This seems a fairly curious reaction to a measure designed to have the opposite effect and which will see up to $400bn used to purchase long-dated bonds and drive down long-term interest rates.
But it appears that concerns over the faltering economy have not been alleviated by ‘Twist’ and these are weighing heavily on markets. It’s possible that sentiment will turn more positive once its impact is more fully considered, but either way it seems further quantitative easing will be needed sooner rather than later.
The most important result of Operation Twist is the Fed making liquidity a priority. In April the European Central Bank raised rates on inflation concerns and this ended up having a negative impact by lowering liquidity and slowing the economy.
How much the economy will grow as a result of measures such as Operation Twist is difficult to tell, but clearly ensuring system-wide liquidity provides the basis for financial stability and a recovery.
The funding question
Ultimately, any fiscal stimulus will have to be paid for, and currently there is no consensus in Congress as to how to get this done. Certainly the long debate in Congress about raising the debt ceiling over the summer did not bring confidence to the markets. The actions by the Congress caused investors to question the political leadership of both political parties, and investors voted with their risk assets.
In order to resolve the political stalemate it seems inevitable that we will have to look at some of the areas that have been sacred cows in the past – defence spending and healthcare and social programmes – and see where spending cuts can be made while looking into enhancing revenue streams. Political compromise will provide leadership to the country and provide investors and companies comfort to move forward in constructive enterprise.
US interest rates
If rates stay low, it’s because the economy is moving forwards at a slow pace. In which case, it is unlikely there will be much inflation, wage growth or consumer demand growth.
What that means is that an asset class like high yield, where you can be paid an average coupon of about 8%, looks very attractive. We believe Treasuries will under-perform in the medium term as rates prove unpalatable to liability-driven investors and there is too much uncertainty in the equity markets to make prudent investment. Investing in an asset class like high yield that provides high current income, without depending on price appreciation as the primary source of total return, seems attractive in the current rate environment.
Currently, the market is pricing in a high yield default rate of around 7% and some 35% cumulatively over the next five years. We believe this is default rate estimate is quite high and we expect a default rate of between 1% and 1.5% in 2012 and below longer-term averages thereafter. Given the 2008-2009 default period and the fact that the asset class did not have excessive lending since then leads us to believe that the next default wave will be shorter and shallower than the last cycle. We simply have not had sufficient time to build up the fuel (i.e. excess CCC issuance) that would result in a default cycle as difficult as the last two.
In the short-to-medium term, high yield is relatively attractive because you are being generously compensated with the yield for what is a very low risk of default. Over time we expect spreads to reflect the true default rates and then spreads can tighten and provide price appreciation.
The combination of high current income, and potential price appreciation as defaults prove manageable, is an attractive combination in the current rate and earnings environment.
