Overheating in the US credit markets

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December 5th, 2013

At the beginning of year, a leading member of the Board of Governors of the Federal Reserve (Fed), Jeremy Stein, wrote an article with the suggestive title of «Overheating in credit markets: origins, measurement and policy responses». At that time, the corporate bond and securities markets were experiencing sharp gains accompanied by a boom in the volume of issuances. These were the first few months of the QE3, the third round of bond  purchases launched by the Fed. Stein noted that the combination of factors such as financial innovation, regulation and a change in the economic environment can sometimes lead to bubbles forming. Specifically, he mentioned the Fed's quantitative easing as one of the changes that, by encouraging investors to «reach for yield», could lie behind the exuberance observed. He was critical in this respect, suggesting that economic policy should be recalibrated.

A few months later, the Fed surprised investors by announcing concrete plans to slow down its bond purchases (tapering). The impact on the markets was intense: long-term interest rates and risk premia rose and there was a sharp drop in trading. Possibly anxious about this reaction (in addition to other considerations related to the real economy, such as doubts concerning the consequences of autumn's fiscal shutdown), the Fed abruptly decided to delay its plans. Today, the consensus opinion is that tapering will begin in Q1 2014 and will be very gradual. After such ups and downs, the panorama in the bond markets is revealing: far from dying down, the signs of overheating have actually intensified. And not just in the USA.

Both credit yields and spreads for corporate bonds and syndicated loans are now at all-time lows: in fact, the worse the credit quality of the issuer, the greater the improvement. The volume of transactions has shot up, even with instruments with such a disagreeable track record as CLOs (collateralized loan obligations) and loans to heavily indebted firms (leveraged loans). Particularly revealing is the huge increase in operations with few protection clauses for the investor (covenant-lite).

In short, these are conditions the Fed is unlikely to ignore, at least those who think like J. Stein. The challenge is to cool these markets down without freezing them, at the same time as continuing to support the real economy. A proper combination of standard and non-standard monetary policy to reduce liquidity might and must help. But the contribution by macroprudential policy is almost more important. In this respect, it is encouraging to know that the Fed, together with other regulatory and supervisory bodies, is studying measures such as forcing brokers to maintain portions of the loans they are putting together as CLOs, as well as increasing capital requirements for the banks acquiring this kind of high risk product.