The latest interest rate reduction by the Federal Reserve Open Market Committee (FOMC) has received much attention in the media and on Wall Street with respect to its potential impact on the stock market. While I believe such analysis is indeed appropriate to provide a historical perspective on how equity markets respond to a series of rate cuts, it is arguably focusing attention on the wrong market. You see, from my point of view, instead of focusing on the equity markets alone, investors should look to better understand the potential impact of lower interest rates on the credit markets.
Historical analysis reveals that after the FOMC lowers short-term interest rates it is not unusual to witness a slight, but temporary, rise in the yield of longer dated credit market instruments. The logic underlying this move is two-fold. First, while investors perceive a reduction in short-term interest rates as beneficial for future economic activity, it also holds the potential for rising inflationary pressure. Inflation, as we know, reduces the value of the fixed cash flow associated with the fixed income investment thereby reducing its value to investors. Secondly, interest rate reductions increase the potential pool of borrowers in the credit market due to the “cost” of money shifting lower. As such, investors anticipate an increase in supply, again causing the temporary reduction in price and a rise in yields of the outstanding instruments. However, in both scenarios the temporary rise in long-term rates is offset by an equally positive impact from the associated borrowing costs, more commonly known as the cost of carry.
Carry is the common term used to describe the difference between the yield of a debt or credit market instrument and the cost of funding. If the carry is positive then the net cash flow from borrowing money to invest in the instrument is positive. If the carry is negative, it is due to a net loss after calculating the cost of raising the funds to invest.
In order to understand why investors need to concern themselves with the cost of carry, it is also useful to understand the yield curve. In a positive sloped yield curve environment, shorter maturity paper yields less than longer maturity paper. In a negative yield curve environment shorter maturity paper yields more than longer maturity paper. Since World War II, the general shape or slope of the U.S. Treasury yield curve (the highest credit quality) has been positive. This has abetted the concept of borrowing short and lending long.
In other words, investors borrow money in the short-term market and invest it in the longer-term market, anticipating that the spread difference in yields sufficient to offset market risk. The farther out on the maturity or down on the credit spectrum investors go, the more risk they were encountering. The point being that the spread, or carry, is itself an inducement to accept the risk. On the other hand, if the yield curve is negative, that is short-term rates higher than longer-term rates, investors know that they will receive less income (yield) for accepting more market risk than the cost of the funds themselves. Simply put, the economics of such an investment are not at all compelling.
How does the current environment look? As investors entered into 2007, with an FOMC biased toward higher rates, the yield curve was negatively sloped. As such, there was little incentive for lending funds for any longer than overnight. Thus, it seems to me, the latest round of rate reductions by the FOMC becomes far more important in the near-term to the credit markets than to the equity markets.
According to the latest available statistics from the Federal Reserve’s Flow of Funds analysis, total credit market debt outstanding in the U.S. at mid-year, stood at $46.6 trillion dollars. This amount, which is slightly more than two and one-half times greater than current estimated listed U.S. equity valuations, includes all types and maturities of credit market instruments. As is common to all credit market investments each has a specific yield that reflects risk and maturity. This fact is critical to the concept of positive carry. As the FOMC reduces the federal funds rate, the cost associated with funding the credit market debt goes down. Each successive reduction in rates changes the cost of carry, depending on the maturity and risk classification, from a larger negative to a smaller negative to eventually, if rates are lowered enough, a positive. Once the “cost” becomes positive investors look to “lend” and invest more. Without going too far into the mechanics of credit creation, suffice it to say credit availability in the markets begins to rise. In turn, this gives rise to increased capital expenditures in the economy and so on and so on. Therefore, it should not come as any surprise to those familiar with credit creation that the FOMC cited their concern about credit availability at the time of their latest rate reduction.
While there is no certainty as to how the latest rate reduction will ultimately affect the equity markets or the economy, the move toward a positive carry
environment is something that investors should not
overlook.
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