Memo to Fed: Take a Vacation

It's been almost two years since the federal funds rate was lowered to emergency levels of 0.0%-0.25% in December 2008; long-term interest rates are back to near historical lows and credit spreads are within a normal historical range. It's not the level of interest rates that precludes companies from borrowing. In fact, new issuance in the corporate bond market has been on a tear, and the supply has been easily digested by the market's demand for fixed-income products.

In its statement released Sept. 21, the Federal Open Market Committee revealed its concern that deflation is now a greater concern than inflation. Further, the statement said the FOMC would "provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate."

This additional accommodation would probably come in the form of another round of quantitative easing. The Fed would most likely buy a substantial amount of long-dated debt, which would further push interest rates down in the short term and add liquidity to the financial system.

The markets have interpreted this language as the Fed having provided a put option. The equity market has gone one further along this path and believes that if the economy recovers on its own, then stocks will go up. Conversely, if the economy slows, investors believe the Fed will institute another round of quantitative easing and the additional liquidity will then push stocks up. This action creates a moral hazard that we believe sets a bad precedent.

The Fed should stop punishing savers who are already earning meagre returns on their investments. By instituting policies to keep long-term rates at these low levels, the government is already indirectly subsidising the banks and keeping housing prices at levels that are higher than they would otherwise be if interest rates were higher. Furthermore, when inflation does return, fixed-income investors in longer-dated securities will be harmed as the duration of their low-coupon debt is longer, resulting in a greater decline in the value of their investments. By keeping rates at such low levels, the Fed effectively deters savings and pushes investors toward riskier assets in the search for additional yield. Savers are further impaired by the decline in the dollar. Since the FOMC statement was released, the dollar has fallen 3.5%, according to the DXY dollar index, with a 4.5% decline versus the euro and a 2.2% decline versus the yen (which is especially troubling as the Japanese government is in its own process of trying to drive down the yen).

The Fed is already using the investment income thrown off from its massive balance sheet to purchase more debt in the secondary market as opposed to letting the portfolio wind itself down. In September, the Fed repurchased $27.5 billion of debt through permanent open market operations. On an annualised basis, that's $330 billion. Since the deficit is $1.3 trillion in 2010, that means the Fed has subsidised 25% of the deficit. Further, if the Fed does institute a significant round of quantitative easing, depending on the size of the programme, that means the Fed will finance an even larger portion of the federal government's deficit.

We wonder what it means when the Fed is contemplating printing enough money to fund a significant portion of the deficit when the deficit is already at all-time highs and the debt/GDP ratio is on its way to levels not seen since World War II. The government has instituted fiscal and monetary stimulus, which has helped the economy bottom out, but now the handoff needs to be made from the public sector to the private sector. In our opinion, the government needs to focus its attention and spend its resources on promoting growth initiatives for private enterprises.

What does this mean for bond investors? We reiterate our recommendation to shy away from very long-duration securities and focus on companies that have the following characteristics:
-- wide economic moat
-- strong free cash flow generation
-- low fixed costs
-- fortress balance sheet with minimal near-term refinancing needs
-- defensive industries with high barriers to entry

Week in Review
Credit spreads were generally unchanged to slightly better last week as the Morningstar Corporate Bond Index tightened a basis point to +160. Over the next week, we expect the market to begin to move its attention from the new issue market to earnings season.

Generally, we expect third-quarter earnings to be in line with expectations. More telling for the direction of credit spreads will be the degree to which firms will be able to maintain the phenomenal operating leverage they have gained from cost-cutting and restructuring programmes. For Morningstar's take on the third quarter and outlook for the fourth quarter in the US, please see the Morningstar Market Outlook.

European corporate credit spreads were also generally unchanged to slightly better last week. The good news was that sovereign concerns regarding Ireland and Portugal appeared to subside by the end of the week. The credit default swap spreads for those two nations tightened from the historically wide levels seen at the beginning of the week by 30 and 35 basis points, respectively. Even beleaguered Greece saw its CDS tighten 35 basis points to +775, and Spain held steady at +230.

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