How is the Federal Reserve going to end the Quantitative Easing party? With a bang or with a whimper? That’s the question many on Wall Street have been asking themselves in recent months. It’s more than just an intellectual exercise, of course. The value of many, many trillions of dollars of stocks and bonds hang in the balance, as well as does the fate of the U.S. economy. Will the Great Unwind lead to a recession, or more, a serious financial crisis, or has Jay Powell, the Fed chief, and his fellow governors put enough foam on the runway to land this crazy thing safely?
To review: The Fed’s deliberate policy of manipulating both short-term and long-term interest rates to their lowest levels in 4,000 years was the brainchild of Ben Bernanke, the former Fed chairman and Great Depression scholar. By the time the 2008 financial crisis hit under his watch, Bernanke figured—correctly—that one solution to our serious economic woes was to buy all sorts of bonds in the marketplace, driving up their price and lowering their yields. He figured—again correctly—that very low interest rates, near zero in fact, would stimulate the demand for borrowings and encourage capital to be invested in all sorts of risky new ventures in search of bigger payoffs than could be found in a low-interest rate environment. Bernanke’s ZIRP, or Zero-Interest-Rate-Policy, has been continued by his two successors, Janet Yellen, now the Treasury Secretary, and Powell, now in what could be his final year as Fed chairman. During that 12-year-period, the Fed’s balance sheet has exploded to nearly $8.5 trillion, from around $900 billion.
That’s a lot of buying, and it has resulted in one helluva party in the financial markets. Since March 2009, the Dow Jones Industrial Average has increased to around 35,000, from 6,500, an increase of some 430%. (The S&P 500 index has increased 550% during the same period.) Taking the high-yield bond index as a proxy, one can see that a similar Fed-engineered bonanza has occurred in the bond market. In March 2009, the average yield on a high-yield bond, according to data provided by the Federal Reserve Bank of St. Louis, was a whopping 18.7% (down from the November 2008 peak of nearly 22% when investors were freaked out). Today, thanks to the Fed’s bond-buying spree, the average yield on a junk-bond is 4.3%, and that has increased in recent months, from an average yield with a 3-handle on it, largely because of the uncertainty about whether and how Powell is going to reverse course and once again cede to the market the job of pricing the cost of money.
The thing is, ending the party is Powell’s job. He’s just not very good at doing it. Some sixty-five years ago, William McChesney Martin, the longest-serving chairman of the Federal Reserve, described his job as akin to the “chaperone who has ordered the punch bowl removed just when the party was really warming up.” Powell tried in 2017 and 2018 to take the punch bowl away. He and his fellow Fed governors raised interest rates five times in a row, at 25 basis points a clip, ending in December 2018, without much perceptible disruption to the economy. The resulting mini-“taper tantrum”—the markets were momentarily unsettled — was actually a welcome start on a return to normalcy in the credit markets.
But it wouldn’t last. In December 2018, after the last hike, President Trump claimed he could fire Powell—he couldn’t—and then complained to his advisers that the Fed chairman would “turn me into Hoover,” a reference to President Herbert Hoover, who many felt exacerbated the Great Depression. In early February 2019, Trump invited Powell to a private steak dinner at the White House, along with Treasury Secretary Steven Mnuchin and Richard Clarida, the Fed vice-chair. There has never been any substantive reporting about what happened at that dinner and no evidence has emerged that the meeting influenced Powell. In July, the Fed reversed course and lowered rates, explaining that there was “sustained expansion” of economic activity, a “strong” labor market and a rate of inflation “near” the Fed’s 2% goal. The central bank cut rates two more times in 2019 before the arrival here of the pandemic, in March 2020, prompted Powell to drastically lower rates and increase the QE program.
Now, with his job on the line—Sen. Elizabeth Warren has said she won’t support a second term for him—Powell is trying to reverse course again, in the face of both risk-taking run amok and rampant inflation that is starting to look less and less transitory. On Sep. 22, while keeping short-term interest rates near zero, the Fed announced that it would begin “soon” to wind down its monthly purchases of around $120 billion of Treasuries and mortgage-backed securities. No one knows what “soon” means but the betting seems to be that “soon” means next year.
Or maybe it means that the financial markets still don’t believe Powell et al have the guts to pull the plug on QE, that instead the Fed would rather have the markets blow up for the less obvious reason than that the Fed tried to pull the punch bowl away. In the few weeks since the September announcement, the DJIA is up around 2.5%, hardly an indication that equity investors see much change coming anytime soon. The much-bigger bond market tells a different story. Bond investors do seem to be slowly getting the message that something different is afoot. On Sep. 17, the average yield on the junk-bond was 3.96%; now it is nearly 4.3%, an 8% increase in three weeks. In the same time frame, the yield on the 10-year Treasury has increased a massive 17.5% to 1.61%, from 1.37%.
There are other signs that bond investors are wising up. In late September, Ahern, a Las Vegas-based equipment rental company, pulled its high-yield debt offering after investors demanded an interest rate of 10.5% and other protections from the company. Rather than pay up, Ahern will instead risk that it won’t be able to refinance the existing bonds when they become due in 2023. This is the best news to hit the junk-bond market in the last year and a half. What it means is that investors are finally getting tough with issuers and insisting that they get both the yield and the protections that they want, or else: no deal. For the first time since March 2020, junk-bond investors are demanding to be fully paid for the risks they are taking. It’s well passed time for that to start happening.
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