Easy money in the form of zero interest rates is working its magic, reflating prices of financial assets in markets around the globe. In response, investors desperate for yield are plunging into riskier assets.
A few months ago, JPMorgan’s weekly Global Data Watch was advising readers to plough into the recovery trade, and then into the reflation trade. Now it is counseling them to “go for yield.”
“Investors should look for high beta and more distressed sectors to outperform,” it noted in mid-December. Those sectors include “high yield, collateralised loan obligations, AAA subprime securities and commercial mortgage backed securities.”
Is this Christmas 2009 or 2007? CLOs – vehicles that invest in bundles of bank loans – were supposed to have disappeared. And wasn’t it writing insurance on subprime securities that blew up AIG?
As asset prices recover, the question being asked is whether zero interest rate policies, especially in the US, are working too well, and are no longer reflecting more sober economic realities.
Yields in the junk bond market have fallen from 20 per cent to 9 per cent. This year, returns in the market overall were 56 per cent and those in the lower rated CCC group returned twice as much.
On its outlook call for 2010, Morgan Stanley’s analyst, Greg Peters told listeners: “We like the junkiest of the junk for next year.”
Prices in the market for credit insurance reflect a similar optimism. Spreads on auto parts makers are trading at a tenth of the levels of a few months ago, reflecting perceived lower risks on payment defaults.
Meanwhile the junior debt of General Growth Properties, a shopping mall company operating in Chapter 11 bankruptcy protection, with $22bn in debt ahead of the junior debt, is trading at over 90 cents on the dollar. Some property experts argue that such healthy prices are justified as the debacle in the commercial real estate market will be far less dramatic than in past cycles because of all the risk capital coming into the sector.
Similarly, hedge funds have made up much of the money they lost in 2008 as a result of poor performance and investor withdrawals. The industry now has $2,000bn under management once more and a few phone calls to prime brokers quickly establishes that leverage is also returning to the markets.
Even the moral hazard trade is alive and well. Investors in the preferred shares of Fannie Mae and Freddie Mac who believed incorrectly that the US government would make them whole were wiped out 15 months ago. Yet, the day before Dubai World announced it needed to restructure its debt in late November, the debt of Nakheel, its property arm, was trading above par. (This is despite property prices and occupancy both having dropped dramatically in the emirate and the documents clearly stating that the debt wasn’t sovereign.)
At the same time, equities continue to rise in the US although virtually all the recent growth in profits comes from one sector – finance. Indeed, quarter over quarter, at the end of the third quarter, financial sector profits were up 36 per cent, while those of non financial firms rose only 2 per cent, (and most of the profits in the financial sector came from the banks).
“ZIRP [zero interest rate policy] is crack cocaine for financial markets,” declares one fund manager at Goldman Sachs.
To be sure, some of this reflects relief that Armageddon did not happen, despite fears that the world was on the brink.
Still, this litany of troubling indications of a possible bubble in the making is eerily reminiscent of the data the Federal Reserve Bank of New York used to compile, in an unsuccessful effort, to persuade then Fed Chairman Alan Greenspan that a bubble was building up in asset prices and that monetary policy was too easy several years ago.
At this point, it isn’t clear whether low rates are the right tonic for markets that still require healing – or a sort of snake oil, compounding the damage, by using a bubble to get out of a crash. After all, it was overly easy money that got the US and the rest of the world into this mess in the first place.
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