A few worrying things

The FOMC has of course already decided to raise the Fed Funds Rate and while we would not expect the move to have a significant impact on the demand for credit within the US real economy – and it may even improve the supply of credit to the economy by improving the functioning of the credit system, we are concerned that a higher cost of funds for those entities that ‘mine’ liquidity in the USD credit markets for use elsewhere within the global economy may add to the deflationary forces that are already established within parts of the global capital flows system.
Moreover, we are also concerned that while the total size of the FRB’s balance sheet is unlikely to change over the coming year despite the shift in interest rate policy, the need to hold the Fed Funds Rate up may result in the Fed withdrawing significant quantities of liquidity from the financial system through reverse repos, and will likely imply a significant reduction in the effective size of the Fed’s balance sheet from an overall monetary stance point of view. In this context, what has been a small price move may prove to be a large quantity move.

We are also concerned that if the FRB does conduct large scale RRPs in order to hold the Fed Funds up, then it will implicitly be supplying hundreds of billions of dollars of collateral to the system. While this might be helpful from the point of view of aggregate credit supply (particularly within the financial system), the release of high quality collateral (i.e. Treasuries) and the expansion of high quality collateral will presumably lower the demand for the corporate and other private sector instruments that the banks had hitherto been obliged to use as collateral during the ‘famine’.  This may have implications for the corporate debt markets. Indeed, we do wonder if the hike in the Fed Funds may turn out to be positive for mortgage lending and the housing market, while negative for the corporate debt markets.

The corporate credit markets represent another of our key themes for 2016. The level of US corporate debt is now back up to an ‘all-time’ high relative to GDP and corporate borrowing is now growing at  a faster rate (in dollar terms) than GDP, a rare and usually worrying event. We suspect that this situation has occurred as a result of a particular confluence of factors, namely the impact of QE and the collateral famine on the demand for corporate paper; the over-reliance of corporate management remuneration on relatively short duration employee stock options; and the (regulatory enforced) relatively rapid employment turnover of senior management. At present, much of the debt that is being issued has a duration of >15 years while the average tenure of a board member is less than half that and the timespan of a stock option scheme is a fifth of the duration of the bond..... Clearly, this situation creates an incentive for management to gear up / de-equitise the employers’ balance sheets. In addition, most of their employers (i.e. shareholders) also possess a relatively short time horizon and so there has been a tendency for the corporate sector to become over-geared over recent decades.

This high level of debt has been built up against a background in which corporate profits are weak according to the NIPA data, corporate guidance is far from upbeat, and the corporate sector is running its first material financial deficit since the GFC. There is also considerable adverse news and sentiment over the corporate debt markets at present, with the result that there seem to be few inflows. We therefore fear that the early part of 2016 may not be a particularly happy period for the corporate debt markets.
In terms of defining just what may make an unhappy year for the corporate debt markets, we should be aware that this unhappiness may take two forms, namely weaker pricing and a rationing of new issuance.  If the latter ‘quantity of issuance weakening’ occurs (and we suspect that this will be how much of the weakness is manifested – the sponsoring brokers will likely ration new issuance), then we would expect many real world companies to become financially constrained with regard to not only the amount of capital spending they can do but also the amount of equity buy-backs, M&A activity and even share option schemes that they can attempt. Hence, problems within the corporate debt markets could adversely affect both the corporate earnings outlook and the valuation of those earnings.