The Fed Bubble is Exploding

For a couple years now, we’ve heard the Fed say it wasn’t seeing any “dislocations” in the markets. “Dislocation” is a fancy, Fed-speak word for “asset bubble.” The Fed has been adamant that it hasn’t seen any asset bubbles forming in the markets as a result of its easy money policies.

But of course, it never sees the bubbles… er, “dislocations”… it is creating. The Fed thought the productivity gains it was seeing in 1998 and 1999 as a result of the Internet could sustain strong GDP growth. Wrong. 

The Fed thought that selling risky mortgages as bonds and insuring them with derivatives was perfectly normal and safe and didn’t indicate a housing bubble. Wrong again. 

So it shouldn’t be a surprise that the Fed missed the latest bubble, which is now exploding right before our eyes. This particular bubble was/is in high-yield bonds. And if you noticed the big declines for the stock market last week, which culminated in a 300-point drop for the Dow Industrials on Friday, well, that’s the one…

Before I go on, let’s set the stage a little.

The Fed pushed interest rates to extremely low levels, as we all know. The idea was to get banks lending and to get other entities like corporations to borrow and invest money in operations. It hasn’t really worked.

I mean, yeah, we’ve had a tepid economic rebound. But we haven’t really seen robust growth. And that’s because the economy hasn’t been strong enough to support an actual increase in demand at the consumer level. Without an increase in consumer demand, companies have no need to build new factories, hire new workers, etc.

We can go on and on about why consumer demand hasn’t picked up. Basically, the Fed wants to see growth like we had between 2003 and 2006. But that growth was artificial, fueled by debt made possible by rising home values. You may remember people bought Hummers and jet skis and vacation homes. It was bubble spending, and why the Fed wants to see it again, I have no idea…

So without an increase in consumer demand, companies have spent money on other things, like stock buybacks. It’s no coincidence that real earnings and revenue aren’t growing for the majority of America’s companies. But earnings per share are growing because there are fewer shares out there — companies have spent around ~$5 trillion a year buying back stock for the last four years. (I’ve written about this before.)

This whole share buyback thing maybe isn’t a good thing, exactly. But it’s not really a bubble, either. Let’s take this as a good spot to look at where the real bubble is…

How the Fed Punishes Savers

In the last couple of years, have you heard the phrase “the Fed is punishing savers?” I’ve heard it plenty, and it always sounds like it means the Fed doesn’t want you to have a savings account, like the Fed is opposed to you saving money. But that’s not really the point. 

The point of the phrase “the Fed is punishing savers” has to do with the huge part of the financial world that needs to make a guaranteed 5% to 7% a year. That’s the banks that hold your savings account, that’s pension funds, that’s insurance companies, that’s annuities, that’s money-market funds…

No one associates any of these entities with economic growth. That’s not what they “do” — they aren’t investments in the traditional sense of the word. All they “do” is hold money for a period of time and seek to provide a small benefit. And they do it mostly by owning Treasury bonds that will pay 5% to 7% a year.  

Now, when you think of insurance companies, pension funds, money-market funds — these aren’t aggressive, shoot-for-the-moon investors. They are the very definition of conservative. But what do they do when they can’t get their 5% to 7% from Treasury bonds? Well, they have to find investments that pay better than Treasury bonds. The Fed has forced them to do this by pushing Treasury bond yields lower by pushing interest rates lower.

There’s one sector of the U.S. economy in particular that’s been happy to sell bonds that pay high interest rates. This sector was making a ton of money selling a product that is indispensible to the global economy — a product that we literally can’t do without. In fact, just two years ago, this sector was called a “revolution” and was responsible for a massive percentage of U.S. GDP and jobs growth.

Care to take a guess what this sector is?

Thank You, Saudi Arabia

Over the last four to five years, U.S. oil and gas companies have borrowed around $500 billion to fund their operations. They were happy to pay 6%, 7%, even 10% interest rates because, with oil at $100 a barrel, they were making boatloads of money. And the more money they borrowed, the faster they could ramp up production and make even more money. 

It seemed like a match made in heaven: Insurance companies, pension funds, and money-market funds need higher yields, while oil and gas companies need money for investment and have no problem paying it back.

But just like with the housing bubble, investors and borrowers made one massive assumption that didn’t seem unreasonable at all. The assumption was that prices couldn’t fall. With housing, prices hadn’t fallen more than a few percent in decades. And with oil, well, if anything, prices would rise. Who’d want to see oil prices get cut in half?  

Yeah, well, thanks a lot, Saudi Arabia.

Now that oil has plunged to around $35, investors are worried that some U.S. oil companies may have a hard time paying their bonds off. And the prices for some of these high-yield bonds have been cut nearly in half. 

They’re Called Junk Bonds for a Reason

High-yield bonds are sometimes called “junk bonds.” It’s not that they are actually junk. But it’s well known that they carry more risk than “investment-grade” bonds. Investment-grade bonds are called that because the companies that issue them are very stable. There’s very little risk that the issuing company will fail to pay the loan. 

High-yield bonds pay more because the risk that the issuing company might default is higher. And the high-yield bond market has ballooned in recent years (from ~$990 billion in 2008 to over $1.8 trillion today) largely thanks to the Fed’s zero interest rate policies.

Now, this is not “new” news. We’ve known that the high-yield bond market was surging for a couple years. But just last week, it became a problem. Check out this chart of the iShares iBoxx $ High Yield Corporate Bond ETF:

As you can see, high-yield bond prices have been crushed. They fell more than 10% last week after one high-yield bond fund, Third Avenue Management, told its investors that they can’t have their money back right away.

Now, Third Avenue isn’t a huge fund. Back in July, it had $3.5 billion under management. But it can’t sell the bonds it owns right now. No one wants to buy them, even at current low prices. And the announcement that it won’t be giving investors’ money back right away has set off a panic similar to a bank run.

Money, or liquidity, makes the financial markets work. There has to be cash on hand, and there is none in the high-yield bond markets because there are no buyers. When you have liquidity problems in one section of the financial markets, investors will take money out of other parts of the market. That’s why Disney (NYSE: DIS) is now trading for $108 a share, after being a $120 stock just a few weeks ago…

It’s why Apple (NASDAQ: AAPL) has fallen from $120 to $113. It’s why Starbucks (NASDAQ: SBUX) has fallen from $64 to $59. Investors need cash, and they are selling stocks to get it.

Make no mistake: This is largely the Fed’s fault, because it left rates too low for too long. Now the question is: How much longer will the high-yield bond market pressure stocks?

I suspect there’s not a whole lot more downside — maybe 1,980 on the S&P 500, which is another 30 points or so away (that equates to around 300 Dow points). 1,950 is another possible target. 

One more note: Be skeptical when you hear guys like Carl Icahn say that the sell-off is “just getting started.” He’d love to see a panic for stocks because he wants to buy stocks when they are on sale. That’s how it works. 

Until next time,

Until next time,

Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.