Why zero interest rate policies cause deleveraging

As I was traveling to Minneapolis today, I had a very interesting conversation -thanks Ted - about the Fed's various zero interest rate policies including quantitative easing and Operation Twist.

The key point that came out of the conversation is that interest rates below 2% provide an incentive for households and businesses to pay down their debt.

The incentive is that by paying off their debt they can earn a substantially higher risk-free rate of return than is available elsewhere. 

This is true for households even after refinancing at today's low interest rates.

As for companies, Ted said that his firm surveys CFOs and that interest rates at this level have essentially no impact on the decision to invest to expand as oppose to making the necessary capital investments to maintain existing capacity.

What zero  interest rate policies have effectively done in this financial crisis is changed the association of risk-free from applying to government securities to applying to the debt owed by individuals and companies.

This suggests that continuing low interest rate policies is in fact counter-productive.

Fed seeks to end buyers' strike

With its announcement that it was going to pursue zero interest rate policies for a minimum of two more years, the Fed upped the stakes in its effort to end the buyers' strike.  The buyers' strike applies to all forms of investment.  This includes everything from risky assets like stocks and long term bonds to business expansion.

The question is will the knowledge that interest rates will be artificially held at zero forever change buyers' behavior?

If the experience of Japan for the last two decades is any indication, the answer is a resounding NO!

Why should the Fed or any other central bank pursuing similar policies expect zero interest rates to end the buyers' strike?

Investors are acting according to Mark Twains' observation that he was more interested in the return of his capital than the return on his capital.  Given what has happened since the start of the Great Contraction this makes sense.

What has happened since the start of the Great Contraction?

Investors learned two lessons from blindly chasing yield.

First, they learned the difference between investing and blindly betting.  Investing requires access to all the useful, relevant information in an appropriate, timely manner and evaluating this information so that the risk and return can be assessed.  Blindly betting is buying opaque financial innovations like CDOs cubed.

Second, they learned that return of their principal is more important than capturing a 1 - 3% higher return on their principal.  When the focus is on return, significant losses of capital result.

What has not happened since the start of the Great Contraction?

Policymakers and economists have not followed the advice that they freely gave to Japan when its bubble burst.  Their advice was that the most important thing Japanese policymakers could do to restart their markets and economy was to publicly recognize the size of the losses related to the bubble and who was holding them.

Why did they give this advice?

They knew that until the losses are recognized buyers will stay on strike.   Buyers know that the losses exist, but without the disclosure of how big the losses are and who holds them, they do not know how the losses will impact them.  So, rather than take a risk - which is what investing is - buyers go on strike and "invest" where they can get their principal back.

By not recognizing the losses, policymakers are perpetuating uncertainty in the economy that undermines buyers' willingness to invest.  In essence, until the losses are recognized, the losses are the elephant in the room that crowds out everything else.

I am not going to speculate about why western policymakers and economists did not act on their own advice since the start of the Great Contraction.  I will just note that they have not acted and the resulting economic malaise and related buyers' strike has been extremely predictable.

Disclosure and the hunt for yield

A Telegraph article reported on the Bank of England's Paul Fisher's speech in which he discussed the implications for financial market stability from investors hunting for yield in a low rate environment.

As predicted under the FDR Framework, investors are crowding into those assets where they have access to all the useful, relevant information in an appropriate, timely manner.  Included in these assets are debt with government guarantees and high grade corporate bonds.

Mr. Fisher is concerned that as spreads on these assets tighten to pre-credit crisis levels, investors will turn to securities they do not understand to pick up additional yield and this will in turn create financial instability in the future.

This is ironic.

At least in the US, it is an explicit goal of zero interest rate policies to force investors into riskier assets.  The Fed has gone so far as to reduce the supply of risk-free assets by purchasing treasury securities.  By doing so, they have artificially depressed the yield across the entire treasury yield curve.

This mis-pricing of the risk-free rate carries over to all other debt securities.  As the spreads over treasuries on these other debt securities return to their pre-credit crisis level, this is an indicator that these debt securities are over-priced.

Why?

Because the mis-pricing of the risk-free securities is now embedded in the pricing of the other debt securities.  For example, say that under the Fed's policy the risk-free securities are trading for 0.25% less than they would without Fed intervention.  This same 0.25% is now embedded in the pricing of the other debt securities when their spreads return to pre-credit crisis levels (otherwise the spreads would be 0.25% higher than pre-credit crisis levels).

It appears that Mr. Fisher is making an artificial distinction by focusing only on those debt securities for which investors do not understand what they are betting on when the largest categories of debt securities are mis-priced too.

"Investors know – and must remember – that there is no such thing as a free lunch, and that additional return involves additional risk," said Mr Fisher, the Bank's executive director of markets and a member of its interim Financial Policy Committee. 

Intelligence gathered by the Bank has flagged up a "number of pockets of increasing risk appetite and a few specific markets which have been showing signs of excess," he said, with the trend most marked in the US. 

Investors are on the hunt for higher yields, or returns, against the backdrop of the massive emergency injection of liquidity into the financial system by the world's central banks. They [central banks] bought up government bonds in vast quantities, which pushed down the yields from these "safe" assets and encouraged investors to look elsewhere. 

The worry is that the lower yields on these traditionally low-risk assets is now coinciding with an apparent shortage of high-quality assets, therefore prompting investors to move into products where the risks are not so understood, Mr Fisher said in a speech to institutional investors released yesterday. 

Mr. Fisher's statement suggests that the stated intent of Fed policy poses risks to financial stability.  Having identified the risks, the question becomes what is the appropriate response by policy makers.  The choices include:

• The Fed stops pursuing zero interest rate policies and the purchase of risk-free debt securities.  This will increase the supply to the market and ease the pressure to move into products where the risks are not understood.

• Governments actually making sure that market participants have access to all the useful, relevant information in an appropriate, timely manner.

• Reminding investors that the last time they purchased debt securities they did not understand, think sub-prime mortgage backed CDOs, they lost a bundle.

Mr. Fisher opts for reminding investors.

... "The combination of portfolio rebalancing and this reported shortage of specific high-quality assets might have wider implications for financial stability if it encourages investors to look for additional yield by moving into more illiquid products ... or into more complex products (which they might not fully understand)," Mr Fisher said. 

He highlighted exchange traded funds (ETFs), which are traded like shares. Their rapid growth has been characterised by "increasing complexity, opacity and interconnectedness, and ... if left unchecked, could grow to pose risks to the stability of the financial system", he said. 

It is not surprising that ETFs are becoming increasingly complex and opaque.  Wall Street is engineering them this way because they know that the regulators are not requiring that all the useful, relevant information be disclosed in an appropriate, timely manner.

However, the most immediate threat to markets was seen as problems around governments' debt and the potential impact on European banks.