Federal Reserve officials are voicing increased concern that record-low interest rates are overheating markets for assets from farmland to junk bonds, which could heighten risks when they reverse their unprecedented bond purchases.
Investors have been snapping up riskier assets since the Fed boosted its bond buying to reduce long-term borrowing costs after cutting its overnight rate target close to zero in December 2008. Enthusiasm for speculative-grade bonds is at unprecedented levels, driving a Credit Suisse index that tracks the yield on more than 1,500 issues to a record-low 5.9 percent last week.
Now, as central bankers boost their stimulus with additional bond purchases, policy makers from Chairman Ben S. Bernanke to Kansas City Fed President Esther George are on the lookout for financial distortions that may reverse abruptly when the Fed stops adding to its portfolio and eventually shrinks it.
“Prices of assets such as bonds, agricultural land, and high-yield and leveraged loans are at historically high levels,” George said in a speech last week. “We must not ignore the possibility that the low-interest rate policy may be creating incentives that lead to future financial imbalances.”
Bernanke himself raised that concern this week, saying the central bank has to “pay very close attention to the costs and the risks” of its policies during a Jan. 14 discussion at the University of Michigan's Gerald R. Ford School of Public Policy in Ann Arbor.
The Fed is purchasing as much as $85 billion a month of bonds, a pace that would balloon its balance sheet to more than $3 trillion by the end of this year. Bernanke calls his debt purchases “credit easing,” intended to push investors into riskier assets to lower costs for borrowers.
While the central bank has set no limit on the duration or size of its bond-buying, several Federal Open Market Committee members said at a December meeting it would “probably be appropriate” to slow or stop purchases “well before” the end of 2013 because of financial stability concerns.
The first sign of Fed tightening may set off a hair trigger in the bond market, said Drew Matus, senior U.S. economist at UBS Securities LLC in Stamford, Connecticut.
“There is no pulling back a little,” he said. When the Fed begins to shrink its portfolio, investors will start to price in the entire stock of bonds coming back into the market. “It is always going to be hard to disengage in a very gradual manner.”
An analysis by the Center for Financial Stability shows why low yields are pushing investors to seek out riskier assets such as stocks: The price they are paying for income from bonds versus stocks is close to the highest level since 1920, according to the New York-based research organization that has Nobel Laureate Myron Scholes on its advisory board.
At current prices, investors in Treasury 10-year notes yielding 1.82 percent are paying 54 times the value of the income to own the notes. By contrast, investors in the Standard & Poor's 500 stock index are paying just 14.8 times earnings, strengthening the incentive to own stocks rather than bonds.
Investors snapping up junk bonds have driven yields to record lows, according to some indexes, and below more senior ranking loans. Credit Suisse's index of junk-bond yields is down from 8 percent a year ago. Junk bonds are rated below Baa3 by Moody's Investors Service and less than BBB- at Standard & Poor's and Fitch Ratings.
Speculative-grade debt buyers are accepting yields as low as 5.98 percent, 8 basis points less than paid on leveraged loans. As recently as June, junk bonds yielded 114 basis points more than more-senior leveraged loans, JPMorgan Chase & Co. data show.
Junk bonds have returned 121.8 percent, including reinvested interest, since the end of 2008, according to Bank of America Merrill Lynch's U.S. High Yield Index. That's better than the 78.1 percent gain for the S&P 500, when including dividends.
Farmland prices in the Kansas City Fed's district, which covers western Missouri, Nebraska, Kansas, Oklahoma, Wyoming, Colorado and northern New Mexico, set records in the third quarter, according to the Fed bank's Survey of Tenth District Agricultural Credit Conditions.
Non-irrigated cropland prices were up 25 percent from a year earlier and irrigated land values advanced more than 20 percent, according to the survey.
“There are extreme market distortions occurring due to the unusual monetary policy,” said Lawrence Goodman, president of the Center for Financial Stability and the former director of Quantitative Policy Analysis at the U.S. Treasury. “The upshot is we are seeing increasing debate in FOMC meetings.”
The 59-year-old Bernanke, who helped the U.S. economy weather the worst financial crisis since the Great Depression, finishes his second term in a year and his legacy will be defined partly by whether the Fed withdraws stimulus without causing a collapse in markets that hurts economic growth.
Policy makers in recent weeks have voiced concern about market imbalances.
Fed officials are “worried” and “working very hard on trying to make sure that we are aware of where imbalances or distortions are showing up and we don't go too far down the road before we try to address those,” Philadelphia Fed President Charles Plosser said to reporters last week.
Atlanta Fed president Dennis Lockhart said this week he is concerned about the markets for Treasuries and mortgage-backed securities. The Fed each month is buying $45 billion in Treasuries and $40 billion in mortgage bonds.
“Markets are highly connected and highly interrelated so a severe spell of financial instability obviously would be much broader than the markets in which we are making the purchases,” Lockhart told reporters in Atlanta. He said he sees “no immediate threats.”
Fed officials frame the debate in terms of costs and benefits and for now see more benefits in trying to reduce unemployment with further balance sheet expansion.
“They are still mostly in the mode of looking to support the economy,” said Phillip Swagel, a former assistant secretary for economic policy at the U.S. Treasury who is now a professor at the University of Maryland's School of Public Policy in College Park.
“For them to take action to head off financial sector froth when the economy is still weak is very difficult,” Swagel said.
Still, the FOMC said last month that “readings on financial developments” now weigh into how long it will sustain stimulus at current levels.
Central bankers elsewhere are also wary of excessive valuations.
Bank of England Governor Mervyn King, whose benchmark interest rate is 0.5 percent, told U.K. lawmakers on Jan. 15 that “the search for yield appears to be beginning again” and merited monitoring. Bank of Canada Governor Mark Carney, who will succeed King in London in July, has warned a rapid drop in house prices is a major threat to the Canadian economy given record household debt.
“Policy makers are right to worry about the risks to financial stability from large-scale asset purchases,” said Richard Barwell, a former Bank of England economist now at Royal Bank of Scotland Group Plc. “There is a delicate balancing act between providing much needed stimulus and encouraging another search for yield with investors over-stretching themselves.”
Bernanke said this week that the central bank since the financial crisis has “increased enormously the amount of resources we put into monitoring financial conditions.”
Bernanke set up a new Office of Financial Stability Policy and Research headed by Nellie Liang, an economist, to conduct financial system surveillance. Daniel Tarullo, the Fed governor in charge of bank supervision and regulation, established the Large Institution Supervision Coordinating Committee (LISCC), a group of economists, quantitative modelers, lawyers, payment systems specialists and reserve bank supervisors who look for risks among the largest financial institutions.
Both groups seek to identify the links between financial firms that could rapidly spread instability, much like subprime assets during the financial crisis last decade.
While saying officials need to be “open-minded” about how monetary policy can lead to excessive valuations, Bernanke said this week he considers supervisory tools “the first line of defense” against asset-price bubbles.
Yet bank regulators don't always act quickly enough to defuse challenges to financial stability, said Sheila Bair, former chairwoman of the Federal Deposit Insurance Corp.
“Sometimes we know a lot and the problem is we are not acting on what we know,” said Bair, a senior adviser to The Pew Charitable Trusts. “I worry that there is still too much” inertia among supervisors of financial firms.