Does borrowing money (to fund a recovery), make the recovery less likely?

2009/02/09 in credit crisis, macro trends

The trouble with borrowing money to pay for stimulus is that interest rates rise, which is exactly the opposite of what the government wanted in the first place (to get credit markets functioning again).  In this blog post, we will look a how there is a limit to the amount of stimulus that will be effective, because after some point…the additional cost of borrowing will push rates back up

Timeline:

  1. Rates elevated (in the credit markets)…see previous GloboTrends posts here, and here
  2. Government tries to bring rates down by flooding market with money.
  3. But, government must pay for money…so it borrows
  4. Issuing of bonds at attractive prices pushes up borrowing cost
  5. Interest rates go back up.

Spending money to bring the rates down…

The US effort to fight the credit crisis (of ’07-’09) has been truly spectacular.   No expense was too great, no tool was off the table.  The treasury / central bank seemed willing to try anything to get credit moving again.  And, to some respects, their efforts have really started to work.  We see credit markets start to function again.  Interbank lending is flowing.  As the graph below shows, the US LIBOR rate has fallen back inline with pre-crisis levels.  (the spread over Treasuries may be high, but that’s due to “artificially” low Treasury rates, as investors flock to Treasuries for security, and not to increased borrowing costs for banks and AAA-quality companies).

ted-spread-libor-normal

“if you look at any debt instrument versus Treasuries, the spread will still be indicating financial stress. But that’s only because treasury securities are trading at unsustainable levels.  source: seeking alpha

ted-spread-libor-normal

The same trend can be seen for Commercial paper markets, Industrial corporate bonds rated AAA to A…but not for industrial corporate bonds rated BBB or lower.  To explain why BBB rated bonds are still increasing, you dont have to look at the weakness of the credit markets, but instead to investors decisions to shun risk and to favor high quality assets.  This is not an indicator of poorly functioning credit markets, but inversely a sign that investors preferences during a recession are reflected in the financial markets.

while investors are flocking back to high quality credits, they are still shunning lower quality bonds. That would be normal investor behavior in a recession.  source seeking alpha

So, government intervention in the credit markets seemed to be working..

But…then LIBOR rates started going back UP!

3m-us-libor

But, LIBOR is climbing at the same time that other indicators of credit availability are doing the opposite and falling.  The mystery to solve is “why would LIBOR rates be climbing while corporate bond rates fall?”

“…recent increase in Libor contrasts with recent improvements made elsewhere in the credit markets. U.S. corporate bond spreads, which reflect the interest rate investors are demanding to hold this debt, have fallen after hitting record highs in December.  Standard & Poor’s said Wednesday that spreads on investment-grade corporate bonds tightened to 458 basis points prior day, down from 523 at the start of the year. Junk-bond spreads fell to 1,424 basis points from 1,647 basis points”  source:  marketwatch.com

Borrowing costs get factored in…

To explain why interbank lending rates are tightening (LIBOR rates are going back up), while other measures of credit market liquidity are easing, you need to look at the flood of new sovereign borrowing coming onto the market (especially from the USA).

In order to fund this boost in liquidity, the US government has needed to tap the market for funds.  In essence, they needed to borrow money in order to fund the recovery.  This makes sense, but the problem is that the very act of borrowing funds started putting upward pressure on the very same interest rates that the government wanted to bring down.

Why? Well, because of how the bond markets work….in order to borrow money the US government offers bonds, and to get investors to buy those bonds, they offer a better price.   As investors can get a better bang-for-the-buck on US treasuries, it pulls up rates across the board.  More supply for equal demand makes the price go higher.  This movement is reflected by the higher interest rates.

The question is a matter of scale.  If the additional borrowing is minimal, then it wont overpower the stimulus, and rates will continue to fall.  But, if the borrowing increases too much, then the very act of borrowing can push rates back up (where the government intended them to fall).   But, how much extra borrowing are we seeing now (and is it enough to push up rates)?

In just this week alone, we are seeing  …”billions of dollars in new debt are due to be sold this this week.  The Treasury was set to auction off $31 billion of 13-week notes and $30 billion in 26-week notes Monday. On Tuesday, $23 billion of 52-week bills go on the chopping block, along with $32 billion of 3-year notes. On Wednesday, the government auctions $21 billion of the 10-year note and $14 billion worth of 30-year bonds will be sold Thursday.”  source:   CNN money

A limit to the stimulus…

Maybe there is a limit to the amount of impact that governments can have in loosening the credit markets.  It would be terribly ironic if the very act of fighting to push down the interest rates might be pushing them back up again.

Question is…how far will rates rise?   That all depends on how much the government borrows to pay for more stimulus.

Moral of the story:  there is a limit to the amount of stimulus that will be effective, because after some point…the additional cost of borrowing will push rates back up

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