The Exit Show



While Mario Draghi is trying to restart lending in the euro zone, central bankers in the U.K. and the U.S. face the opposite problem: finding an exit strategy and managing the asset bubbles created by cheap liquidity.

After several years of low rates and an almost uninterrupted search for yield, both the U.S. Federal Reserve and the Bank of England have noted signs of overvaluation in U.K. property, U.S. junk bonds, in leveraged loans, in banks' so-called "contingent capital" instruments or CoCos—to cite just a few areas. Investors need a reality check. And I believe it is time for Janet Yellen and Mark Carney to stop pretending policy can be dovish forever.

How will the Fed and the BOE manage their exit strategy? On the one hand, recent data shows the recovery is still fragile, and exiting stimulus too quickly risks derailing it. The U.K. is a classic example of this problem. Thanks to quantitative easing, confidence and spending have remained relatively stable during the crisis, yet wages are stagnating and consumers are getting deeper into debt to buy new cars and homes. With a housing bubble in London and southeast England but slow growth elsewhere, Mr. Carney has pledged not to apply the same policy response for London as to the whole country.

But if tighter policy can disrupt the recovery, doing nothing gives a green light to investors and consumers to take on even more risk. As Reserve Bank of India Governor Raghuram Rajan said last month, "The more credible the forward guidance on 'low for long,' the more the risk taking." The premium on high-yield debt will tighten further to 2% by the end of 2014 from 2.5% currently, according to RBS estimates, going below the break-even rate against a stable default cycle.

This means the market is almost priced for perfection. Taking advantage of these low yields, consumers are borrowing at longer maturities and corporates are issuing risky covenant-light or pay-in-kind debt. Mergers, acquisitions and leveraged buyout activity are also on the rise. The U.K. government's help-to-buy program has encouraged mortgage loans with down payments as low as 5%. The number of high loan-to-income mortgages are rising to a new record in London. Finally, while the music is playing in the markets, the Haves continue to benefit from financial gains more than the Have-nots.

Without action, these trends may translate into threats to financial stability. One risk is that central banks may lose credibility, by maintaining persistently dovish forward guidance in spite of improvements in labor markets. An even bigger risk is that for increasingly complacent investors and consumers, a hawkish change in policy may turn into a disorderly rush for the door, or an unsustainable rise in debt costs.

In its latest Financial Stability report, the European Central Bank wrote that "an excessive search for yield" could make bond markets "highly vulnerable" to changes in monetary policy. The BOE estimates that an average British household's mortgage costs would rise to 39% of its gross income, from 31% currently, if the bank hiked its base rate to 2% from 0.5% currently.

Many other policy makers have raised their concerns recently. But these warnings alone are insufficient: Investors, and the U.S. futures market, aren't worried about any changes in policy. And even the most conservative asset managers I know are throwing in the towel and buying riskier and more sophisticated products to keep up with their competitors. Many don't believe these products to be good value, but say they'll be able to get out before things get out of hand.

These are signs central bankers can no longer ignore. I believe the best solution is to adopt a more realistic forward guidance now, showing investors and consumers what the exit strategy is before they take unreasonable risks.

"Now, back to macro. What's your exit strategy?" Roman Nagel (Eddie Izzard) asks Danny Ocean (George Clooney) in the movie "Ocean's Thirteen." Nagel is advising on Ocean's plan to bankrupt a casino by rigging the odds and making every player win. As Nagel points out, the players will "all think it's their lucky night, but you'll never get them out of there with their winnings, they're going to gamble it all back. That's Vegas and that's your problem." Spoiler alert: To prevent the players from gambling (and losing) back their winnings, Ocean's team ends up using an underground excavator to shake the casino building, simulating an earthquake and prompting all the gamblers to rush out.

Today's investors and consumers are also feeling as if it's their lucky night. I hope Mr. Carney will act before they take unsustainable risks, and that his exit strategy will prove more orderly than Danny Ocean's.

This article was originally published by The Wall Street Journal on June 5, 2014.


macrocredit © 2019 by Alberto Gallo.

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