After six years of near-zero interest rates, the next US tightening cycle is looming. We know a lot about this next cycle. We know that the direction for rates will be higher and we know that economic data from the US is strong and inflation is low.
There are also things we know we don’t know – the ‘known unknowns’. We know that we don’t know when rates will rise, how much they will rise by and what the pace of future rate rises will be. We know that we don’t know the impact that low inflation will have on the decision of the US Federal Reserve (the ‘Fed’).
And while we know what the current economic data is, we have no idea what it will be in a year’s time, let alone for the next five years.
The real risk to the corporate borrower is that the same mistakes will be made again, leading to much higher rates, much faster
The decision whether to hedge or not to hedge is also a ‘known unknown’. Not hedging against an increase in rates will result in a business incurring higher funding costs depending upon how far rates rise, but we know that we don’t know exactly what that final cost will turn out to be.
Hedging too early will involve an unnecessary cost of negative carry, however. These ‘known unknowns’ are a risk to corporate borrowers with floating-rate exposure, but there is a greater, more unquantifiable risk that should guide a borrower’s hedging decision – the risk posed by the Fed itself.
Over the past four decades, there have been eight cycles of higher US interest rates. The average increase of each of these eight periods is 573 basis points, and we don’t know whether this next cycle will produce a lesser or greater move than the average.
There is, however, a key observation that links all eight cycles – a combination of too much discretion on monetary policy and a history of Fed forecasting that has consistently lagged behind economic reality. The result has been that, in each cycle, the Fed increased rates further and faster than anyone had expected.
The real risk to the corporate borrower is that the same mistakes will be made again, leading to much higher rates, much faster. Simply put, history shows us that Fed mistakes turn problems into catastrophes.
In the US, a stock market panic in 1907 sent the New York Stock Exchange spiralling downward and led to a bank run. With no Fed to inject cash into the market, it fell upon investment banker JPMorgan to organise Wall Street. Morgan rallied people who had cash to spare and moved that capital to banks that lacked funds.
The panic led the government to create the Fed, in part to cut its reliance on financial figures such as Morgan in the future.
During the crash of 1929, the Fed took the opposite course, cutting the money supply by nearly a third and choking off hopes of a recovery. Consequently, many banks suffering liquidity problems simply went under and what could have been a recession ended as a depression lasting 10 years.
It caused drastic declines in output, severe unemployment and acute deflation in virtually every country on Earth. In a speech on 8 November 2002, Ben Bernanke, later to become chairman of the Fed, admitted that the Fed’s actions caused the Great Depression. “We did it,” he said. “We’re very sorry.”
Following the 2001 recession, the Fed, under Alan Greenspan, took rates down from 6.6% to 1.0% and it kept them there too long. While there were indeed other culprits, not least a lack of effective regulation and bad lending practices, this loose monetary policy contributed to a massive move into property speculation and over-borrowing.
The Fed did not acknowledge any excessive borrowing and affirmed that it saw no risk from the sub-prime crisis. Until the boom in sub-prime mortgages turned into a national nightmare, warnings to Greenspan were rebuffed. Greenspan and other Fed officials repeatedly dismissed commentary about a speculative bubble in housing prices.
It has been said that the 100-year history of the Fed is a history of mistakes
In December 2004, the New York Fed issued a report, bluntly declaring that “no bubble exists”. Greenspan predicted several times – incorrectly, as it turned out – that housing declines would be local, but almost certainly not nationwide. Today, Bernanke openly admits the failings. “Were there mistakes? Absolutely. I’m going to try in my own writing and thinking to understand for myself what they were…”
At the height of the sub-prime crisis, the Fed put up $29bn to keep Bear Stearns out of bankruptcy. In the Fed meetings before Lehman Brothers collapsed, its focus was elsewhere, despite the sub-prime crisis and contraction of credit. At the June 2008 meeting, the minutes show that there were 468 mentions of the risk of inflation versus just 35 of a systemic risk to the economy.
On 16 September, one day after Lehman’s collapsed, there were 129 mentions of inflation and just four of a systemic risk. In fact, James Bullard, president of the St Louis Fed, stated that by letting Lehman’s collapse, the Fed believed that “the level of systemic risk has dropped dramatically and possibly to zero”. We all know what happened next…
It has been said that the 100-year history of the Fed is a history of mistakes. Even the Fed’s modern-day attempt at forward guidance has been dogged by criticism: from Bernanke’s taper tantrum statement in 2013 to present Fed chair Janet Yellen’s announcement that rates would increase six months following the end of quantitative easing (QE). Both caused financial chaos.
In February 2015, Yellen appeared before the Senate Banking Committee to justify the Fed’s actions. The opening remarks from the congressmen were that “there does not appear to be all that much guidance in the Fed’s forward guidance”.
It could be said that the Fed has already sown the seeds of the next crisis. By keeping interest rates near zero for six years, investors worldwide have been hunting for yield.
QE has encouraged traders to take highly concentrated positions in fantastically overpriced markets. Corporate and emerging-market bond yields have plummeted, stock markets have soared and yields on more than $2 trillion of sovereign bonds are negative.
An unlimited tolerance for risk has developed along with years of falling volatility. For six years, investors have swapped risk for ever-lower returns, but 2015 has already seen the re-emergence of volatility with currency and bond markets experiencing their wildest price swings in more than three years.
More than ever before, the list of uncertainties facing the Fed implies an even greater margin of error in setting the right interest-rate policy this time
Investors are being reminded that volatility rises like a phoenix from the ashes of complacency at a moment’s notice, particularly when risk becomes almost meaningless.
The biggest risk and justification for the corporate borrower to hedge is not the economics of finance. It is the risk posed to the borrower by the Fed itself.
Divergent monetary policies throughout the world, low inflation, collapsing oil prices, full employment in the US, slow wage growth and a strong dollar are just some of the challenges facing the Fed.
More than ever before, the list of uncertainties facing the Fed implies an even greater margin of error in setting the right interest-rate policy this time. US lawmakers would ideally like to cut back the Fed’s discretion.
A groundswell of leading economists favours the Fed following a mechanical, rules-based system for managing monetary policy, while some have said that the Fed should be replaced by a computer.
With no sign of change as we go into the next interest-rate cycle, the history of the Fed should provide the corporate floating-rate borrower with the motivation to hedge, and to hedge quickly.
Max Knudsen is head of Abu Dhabi global market sales at FGB
