Monetary policy, bond markets, and the job-rich recovery

Hyman Minsky argued that monetary policy affects the economy in the following way. The Federal Reserve reduces short-term interest rates. There's now no profit to be made sitting on money, so financial managers shift funds out of short-term, risk-free assets into long-term risky assets like corporate bonds. The increased demand for bonds pushes their prices (which were low at the trough of the recession) up and their yields (which were high) down. Credit spreads (the difference between risky rates and risk-free rates) therefore plunge. Businesses can borrow more cheaply, so begin to undertake investment projects that they had delayed due to the recession. Consumers also face lower borrowing costs, so they loosen up, and the recovery is underway.

The story implies that a plunge in credit spreads, say as measured by the difference between the yield on Baa corporate bonds and 10-year Treasuries, should normally precede a recovery in employment. Look at the historical record:

1974-76: Baa-Treasury spread peaks at 3.31 in January 1975, falls to 2.49 by July. Strong growth in employment begins that month.



1981-84: Baa-Treasury spread peaks at 3.82 in October 1982, falls to 1.79 by August 1983. Strong growth in employment begins in April 1983 with spread at 2.89.



1990-94: Baa-Treasury spread peaks falls, rises, falls again in early stages of the "jobless recovery." The last peak, at 2.25, comes in October 1992. From there it falls to 1.29 by December 1994. Strong growth in employment begins December 1992.



2000-2004: Another jobless recovery, with Baa-Treasury spread bouncing around until it peaks at 3.79 in October 2002. From there it plunges to 2.03 by May 2004. Strong growth in employment begins in March 2004.



So what have we seen this time around? A much more severe jump in credit spreads (up to 6.0 in December 2008) and a much more severe recession. But there's been a continuous drop in the spread beginning in March 2009, and the spread is now at 2.65.



Today the WSJ reports on the rally in corporate bond markets, and it sounds like it could have been written by Minsky (or Barbera) himself.

Investors flooded risky companies with money in March even as the government prepares to shut down a key engine driving one of the greatest corporate-bond rallies in history. A total $31.5 billion in new high-yield debt, otherwise known as junk bonds, hit the market through Tuesday, exceeding the previous monthly record in November 2006. Partly propelling the activity: The Federal Reserve's massive mortgage-buying program, which comes to an end Wednesday. By buying $1.25 trillion of mortgage securities, the Fed absorbed a flood of assets that otherwise would have needed buyers. That kept money in the hands of investors, who went searching for something else to buy. The Fed's underpinning encouraged investors to seek riskier, higher-yielding securities. A natural choice: corporate bonds...

The revival of bond fortunes has roots in the Fed's decision, around Thanksgiving 2008, that may have done more than anything else to encourage more investors to take a flyer on bonds. On Nov. 25, the Fed announced it planned to buy debt and mortgage-backed securities issued by housing-related governmentsponsored entities such as Fannie Mae and Freddie Mac. The program pushed mortgage-security prices higher, giving fixed-income managers an incentive to sell to the Fed. In return, they had a flow of cash that had to be put to work. With Treasury debt yields at record lows, the best alternative remaining was corporate debt. "That was the big turning point," says Ashish Shah, head of global credit strategy at Barclays Capital. "That's what drove money into credit."

The Fed expanded this program on March 18, of last year, to buy $1.25 trillion in mortgage securities, along with $200 billion in debt of Fannie and Freddie and up to $300 billion in long-term Treasury debt. The expansion fueled the second leg of the rally, which hasn't stopped.

The behavior of credit spreads in the last year looks very much like it did in 1975-76, 1982-83, and 2003-04. The change in employment has been following a path similar to that in 75-76 and 82-83. It's taken us longer to hit zero this time around because the declines were so enormous during the recession. With monetary policy having delivered a 340 basis point reduction in credit spreads over the last year (compared to 82 in 75-76, 203 in 1982-83 and 176 in 2003-04), is it unrealistic to think we're on the verge of a strong recovery in employment? I don't think so.