Just as financial markets are getting comfortable with the low-interest-rate environment and expanding money supply, the minutes from the last US Federal Open Market Committee meeting on February 5 shows that several members "expressed some concerns about
The concern within the FOMC is real and the effect can be seen anywhere. As liquidity has been flooding the financial markets, yields have been going lower and lower. To generate a meaningful yield, investors have been forced to take on more risk by investing in lower-rated credit assets or higher-risk asset classes.
Prices of assets such as equities, bonds, land, and high-yield and leverage loans are at a historical high.
In the United States, corporations issued US$274 billion (Bt8.18 trillion) of junk bonds
in 2012 – up 55 per cent from the year earlier. In Thailand, we are seeing more issuance
of corporate bonds with credit ratings lower than “A-”, which was uncommon before 2008. The core issue here is that risk and reward are at an imbalance. Besides piling into riskier assets, investors are doing it at ever-lower rates. This provides a false sense of security and fuels a higher risk-taking appetite.
One way of looking at this is that we may have replaced the housing bubble with a credit bubble. And as we have seen throughout history, eventually all bubbles burst. It’s difficult to say when the bubble will burst, but it could be sooner rather than later.
Right now the market has been assured by the US Federal Reserve that it will continue to expand its balance sheet until unemployment reaches 6.5 per cent, from 7.8 per cent currently. However, if market conditions change – rising inflation or healthy economic growth – and the Fed needs to reduce its balance sheet, it will need to sell the bonds it is holding. This will drive down bond prices and yields will go higher.
The big problem is that the Fed balance sheet is so big right now, at $3 trillion – about $1.7 trillion in US Treasuries and $1 trillion in mortgage bonds. As the Fed is now the largest buyer of on-the-run US Treasury bonds, if it were to stop buying, the rise in yields could be violent.
Financial institutions, mutual funds and hedge funds will also want to rush to sell bonds and avoid being the last investors to hold, in layman’s terms, hot potatoes. The hoarding mentality to exit a position is a common market reaction whenever participants all have the same position, as in this case, and the market is going against them. The rise of yields will not be limited to just US Treasuries – corporate and mortgage bonds and corporate loans will all be higher as the rate of the risk-free borrower, the US government, is higher.
The best case the Fed can hope for is an orderly unwinding of its balance sheet. However, if the rise is a volatile one, it could derail the economic recovery. Excessive risk-taking and high leverage may trigger another round of financial instability. Whatever happens, it will sure be an interesting time for investors worldwide, as this is uncharted territory and no textbook can predict how it will play out.
_ Thiti Tantikulanun is head of capital markets at Kbank.