Are companies healthier today, as the narrow spreads might suggest? On the contrary–the underlying ratings have deteriorated significantly. In 1980, 78% of the nonfinancial U.S. companies rated by Standard & Poor's were investment grade. Today, only 38% meet that standard. Even within the speculative-grade universe, the balance has shifted to the negative: In 1980, 69% of speculative-grade bonds were rated "BB"; today, only 35% are "BB" and 59% are "B." If spreads were reflecting financial realities, they should have widened, not narrowed.
Obviously, other considerations beyond the credit health of individual companies influence spreads. The primary reason for low spreads is the enormous flood of international liquidity. The trade surpluses of the oil-producing states and Japan and China all have to go somewhere, and last year the U.S. took in $1.1 trillion in net foreign capital. That capital is increasingly flowing into the private bond market, while purchases of Treasury securities are declining. Fund managers are hired to provide returns to their investors, and speculative-grade debt yields larger quarterly bonuses than buying safer securities. Many managers admit privately that they think the rewards being provided for taking on risk are insanely low, but they are being shipped the money to invest, and they just do as their clients tell them.

Thus, a key concern should be the potential for an overreaction by the markets when the default rates do ultimately begin to jump. We are not sure that the buyers of these securities understand the risks they are accepting, and when the losses start to appear, as they are already beginning to in the subprime mortgage and CDO markets, foreign investors could decide to dump U.S. investments. These are just possibilities at the present, although there are already rumblings that China, at least, may look elsewhere for investments.

The announced formation of a China investment trust, similar to those set up by Singapore and several OPEC states, allows the Chinese government, for instance, to move away from bonds into equity and other riskier but more lucrative securities. The government has also announced an intention to spread those investments across more currencies and reduce the domination of dollar-denominated investments. And while there aren't comparable bond markets to those in the U.S., especially outside of government issues, broadening to equities increases the opportunities to diversify.

Given the U.S.'s excessive reliance on inflows of foreign capital, which last year financed one-third of gross investment, any international buyer reluctance would significantly dampen economic activity. A reduction in capital inflows would pull the dollar down and push bond yields even higher. Costs of borrowing–currently very cheap, even considering low inflation–will start to rise, as well. One positive sign that would point to a softer landing, despite the current historically low spreads, is the recent cancellation of a long list of proposed issues suggesting that the market may be becoming less liquid and some credit market standards are being restored.

U.S. Investment Magnetism Slips

By Bruce Kasman

The global economy has delivered strong and broadly based growth in recent years, despite being buffeted by a number of adverse shocks. An important source of this strength and resilience has been monetary policy. Although real policy rates are no longer as stimulative as they were earlier this decade, policy normalization has been gradual and predictable. Indeed, three full years into a tightening process, real policy rates are only now approaching their long-term norms. The dollar's decline has also contributed to accommodative global monetary conditions by promoting substantial reserve accumulation by emerging market central banks that boosted global liquidity.
An accommodative and predictable global monetary stance has delivered more than growth; it has also promoted buoyant financial markets. Low real funding costs and a significant decline in macroeconomic volatility have worked in concert to compress risk premiums in equity, credit and bond markets. Our analysis suggests that this sharp decline in realized volatility accounts for much of the gains generated in risky assets in recent years.

However, it is important to recognize that the behavior of central banks marks a distinct break from the past two global economic expansions. In each of those periods, central banks moved aggressively to restrain growth when resource utilization rates reached levels perceived as elevated. Now, global rates of resource utilization are above peak levels reached during the previous expansion. But global real policy rates are about 140 basis points lower than they were previously. In this sense, central banks appear engaged in a grand experiment, testing the limits of non-inflationary growth in a world of high utilization rates.

Although a number of country-specific factors have motivated the grand experiment, there has also been a general change in central bank attitudes regarding the linkage between inflation and resource utilization. Inflation did not rise materially when resource utilization rates rose during the late 1990s, and both inflation and inflation expectations have remained relatively stable in recent years as well, despite escalating energy prices and resource utilization rates. These developments have encouraged central bankers to respond in a less preemptive manner than they have in the past.

Interest-rate markets currently anticipate little monetary policy tightening over the coming year, as they project the continued success of the grand experiment. However, central banks have not relaxed their commitment to low-inflation outcomes. Against this backdrop, the risk profile on central bank action is changing as downside global growth risks fade, resource utilization continues to rise, and prices on raw materials and finished goods are firming across the globe. The shift toward more hawkish rhetoric reinforces the message that the commitment to the grand experiment is conditional: Central banks are unlikely to tolerate much inflation disappointment in an environment of peak levels of resource utilization.

The sensitivity of financial markets to signs that the grand experiment is fraying should not be underestimated. Our analysis suggests that a rise in core inflation that produces a partial retracing of the recent deviation of central bank policy from its historical norms could deliver more than 100bp of global tightening in the coming year. Perhaps more important is the likely response by credit and equity markets to a signal of intent by central banks to actively slow growth. This signal would alter the perception that central banks are predictable and would greatly increase the "tail" risk of a slide in profits and rise in defaults.

Looking For Something Modest

By Lewis A. Alexander

Over the coming years, a number of factors that have tended to hold down long-term interest rates in the U.S. can be expected to slowly reverse and with them, long-term rates will rise modestly from current levels. For example, over the next year, the yield on 10-year U.S. Treasury bonds should increase to about 5.25%. This forecast reflects the outlook for robust global economic growth with modest upward pressure on inflation.

In part, thanks to these higher rates, borrowing costs for corporations should also gradually move upward. But a moderation of profit growth, as well as increasing leverage on corporate balance sheets and a more cautious attitude among investors, should contribute to higher corporate credit spreads, as well.

The ongoing correction in the housing sector will be a drag on the U.S. economy for some time. But housing's impact on the rest of the U.S. economy has been modest so far, and that pattern should continue. Inflation appears to be moderating and, in this environment, the Federal Reserve is likely to leave short-term interest rates unchanged for some time.

Growth outside the U.S. appears quite robust, which should lead to further monetary tightening in a number of countries, including Japan, the Euro area, the U.K. and Australia. Again, this should put some modest upward pressure on U.S. long-term rates in coming quarters.
In recent years, global trends in savings and investment have also tended to hold down long-term rates. Investment in a range of countries has been low by past cyclical standards. At the same time, savings have grown rapidly, particularly in some emerging economies such as China, and in major oil exporters. There are now signs, however, that these patterns are beginning to change. First, investment has picked up in most industrial countries in the wake of strong economic growth. What's more, both investment and consumption appear to be accelerating sharply in oil exporting countries. There are also signs that some emerging economies may be reaching the limits of their willingness to accumulate foreign exchange reserves.

Investor appetite for risk has been very strong in recent years, resulting in relatively low risk premiums. This has been reflected in relatively flat yield curves and low long-term interest rates. To a significant degree, investors' robust demands for risky assets have been driven by positive fundamentals, including strong and stable economic performance. But low risk premiums may also have reflected a degree of irrational exuberance. There are signs that investors are becoming somewhat more discriminating, and this should put upward pressure on these premiums and long-term interest rates over time.

But, despite these various pressures and moderate further tightening abroad, long-term rates in the U.S. should be expected to rise at a very modest pace, since all these trends are likely to play out slowly.