Fed must not linger too long on QE exit

It has been a good six months for borrowers in the high yield market who raised a record $180bn in the period. Two-thirds of that has gone to refinance debt at ever lower yields, and another 16 per cent to help finance new mergers and acquisitions.

Still, although there is virtually no sign that the Federal Reserve has any intention of exiting its easy money policy any time soon, the congenitally pessimistic denizens of the bond markets are already fretting that when rates rise, the process will be far more painful than in the past as investors all decide to hit the sell button at the same time. Many hedge funds hold short futures positions in a bet that rates will rise in the middle of 2015 (though in smaller size than at the beginning of the year when a sizeable number lost money on such bearish trades).

Demand for credit has grown far faster than equities, according to analysts. Indeed, since the end of 2008, the three fastest growing asset classes have been fixed income exchange traded funds, emerging market corporate debt that is dollar denominated, and US high yield.

Meanwhile, spreads to Treasuries continue to grind tighter. All this makes these asset classes, and high yield debt in particular, more vulnerable to outflows with even a small move up in rates.

In other words, the longer easy money continues, the trickier the exit and more dire the consequences in the eyes of the debt markets.

That is, of course, partly because the banks are no longer making two way markets as robustly as they used to do as a result of constraints imposed upon them (by the same people bringing them easy money). No regulated financial institution wants, or is, allowed to take the risk of taking the other side.

That suggests that prices of illiquid corporate bonds - whether in the US or outside - will gap down when the appetite for risk goes into reverse with the eventual end of easy money. In April, the International Organization of Securities Commissions warned of the liquidity risk bond market investors face. And two weeks ago JPMorgan's market strategist entitled his weekly outlook 'From leverage risk to liquidity risk', to underscore the dangers inherent in the process.

"The brute macro forces that are driving global markets this year are low growth, easy money and low volatility," noted Jan Loeys. "This trio is a substantial boost for broad asset price inflation. Given the reduced ability of banks to use their balance sheet to buy risk assets during a fire sale, there is now a higher risk that when the Fed starts hiking in earnest, outflows form high yielding and less liquid debt will lead to a free fall in prices."

Shortly before this warning, BlackRock floated the idea of gating investors who want to redeem in size from bond funds, or charging them penalties for withdrawing their money. The idea may or may not work but the fervour of the debate points to just how much concern the eventual prospect of higher rates has given rise to.

That is fine. Market players are right to worry about such matters since that is their daily bread. The problem is that the Fed seems to want to begin tightening (at some stage in the future) without bringing asset prices down, since the whole point of the QE exercise was to raise asset prices in the first place.

The stock market continues to set new highs, though corporate earnings do not warrant those gains. Meanwhile, with growth down almost 3 per cent for the first quarter, GDP for the first half will probably be close to zero. Corporate investment in anything other than share buybacks is minimal. Indeed, the Fed policies give companies every incentive to indulge in share buybacks rather than investing in plant and equipment, let alone in hiring.

Meanwhile, speaking at the International Monetary Fund on July 2, Janet Yellen, chairwoman of the Fed said that "financial stability risks shouldn't have a central role in monetary policy decisions, at least most of the time." For financial stability, substitute asset price inflation. What she implies is that there is not enough of a bubble to warrant a departure from easy money. The very desperate search for yield is considered an affirmation of Fed policies.

The Fed wants to have its cake and eat it too.

One former financial official contrasts the Fed's willingness to raise rates in 1994 (and never mind the consequent bond market sell-off which almost brought Goldman Sachs down), with its stance in the years since then, with the Greenspan, Bernanke and now Yellen puts designed to cushion financial markets from such corrections. Yet in 1995, the economy recovered despite the fact that financial markets had a bad time the previous year.

Might it be that the Fed has everything in reverse?

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