Taking the easiest route often leads to destinations we’d rather avoid. Skipping work to catch extra sleep and relying on credit cards can ultimately lead to financial ruin.
The same principle applies to monetary policy. Cheap credit strategies, while seemingly advantageous in the short term, often result in long-term complications for society. When central banks implement artificially low interest rates through asset purchase programs, the repercussions are significant.
Once these consequences begin, they relentlessly unfold until they reach their conclusion. The periods of easy credit are invariably followed by the inevitable fallout of unmanageable debt. As increasing amounts of debt fall into default, the structural integrity of the debt system deteriorates. However, it can be challenging to pinpoint the exact moment this tipping point is crossed, often only recognized in hindsight.
Though quantitative easing formally concluded over two years ago, the intervening period seemed stable, with asset prices continuing to rise. Yet, the lurking dangers of quantitative easing are becoming impossible to ignore.
The signs of decline have taken years to become evident, but now the credit markets are showing early signs of distress. We anticipate these indicators will intensify as the year unfolds.
The Insanity of the Echo Bubble
In a recent article titled LIBOR Pains, Pater Tenebrarum concisely outlines the current predicament:
“Several important observations come to light in this discussion: 1. corporate debt relative to assets has reached an all-time high, reminiscent of the frenzied late 1990s; 2. US corporations are spending significantly more than their revenue allows, with capital expenditures, investments, dividends, and stock buybacks dwarfed by their gross cash flows, creating an unprecedented gap even larger than in 2007; 3. the return on equity for US firms is at a record low (yes, you read that correctly!).”
This scenario of high debt levels combined with low profitability and poor returns on equity paints a troubling picture for the future. How did corporate leaders find themselves in such a precarious situation?
In essence, misleading signals from the Fed’s cheap credit led them to make decisions that would not have been wise under normal circumstances. Companies accumulated excessive debt for investments that have not generated expected returns, while financial engineering only exacerbated these errors.
Major banks bundled their corporate loans into collateralized loan obligations, which were then transferred to hedge funds, further inflating the debt bubble. As Pater sums it up:
“The prospect of earning a meager 8 percent annually on an investment that is leveraged 10:1 was hailed as a lucrative opportunity, igniting demand for these securities and driving up their prices, despite the fact that banks were likely producing them in overwhelming quantities. This serves as undeniable evidence of the insanity surrounding the echo bubble.”
The consequences of this madness are far-reaching. While financial markets—and the Fed’s cheap credit—may initiate these debt bubbles, their effects ripple out into the real economy, where they manifest in absurd and detrimental ways.
Credit Contraction Episodes
Over the past eight years, numerous misallocations of capital resources have occurred, leading to severe market distortions in certain areas. In many cases, new credit is no longer expanding; instead, it is contracting.
For instance, excessive borrowing to purchase cars has taken place, with many individuals utilizing the Fed’s low-interest rates to buy vehicles they cannot afford. Auto loan delinquencies have surged to $23.27 billion, the highest since late 2008.
Like corporate debt, the inflow of consumer credit was bolstered by packaging subprime auto loans into asset-backed securities, providing misleading signals to the automotive industry. Business leaders made unwise investments in production capacity that were ultimately unnecessary.
Not only have excessive numbers of cars been purchased using cheap credit, but the same low rates also financed the production of these surplus vehicles. Consequently, a major error has occurred.
Now, the automotive industry is faced with a significant challenge. As Detroit News reports:
“New- and used-car sales have surged for seven consecutive years as the economy has improved, a streak not seen since the 1920s. However, industry analysts express concern that the used-car market may struggle to absorb an unprecedented number of vehicles returning from leases.”
“Most leases are for 36 months, so three years after leaving dealerships, these vehicles re-enter the market as used cars. In 2017, the auto industry anticipates a record 3.6 million off-lease vehicles.”
There are simply too many cars available. Consequently, auto sales are trending downward rather than upward. Specifically, U.S. auto sales declined for the third consecutive month in March. Such undesirable credit contraction episodes typically occur just before the debt structure starts to collapse in a significant way.
In conclusion, the current economic landscape reveals troubling signs of credit contraction and mismanagement that could lead to broader implications. As markets continue to grapple with these challenges, vigilance and sound decision-making will be crucial for navigating the uncertain road ahead.
Sincerely,
MN Gordon
for Economic Prism
