It’s the season to talk about the man who delivers presents. No, not Santa Claus, but Fed Chairman Bernanke who has been delivering the green stuff for the past four years – in a helicopter, not a sleigh… My last installment introduced the Fixed Income Bond Deer – the investor caught in the headlights confused about what to do. This week we contemplate the following: should “Bond Deer” be grateful for the green stuff or frightened by the possibility that it is fueling the next bond “bear” market? The answer: it depends on how long this experiment continues.
The Great Experiment
The great experiment – unprecedented and continuous monetary accommodation by the Fed began in response to the 2008 financial crisis and contrasts with the restrictive monetary policy that helped precipitate the Great Depression of the 1930’s. To avoid a repeat, the Fed has ventured into the uncharted waters of Quantitative Easing, resulting in a Fed balance sheet that has ballooned beyond recognition:
While a rerun (so far) of the Great Depression has been avoided, investors are understandably nervous about the unintended consequences of the Fed’s experiment. To date, monetary stimulus has resulted in a desperate hunt for yield and income, but hasn’t shown up in a meaningful way in the “real” economy. The current depressed nature of the money multiplier (the frequency a dollar circulates through the economy) is evidence of this.
Some have suggested that because the Fed has merely been filling in the monetary hole brought on by systematic deleveraging – consumers and businesses spending less and paying down debt we have not yet seen any meaningful pickup in inflation. But I believe it is only a matter of time before the so-called “high powered” money injected by the Fed begins to leach into the real economy. It will occur through the levered magic of lending.
Will Monetary Velocity Reignite?
The fact that credit demand is no longer dropping like a rock and is now actually growing year over year is a sign that we may not be too far from that event.
Therefore, the questions all nervous Bond Deer need to answer: when will lending revive more meaningfully, and will the stimulus be removed before monetary velocity reignites inflation? Currently, credit channels are fractured. Credit is freely available to those who don’t need it: large corporations and individuals with high FICO credit scores. But it is substantially unavailable to those who do need it: individuals with underwater mortgages and small business owners. A robust credit recovery requires repaired consumer balance sheets and a resurgence of bank risk appetite. Did someone say housing revival?
I believe conditions for a full blown credit recovery are beginning to fall into place. Housing prices are rising, which will help to repair consumer balance sheets and potentially release significant pent up demand. I also suspect that the Fed will maintain its accommodative stance long after the “coast is clear,” as its mandate for full-employment will take a while to achieve. For more on that see my colleague Sam Wardwell’s latest blog, Will Rates Rise if Ben Bernanke is Replaced?, at followPioneer.com.
Inflation the Enemy
As lending revives and monetary velocity rises, so too will inflation expectations. The graph below illustrates this is already occurring.
The precursor of a bond bear market is taking shape. As inflation rises, it erodes the value of bonds already issued. Investors in higher quality, lower-yielding long duration fixed income strategies will take the brunt of the “Duration Two-Ton” as we coined it last week, and should be taking precautionary steps. But before we call “game over” for the high quality bond market, we need to examine the possibility that monetary stimulus has only postponed a deflationary crash, and that the headlight-blinded Bond Deer should be more frightened of the “Credit Express” barreling down the highway. And, we have yet to contemplate the possibility that this all ends very badly if our federal government is unable to get runaway deficits under control. So, more to come…