Goodbye ‘Planet Rates’, Hello ‘Planet Quantity’: Credit Markets in a Zero Rate World
By Luke Spajic
May 22, 2012
- There is a sense that developed market economies are somehow undergoing a “reversed metamorphosis” reverting from butterfly back to caterpillar where growth is crawling as opposed to flying.
- The fear of credit destruction, perhaps triggered by deflationary scares, becomes a bigger obsession for central banks.
- The culture of credit risk-taking changes as rates go lower and approach zero with a perennial risk of the economy tipping into deflation.
- The danger becomes pronounced if there is then a tilt towards less risk-taking, running high cash balances and a lot of waiting on the sidelines.
It wasn’t that long ago when central banks would oscillate between raising and lowering the short-term policy rate in order to pull and push consumers, savers, borrowers and investors into behaving differently. We call such a world, given its high interest rate sensitivity, “Planet Rates”.
In “Planet Rates”, appetite for credit risk could be influenced by moves in the policy rate. All other things being equal, a move lower in rates was designed to ignite animal spirits, push the demand for credit higher and increase collateral values (e.g., houses, stocks). It was a tactic that would tend to bring markets back from periods of paranoia and stress, and restore belief in the orderly workings of a leveraged credit market. However, when policy rates in the U.S., U.K. and Europe reached historic lows – joining Japan – the dynamics changed dramatically. While the willingness of policymakers to affect rates remained undiminished, their general effectiveness has dwindled massively.
The main features of a life on ‘Planet Rates’:
- The “rate” would set the price: The policy rate was central to calculating the future stream of “risky” cash flows for a financial instrument. Any security could be valued from a curve stretching out well into the future. By moving the policy rate lower, credit would potentially look more attractive as an investment, and by raising it, the demand for credit would likely fall.
- Facilitate credit supply via risk transfer: Traditional banking functions entailed taking deposits and extending loans. The simplistic “2-3-4” rule illustrates this best as it describes how, theoretically, bankers would give depositors 2% interest on their accounts, lend money at 3% and be on the golf course by 4:00pm. However, this rule has changed in recent times since banks need to retain more capital on their balance sheets to create credit.
- Credit demand curve: Borrowers were encouraged to take on larger loans based on future earnings and the value of their collateral, typically their homes. Increases in income and house prices have served to push the demand for credit further out the curve.
- Derivatives: Off-balance-sheet activity rose in tandem with the growth of credit supply and remained unconstrained by capital limitations. Additionally, derivatives were less regulated, and generally with less regulation came less diligence, including counterparty considerations. Liquidity greased the machinery of derivatives-led leverage.
Everything has changed. We believe the old maps have to be redrawn to steer investors away from the traps that “Planet Quantity” brings with it. By traps, we refer to the mechanism or process that places limits on how an economy can operate and/or how investors may behave in this new global economic backdrop.
- Life on ‘Planet Quantity’: the traps and financial repression
When rates approach zero, economies and investors can fall into a number of traps. While these may vary in scale and scope, they all have potentially far-reaching implications that could affect growth expectations, attitudes to credit risk and, most importantly, investor behavior.
- Liquidity trap: With interest rates at or near zero, there is a perennial risk of the economy tipping into deflation. Coupled with low productivity, there is an elevated risk of low (or negative) unit labor cost growth, which is directly linked to deflation. Economists Kenneth Rogoff and Carmen Reinhart state that high debt-to-GDP ratios may suffocate future economic growth as sovereigns struggle to grow given their high debt burdens. They cite a 90% debt-to-GDP ratio as threshold above which growth struggles to get beyond 1%. There is a sense that developed market economies are somehow undergoing a “reversed metamorphosis”, reverting from butterfly back to caterpillar where growth is crawling as opposed to flying.
- Bank trap: Generally speaking, banks no longer lend in the way that they used to. Instead, they tend to hoard capital and prefer to extend less credit to the private sector. In the current market, they are also more likely to fund the budget deficits of their governments. As a result, corporates may accelerate their deleveraging and potentially freeze themselves out of credit markets, which is what happened in Japan.
- Asset manager trap: Many public and private pension funds still have annual projected returns of 7%–8% baked into the cake. However, much of their profit is often needed to plug deficits. In addition, many insurance companies facing Solvency II, the new capital adequacy requirements for the European insurance industry, often end up owning low beta credit with lower yields because they must hold sovereign debt given they are generally perceived to be relatively low-risk instruments. This is despite many not behaving like low risk assets today.
- Synchronicity trap: In the 1990s, Japan was almost alone in going through its post-credit-bubble fiscal adjustments. The trouble now is that developed economies must deal with a debt overhang and try to keep their GDP growth positive, challenging them all at more or less the same time. This inevitably poses challenges for investors too.
Investors living through “Planet Quantity” also have to grapple with risks that stem from greater government borrowing and private sector delevering, both of which are affecting credit values and flow.
To counter the effects of the financial crisis and keep GDP growth positive, governments must borrow. This borrowing prevents total leverage from falling. In short, the new flow of government bond issuance simply transfers the stock of credit from private to public debt. This poses additional risks, namely to the value and flow of credit.
A potential consequence of this large amount of government borrowing is credit destruction. The best example is Greece. When the balance of probabilities shifts towards credit deterioration, it becomes very difficult for credits to make a comeback without external balance sheet support. Look at what happened to Lehman, which didn’t get support, versus AIG, which did. Will European policymakers do enough for Spain and Italy?
What about the future flow of credit? The core idea here is a counterintuitive one: Lower rates are not necessarily accompanied by more credit creation. Quite the opposite is usually the case when bank balance sheets are impaired and have to be repaired. The flow of credit to many different credit markets is cut off, affecting mortgages and small- to medium-size enterprises (SMEs). Banks need a positively sloped yield curve in order to make credit intermediation profitable, which makes bank capital effective. The trouble with private sector delevering is that the marginal unit of bank capital may be ineffective. Pushing this further, the credit multiplier can become infertile and the flow of credit may just dry up.
In a zero rate world, the stock and flow of credit changes shape. Some parts of the credit market may grow (like government supply), others may shrink (private sector debt) and some may be destroyed altogether (like Greece through a write-down of debt) or some may simply fail to get the credit they need (like SME lending). The fear of credit destruction, perhaps triggered by deflationary scares, becomes a bigger obsession for central banks. Without rates as an effective weapon, central banks increasingly turn to quantities as their main defense mechanism.
Overall, we believe the culture of credit risk-taking changes as rates go lower and approach zero. The danger becomes pronounced if there is then a tilt toward less risk-taking, running high cash balances and a lot of waiting on the sidelines. The wait is for the next quantitative impulse, which is designed to work in a number of ways. For example, it may add liquidity, remove the left tail risk (an investment’s most extreme downside performance potential) of a financial or sovereign that is struggling to finance itself or facilitate buying in a particular market segment, like mortgages. In our view, this is why we are witnessing bouts of risk-on and risk-off as investors try to anticipate the next round of quantitative intervention. With such uncertainty, we believe it is prudent to seek the return of capital rather than the return on capital.
In this dynamic environment, where policy rates often don’t work like they used to and quantitative impulses now tend to be the most powerful tool for policymakers, we believe investors must be more mindful when valuing credit opportunities and be equally aware of disruptions to the flow of credit.
With ultra-low policy rates changing the gravitational pull on credit markets and balance sheets either in the throes of beefing up their balance sheets (in the case of governments) or delevering (private sector), credit investors may be forced to repeatedly go back to the drawing board and revise their maps in an effort to successfully navigate the market paranoia and stress.