Friday, February 8, 2013

Junk Bonds: Is This The Fed's 1996 Moment?

In December 1996 Fed Chairman Alan Greenspan gave an after-dinner speech in Washington discussing monetary policy and its effect on the economy and capital markets.

While the speech was notable for the type of comments that Greenspan for which the Fed Chair was famous - namely, sounding impressive but giving away very little about the future of Fed policy - he did insert this paragraph which garnered worldwide attention (I have added the emphasis):

Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.

The next day, the world's capital markets were rocked.

 Greenspan's comments suggesting that asset prices had reached "irrational exuberance" levels spooked investors as they feared a tightening of Fed policy was imminent.

Greenspan's comments, however, were premature.  Stocks continued to move higher for the next three years, eventually peaking in March 2000.  Eventually, however, his analysis was proved accurate, as stocks began the decade-long malaise that characterized the first decade of the 21st century.

Fed officials have since become reluctant to make any suggestions on their views on the markets.  If they do, their caution or optimism is usually couched in very oblique terms.

So I read with some interest that at least one member of the current Fed board believes that high yield bonds have reached levels were he considers them close to "bubble" territory.

Here's how the New York Times this morning reported comments from Fed Governor Jeremy Stein, who apparently has recently become a more prominent member of the Board:

...Jeremy C. Stein, a Fed governor, highlighted a surge in junk bond issues, the popularity of certain kinds of real estate investment trusts and shifts in bank balance sheets as areas the Fed is watching closely, although he played down any immediate threat to the financial system or the broader economy...

Mr. Stein gave no indication that Fed officials were contemplating any change in their aggressive efforts to hold down interest rates. Rather, he described the signs of overheating as an emerging trend that might require a response if it intensified over the next 18 months.
But the speech nonetheless underscored that the Fed regards investment bubbles, rather than inflation, as the most likely negative consequence of its push to reduce unemployment by stimulating economic growth.
Mr. Stein also challenged the general view among central bankers that excessive speculation was best addressed through targeted regulation like loan underwriting standards, and not broad changes in monetary policy. He urged an “open mind” about the use of higher interest rates and changes in the Fed’s investment portfolio to curtail such speculation.
In my opinion, comments like these from Governor Stein will someday viewed as some of the early warning signs that the Great Liquidity Policy that the Fed adopted in the midst of the 2008 credit crisis is nearing an end.
But for now, at least, I suspect that the "irrational exuberance" of high yield investors has a little more to go.