow Greece and default, the broader impact could be catastrophic. The current vogue of hiding in supposedly safe borrowers would be pointless given how widespread losses would be.
While such defaults have yet to transpire, the pressure on borrowers that struggle to get their hands on cheap funding is already affecting stronger ones.
Within the eurozone, for example, countries such as Germany and France have been dragged towards recession by the falling demand from Italian and Spanish consumers and corporates. So while corporate bond yields are at their lows, unemployment continues to edge higher.
Central banks may be hoping that time will heal such problems, believing that strong borrowers will eventually use their cheap funding to invest and ultimately drag the weaker borrowers out of their decline.
But surely their confidence must be waning. They could instead decide to target weak borrowers, and directly offer them cheap funding. This requires an acceptance of the associated default risk and an appetite to absorb such losses.
Unfortunately central banks are ill-equipped to intervene in such a way, given they will have to choose which borrowers to actively support and which to reject. Even if they become comfortable with this new role, their mandates might legally prohibit it.
This is the case in Europe, where treaties specifically forbid the ECB from financing government deficits. Barring a growth miracle, these restrictions need to change and the sooner the better.
Ben Bennett is credit analyst at Legal & General. The views expressed here are his own.