The massive liquidity infusion by the Federal Reserve, say its critics, has left the US economy awash with cash. So much so that when economic activity revives, the Fed won’t be able to mop up the surplus liquidity quickly enough and the US will have very high inflation, which it will dutifully export to the rest of the world. How true is this view? Let’s just say the jury is still out on this one.
Research by Michael R Rosenberg, a former head of fixed-income and foreign-exchange research at Merrill Lynch and Deutsche Bank, helps to put the challenge before Federal Reserve chairman Ben Bernanke in perspective.
In an analysis on financial conditions for financial-information provider Bloomberg, Rosenberg has broken down the US investment-grade credit spread — the difference in yields on Aaa-rated and Baa-rated bonds — into two parts. The first component, which he calls the “liquidity-risk premium”, is the excess yield demanded by investors to hold between Aaa-rated corporate bonds rather than US treasuries. The second component, which corresponds with what Rosenberg terms as the “default-risk premium”, is the additional reward investors want in order to hold Baa-rated bonds instead of those that are adjudged to be Aaa.
The liquidity-risk premium in the US hit a low of 62 basis points in June 2007. Then, as the mortgage crisis began unfolding, the premium started to climb up, hitting a high of almost 300 basis points in mid-March this year. After the Fed began buying treasuries directly from the government — a policy known as “quantitative easing” — the liquidity risk premium fell steadily. It stands at 200 basis points now. By historical standards, liquidity in the US bond markets is still fetching a substantial premium. But the rate at which the Aaa-treasury spread is falling does seem to indicate that return to ‘normal’ premiums for liquidity may not be far.
This does bolster a case for the Fed to start drawing up an exit plan. However, one must also consider the default-risk premium, which is where the story gets interesting because the excess yields that investors are currently demanding for holding Baa bonds — rather than Aaa bonds — is still at an elevated level and trending lower painfully slowly.
Bernanke has a vexing problem. If he withdraws liquidity too soon, the default-risk premium — which is currently at 217 basis points, compared with the average of just 85 basis points between 2004 and 2007 — could once again start rising toward the post-Lehman high of 350 basis points. And that might throw the US economy into the vortex of a deep depression. But if Bernanke prints a few more trillion dollars in crisp new dollar bills to force down the default-risk premium, then there’s a good chance that he’ll end up proving his critics right.
One of the staunchest critics of Fed’s policies is investor Jim Rogers, who sounded deeply pessimistic about both US bonds and currency in an interview he gave me in Mumbai this week. “I can’t understand why I am one of the few people who see this. Either I’m nuts, or they’re nuts,” said the chairman of Singapore-based Rogers Holdings. “You have huge amount of money being printed at a time when the supplies of everything are under duress — the inventories of food are the lowest they’ve been in decades; nobody can get to open a mine. This is the perfect scenario for higher prices and long-term inflation.”
Research by Michael R Rosenberg, a former head of fixed-income and foreign-exchange research at Merrill Lynch and Deutsche Bank, helps to put the challenge before Federal Reserve chairman Ben Bernanke in perspective.
In an analysis on financial conditions for financial-information provider Bloomberg, Rosenberg has broken down the US investment-grade credit spread — the difference in yields on Aaa-rated and Baa-rated bonds — into two parts. The first component, which he calls the “liquidity-risk premium”, is the excess yield demanded by investors to hold between Aaa-rated corporate bonds rather than US treasuries. The second component, which corresponds with what Rosenberg terms as the “default-risk premium”, is the additional reward investors want in order to hold Baa-rated bonds instead of those that are adjudged to be Aaa.
The liquidity-risk premium in the US hit a low of 62 basis points in June 2007. Then, as the mortgage crisis began unfolding, the premium started to climb up, hitting a high of almost 300 basis points in mid-March this year. After the Fed began buying treasuries directly from the government — a policy known as “quantitative easing” — the liquidity risk premium fell steadily. It stands at 200 basis points now. By historical standards, liquidity in the US bond markets is still fetching a substantial premium. But the rate at which the Aaa-treasury spread is falling does seem to indicate that return to ‘normal’ premiums for liquidity may not be far.
This does bolster a case for the Fed to start drawing up an exit plan. However, one must also consider the default-risk premium, which is where the story gets interesting because the excess yields that investors are currently demanding for holding Baa bonds — rather than Aaa bonds — is still at an elevated level and trending lower painfully slowly.
Bernanke has a vexing problem. If he withdraws liquidity too soon, the default-risk premium — which is currently at 217 basis points, compared with the average of just 85 basis points between 2004 and 2007 — could once again start rising toward the post-Lehman high of 350 basis points. And that might throw the US economy into the vortex of a deep depression. But if Bernanke prints a few more trillion dollars in crisp new dollar bills to force down the default-risk premium, then there’s a good chance that he’ll end up proving his critics right.
One of the staunchest critics of Fed’s policies is investor Jim Rogers, who sounded deeply pessimistic about both US bonds and currency in an interview he gave me in Mumbai this week. “I can’t understand why I am one of the few people who see this. Either I’m nuts, or they’re nuts,” said the chairman of Singapore-based Rogers Holdings. “You have huge amount of money being printed at a time when the supplies of everything are under duress — the inventories of food are the lowest they’ve been in decades; nobody can get to open a mine. This is the perfect scenario for higher prices and long-term inflation.”
Bernanke doesn’t buy this argument. In his testimony to the House Budget Committee this week, the Fed chairman said that he foresaw inflation to remain low. “The slack in resource utilisation remains sizeable, and notwithstanding recent increases in the prices of oil and other commodities, cost pressures generally remain subdued,” he said. “As a consequence, inflation is likely to move down some over the next year relative to its pace in 2008. That said, improving economic conditions and stable inflation expectations should limit further declines in inflation.”
What makes this debate very relevant to us in India is that we need to import both commodities and capital from the rest of the world. We would be hurt if oil went back up above $100 a barrel; we would suffer a great deal more from a premature withdrawal of US liquidity, especially if that were to lead to yet another spike in investors’ perception of default risk in the world’s biggest economy.
It’s instructive to see how the liquidity-risk premium shot up in India following the collapse of Lehman Brothers and the attendant jump in the default risk in the United States. The spread between Aaa-rated corporate bonds and Indian government bonds tripled to 420 basis points in just about a month. The liquidity shock has since then eased considerably: the Aaa spread is down to a little more than 200 basis points. But unlike in the US, the liquidity-risk premium in India has stopped falling. Domestic liquidity may get squeezed if finance minister Pranab Mukherjee decides to use the budget to ramp up government spending in a big way.
As Nobel-winning economist Paul Krugman has been pointing out, the risk that Obama administration’s big-spending ways will “crowd out” the private sector is minimal. Obama’s fiscal expansion is simply allowing excess household savings to get absorbed in the absence of private credit demand even at near-zero interest rates.
Our situation is different. “With every percentage-point increase in the fiscal deficit, maintaining adequate liquidity in the system becomes that much more difficult,” RBI governor Duvvuri Subbarao said at the Economic Times Financial Management Seminar last month.
Bernanke’s final choice will matter tremendously for equity investors in the Indian market. If the Fed chairman elects to ignore the inflation risk, the commodity producers that make up almost 30% of the sensex ought to continue to do well. But if Bernanke moves in quickly to withdraw liquidity, the worsening US unemployment outlook and the consequent increase in the default-risk premium may stamp out the worldwide equity rally.
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