As quantitative easing morphs into a wide-ranging asset buying programs, it is masking the health of the real economy.
The South African Reserve Bank (SARB) has been the latest central bank to dig deep into its toolbox and pull out the unconventional Quantitative Easing magic wand. In the depth of the Corona crisis, over the last few weeks the debt market was marred by very unusual intraday spikes in yields. The liquidity suddenly seemed to vanish, something very rare in such a liquid market. The SARB decided to buy unspecified amounts of bonds to provide the liquidity and normalise the yields, thereby starting their very own Quantitative Easing program.
In 2008, faced by unprecedented financial liquidity constraints, Ben Bernanke, the Fed chairman at the time, unleashed an economic stimulus bazooka called Quantitative Easing (QE). Essentially, the Reserve Bank would print new money to buy Government Bonds, so that anyone holding bonds (like Banks, Insurance companies and Investment Funds) could sell them to get access to cash, without causing a rise in the yield (and therefore a loss of capital). This proved popular because in theory, a Reserve Bank, operating in a free-floating currency market, has got an unlimited balance sheet capacity. QE was adopted by a few big Central Banks in the developed world, who were facing liquidity crunches and were desperate to keep the yield low.
A low yield has got a very wide impact on the economy. Firstly, it means that the Government can borrow more capital without paying more in interest. Therefore, the Governments, on paper at least, were able to stimulate the economies with borrowed money. But countries like Germany and the UK steered their way to fiscal prudence instead of stimulating the economy. The USA in contrast spent billions on foreign wars instead of revitalising their creaking infrastructure.
The second big beneficiary of low yields are banks. They can borrow at the Reserve Bank cheaply. The assumption is that they would pass on the low interest rates to their clients. It is doubtful how successful this was, since the banks had to grapple with ever increasing reserve requirements and snowballing compliance, thus were shy to lend their money out again. In-fact, a popular trade was a carry trade, i.e. using their cheap borrowing to invest in investment grade bonds thereby earning the small differential in interest – almost risk-free.
The third beneficiary of low yields were big companies who had the ability to issue their own bonds and sell them to investors. Since the alternative, the low yielding government bonds did not pay much, investors were happy to snap up any investment grade corporate debt yielding just slightly more. Companies like Apple found it more efficient to borrow money to pay dividends than to use their vast cash reserves. Second Tier companies also benefitted from the low yields, because even though their debt is sub-investment grade, they only had to pay yields slightly higher than their class-one peers. The result was a debt binge, with too many companies taking on too much debt. Now the Fed and the European Central Bank have announced that they will not be restricted by sovereign debt, but also buy corporate debt.
Big and listed companies benefit from low interest rates in another way. Since the sovereign debt is issued in the countries currency it is essentially the safest investment, and all other investment valuations take that as a yard stick. If the US 10 year debt yields 0.5%, then all other investments would need to return more than that, and the quantum is determined by the risk that the investment poses, ie the risk premium. Financial Research Analysts value shares of companies as a more attractive investment opportunity if their projected return would be higher than the risk free rate (10 government bonds) plus the assumed risk premium of the company. Thus, big dominant company with plenty of cash on their balance sheet could issue shares which would be prized much higher because of the low demanded return. Because of that, the internal rate of returns only needed to be relatively low. The effect has been a lot of money is being spent on projects that otherwise would have never passed the investment grade hurdle and will fail to enhance shareholders value. Another effect was that countless companies borrowed money to buy back their own shares. Earnings per share would grow, even if there was no actual top line growth, i.e. growth in turnover.
All this masks the health of the “real” economy. The trickle-down economic assumptions did not reach the masses. Most employees in the USA, as an example, are employed in the small or medium size enterprises (SME). It is much harder for these companies to benefit from the low interest rate environment. They are not able to issue bonds, and if they do, their quantity is so low that no institutional investor would bother looking at them. For most small businesses and start-ups it is very hard to borrow any money from banks, and if they do, the conditions are very onerous and combined with personal sureties. Therefor their “hurdle rate” is much higher. They have not been able to grow their businesses at the same pace as big companies have. This thirst for growth by the big created massive price increases for scarce resources. Specialized labour became very expensive (and they in turn increased the price for limited resources such as property beyond most affordability levels). These distortions are not reflected in inflation figures, because as long as the productivity gains equal or exceed the cost escalations, the cost per unit stays the same or falls. The main beneficiaries were big companies and e-commerce companies, not the small construction companies or the neighbourhood shops.
This has led to big distortions. California has just experienced the longest period of growth, but they have also had a massive increase in the homeless population. A recent survey found that 1 in 10 households across the USA would not be able to handle an unexpected $400 bill. These are not the typical signs of boom years, rather a worrying sign of policies not working. Much of the stimulus plans just passed by the American government to counter the effects of the Corona Virus relies on the type of trickle-down economics that has failed over the last 10 years. At some point the politicians need to step up and take the responsibility of building stronger more diversified economies rather than relying on Central Bankers to increase the economic activity, because they are always only able to target the big companies and hope for the stimulus to trickle down to everybody else.