Monday, July 8, 2013

Where did the Reach for Yield Go?

Friday’s strong data caused bond yields to spike. This has caused some consternation from economic commentators, and Paul Krugman in particular has argued that the rise in interest rates will have severe economic impacts. While I want to touch on these issues, I will approach them from a different debate -- that over the "reach for yield". My thesis? The recent rebalancing in the stock market shows that the reach for yield was overstated, and that, from this, we can conclude the taper will not have a severe negative effect on growth.

Let’s start by refreshing our memory of “reaching for yield”. In his February speech, Jeremy Stein argued that because many institutional investors need to meet nominal return requirements, these investors were reaching into riskier assets. Even though these assets may not offer high expected returns, their variance profiles offer better chances of hitting the nominal requirement. This game of distributions is illustrated below. Even though the safe red (i.e. low variance) asset has a higher expected return, the risky blue (high variance) asset has a better chance of getting the fund manager over the critical red required return line. As a result, a market wide reach for yield may result in a mispricing of risk, jeopardizing financial stability.

These arguments have been echoed by many other commentators. Here’s Martin Feldstein in the WSJ using the reach for yield as an argument to taper:
Although the economy is weak, experience shows that further bond-buying will have little effect on economic growth and employment. Meanwhile, low interest rates are generating excessive risk-taking by banks and other financial investors. These risks could have serious adverse effects on bank capital and the value of pension funds. In Fed Chairman Ben Bernanke's terms, the efficacy of quantitative easing is low and the costs and risks are substantial.
And here’s Rajan in a speech at the Bank of International Settlements
If effective, the combination of the "low for long" policy for short term policy rates coupled with quantitative easing tends to depress yields across the yield curve for fixed income securities. Fixed income investors with minimum nominal return needs then migrate to riskier instruments such as junk bonds, emerging market bonds, or commodity ETFs, with some of the capital outflow coming back into government securities via foreign central banks accumulating reserves. Other investors migrate to stocks. To some extent, this reach for yield is precisely one of the intended consequences of unconventional monetary policy. The hope is that as the price of risk is reduced, corporations faced with a lower cost of capital will have greater incentive to make real investments, thereby creating jobs and enhancing growth.
Indeed, Bernanke felt it was necessary to address these financial stability concerns at his February and May testimonies. He argued that even if low rates encourage a reach for yield, the only way to get sustainable rates in the long run is to keep rates low now. In the metaphor of Kochlerata, you need to keep the coat on until you are warm enough to take it off.

Bernanke can rest easy. Financial data since his testimonies has even further strengthened the arguments against a reach for yield. To see why, it is important to remember two stylized facts. First, "reach for yield" is a story about financial stability. Because people are going into riskier assets, this results in a systematic underpricing of risk. Second, it’s a story about increasing risk appetites. Excessively low interest rates trigger a flight *from* quality as fund managers look to hit their nominal return requirements.

But recent moves in equity prices contradict this story. The WSJ observes that defensive sectors are underperforming.
He said he still favors stocks over bonds, and has avoided "bond proxies" such as utilities, real- estate investment trusts, and other sectors with high dividend payouts
Those areas are "really expensive, and they have little to no earnings growth. They have benefited hugely from easing," he said. 
Those traditionally defensive sectors dragged on benchmarks. The sole decliners in late trading were the utilities and consumer-staples sectors, which lost 0.9% and 0.3%, respectively. Those areas were among the biggest gainers in the beginning of the year, when yields on Treasury bonds remained low.
Whereas cyclicals are responding very well:
Given the cross currents in the market, including the Fed's commitment to keeping overnight rates low at least until the unemployment rate falls through 6.5%, investors wouldn't want to overinterpret what's happened to the yield curve. But the stock market told a similar story of stronger growth expectations Friday. Shares of economically sensitive companies, like banks, retailers and manufacturers, rallied, while defensive areas, like utility and telecom shares, did poorly.
In other words, the recent taper has caused people to pivot out of safe sectors into riskier ones -- the opposite of what a reach for yield story would suggest. In fact, there appears to have been a flight *to* quality that is only recently being reversed. These movements are also consistent with recent data showing the equity risk premium, or a measure of stock market performance relative to the bond market, is at extremely elevated levels. With the taper we should expect this premium to fall as investors naturally increase their risk appetites.

Now, some may argue that there was a reach for yield in the fixed income market that is now being unwound. Indeed, mortgage rates and junk bond yields are rising:
Rates on a 30-year mortgage have climbed from 3.45% in April to more than 4% in June, according to Freddie Mac FMCC +1.97% . The 30-day average yield on new bonds sold by companies with "junk" credit ratings hit 7.72% in June, up from 5.79% in April, according to S&P Capital IQ LCD.
The risk premium on high yield bonds has also risen slightly. But there are two reasons why we should discount this observation.

First, the bond spreads will have a minimal effect on financial stability. The concern shouldn't be whether individual funds will suffer, but rather whether there has been a massive mispricing in risk. But if the risk was underpriced in the debt market, then the equity prices should have been overpriced to match the artificially low cost of capital. However, since there did not appear to be a reach for equity yield, then any reach for yield in fixed income should also have negligible effects.

Second, the high yield spread is still not outside of its historical range. Even in the 1990’s, when the Fed was never criticized for promoting a reach for yield, the spread was still very low. Therefore we should be skeptical of arguments that there was a massive mispricing in the corporate debt market to begin with.

This perspective from the reach for yield debate leads to two insights.

First, Fed policy has not been distorting financial markets. If anything, people have been too conservative on equities. Monetary policy, by encouraging risk taking, has been doing the right thing to do to help reboot the market. Even if you don’t want firms reaching for yield, they should at least be encouraged to stretch.

Second, it’s not clear if the taper will be all that “terrible” for equities. Of course, the human cost of tight monetary policy is enormous. I personally believe that the Fed should not taper in the face of such elevated levels of unemployment and depressed levels of nominal GDP. Nonetheless, the taper is likely to have only moderate impacts on the stock market, in spite of what short term correlations may suggest.

The greatest irony is that only after the Fed tightens do we realize that the Fed didn’t need to tighten at all. But now that it has, it doesn’t look like the financial impacts will be that large after all.