What Mischiefs Hath the Fed Wrought?
Two recent headlines tell of dangerous distortions developing in the economy’s financial system.
On the surface, the two news items seem unrelated. One tells how American banks have turned away from lending to businesses and individuals in favor of holding cash and buying federal government-guaranteed paper. The other tells how investment managers, in an effort to secure adequate returns, are taking on more and more risk.
Though seemingly contradictory, both these trends are consistent symptoms of the Federal Reserve’s (Fed’s) expansive, low-interest rate policies. The second of the two sets up finance for losses that could create a recession-inducing crisis of the sort, if not to the degree suffered in 2008-09. The first trend, by starving the broad economy of credit in an environment otherwise flush with Fed-provided liquidity, could only hasten the onset of such a crisis.
Investors – except those inexplicably attracted to AMC or GameStop – seldom seek risk for its own sake. They reach for it, as they are doing now, only when safer investments offer inadequate returns. The Fed’s low-rate policy has secured that inadequacy for bond investing by driving down the rates paid on quality paper below the rate of inflation. Ten-year treasury bonds, for instance, pay 1.6-1.7 percent today, well up from their lows of 0.7 percent last fall but still considerably below recent inflation rates verging on 4.5 percent or even longer-term inflation averages of just over 2.0 percent. Buyers of such paper would effectively have to accept a loss on the real value of their investment of somewhere between 1.0 percent and 3.0 percent. It is much the same picture with quality corporate paper.
The only way left to beat inflation is to take risks that many investors – especially bond investors — would have avoided in the past.
Investors have accordingly turned more and more of their asset allocation toward equities, crypto-currencies, and even more exotic instruments. So far, the ongoing rallies in all these areas have served risk takers well, but they know that their risky holdings will always impose more volatility than quality bonds did. Their buying certainly shows in the rising global capitalization of crypto-currencies, which has expanded from $500 billion just six months ago to some $2 trillion today.
The sudden 140 percent jump in monies raised by SPACs (special purpose acquisition companies) in just the last six months also captures the effects of this rather desperate risk-taking trend. Within the bond area, investors have moved from quality toward “junk” issues, and even those issues, because of the Fed’s low-rate policies, offer returns barely above the rate of inflation.
The demand for low-quality paper has inspired an ominous surge in the issuance of junk. And that rise has followed Fed policy in lockstep. In early 2019, before the Fed renewed it low-rate policies, junk issuance averaged about $75 billion a quarter. Issuance jumped to about $110 billion after the Fed’s move to reduce interest rates during the second half of 2019. Junk issuance rose to $150 billion a quarter as the Fed exaggerated these policies in 2020. Issuance topped $200 billion in this year’s first quarter, an increase of more than 150 percent in less than two years.
Anecdotal reports suggest that inadequate returns on quality loans have induced even fintech players to shift from broad-based lending toward riskier, higher-paying loans.
For the time being, there is a reasonable expectation of a payoff to the risk taking.
The economy is surging in response to the full re-opening from pandemic strictures, and Washington is pouring out a tsunami of money. But there is still no mistaking the fundamental increase in the financial system’s vulnerability. Any economic setback, even slowdown in today’s torrid pace of growth, could lead to huge losses for investors, even bankruptcies among those who, had it not been for Fed’s extremely low-rate policies, would have been more secure in quality bonds. And those losses and bankruptcies, when they arrive, will have knock-on effects throughout financial system.
To be sure, the Fed may have had little choice. It faced frightening imperatives during the pandemic and presumably in 2019, when it renewed these policies of extreme ease, but a more judicious approach might have served the immediate needs of that moment without driving this dangerous pro-risk trend.
On the banking side, the Fed’s behavior has created something of the opposite trend. It has driven banks away from lending to even quality businesses and induced them to make more investments in safer, lower-yielding government-backed paper. Banks have been able to avoid the pressure to take risk because they, unlike investors, deploy neither their own money nor monies entrusted to them to earn returns. Banks instead earn with their depositors’ funds, and the difference turns investors’ risk-return calculation on its head.
When the Fed drives down interest rates, it does destroy investment returns for banks as well as investors, but, unlike the case of investors, it also reduces the cost of funds to the banks.
Take just one comparison.
In early, 2019, banks could get about 2.5 percent on a 10-year treasury, much higher than today, but back then, they had to pay about 1.3 percent on average to depositors. The decision to deploy funds into treasuries earned them a premium of 1.2 percentage points on their cost of funds.
Today, although the 10-year treasury note pays a lot less, the Fed’s actions have lowered the cost of collecting deposits to a mere 0.1 percent, allowing the banks to put funds into treasuries and make a 1.5 percentage point premium over the cost of funds, more than two years ago. Since that premium constitutes a stunning percent 1,500 percent over their cost of funds, it should be little wonder that bank decision makers have little interest in the risks inherent in lending to individuals and businesses.
Banks’ response to these Fed-induced incentives is clearly evident in their asset mix.
According to Fed data, little of the huge deposit growth over the past year has found its way into lending to individuals and businesses. Deposits at the top 25 banks in the United States have risen from $8.7 trillion to $10.1 trillion during this time. All has gone into either cash or paper guaranteed by the federal government. These, in fact, are the only asset categories on bank balance sheets that have grown.
Loans to businesses and individuals – the stuff that drives the economy — have declined outright, falling by some $447 billion to $5.45 trillion. Loan-to-deposit ratios at these top banks barely reaches 50 percent, the lowest level in 36 years. Data on smaller banks — a primary source of credit to small businesses — shows similar trends.
There is some comfort that, in the event of an economic slowdown or setback, the risk flight in the banks will mitigate the overall damage to the financial system brought by others’ risk taking. But banks’ refusal to make business loans, as they once did, makes that economic slowdown or setback more likely than otherwise.
It also draws the date of that inevitable event closer than otherwise. Pent-up demand from the pandemic lockdowns and the largess that Washington has heaped on the economy and plans to heap on it makes that day of reckoning some time off yet.
But the present sources of economic strength should play out by 2023, making that year or 2024 likely times when these problems will arrive, unless, of course, the Fed does something in the interim to alter the perverse incentives it has imposed. Sadly, nothing the Fed has said or done shows that it has any intention to make such an adjustment.