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JPMorgan’s Bond Chief Has No Time for Fed Haters

Brian Chappatta

(Bloomberg Opinion) -- The Federal Reserve has always been a popular villain to some investors. The U.S. central bank, the argument goes, consistently bends to the whims of financial markets, keeping interest rates artificially suppressed to force savers into ever-riskier assets at ever-higher prices.

The coronavirus pandemic and the Fed’s kitchen-sink response have only amplified these feelings. Oaktree Capital Group’s Howard Marks and Berkshire Hathaway’s Warren Buffett are among those who have said they couldn’t make deals because the central bank kept prices too high. I’ve argued that the Fed buying high-yield exchange-traded funds defies explanation, while my Bloomberg Opinion colleague Mohamed El-Erian this week implored the central bank to resist market pressure to do more. More broadly, the V-shaped rebound of nearly 40% in U.S. stocks when the unemployment rate is likely close to 20% just doesn’t sit well with some people.

Bob Michele, global head of fixed income at J.P. Morgan Asset Management, shared some no-nonsense advice: “It’s a return to financial repression — deal with it.”

As someone who oversees $615 billion across debt markets for the asset manager and got his start just as U.S. Treasury yields peaked in the early 1980s, Michele has had a bird’s-eye view of the long-running bond bull market and has seen global central banks take increasingly novel measures to support their economies. 

I spoke with Michele by phone last week. This is a lightly edited transcript:

Brian Chappatta: You wrote, “It’s a return to financial repression — deal with it.” Other high-profile investors haven’t taken the central bank’s actions in stride. Has the Fed done anything up to this point that they shouldn’t have?

Bob Michele: They’re doing everything they needed to do. I know the markets have recovered a lot, and a lot of investors are frustrated they didn’t get a chance to put money in the markets at the bottom. But people forget what those first couple of weeks in March looked like as the pandemic was gaining traction. There was this flight to quality, and as risk assets started selling off, Treasuries started to sell off as well. The markets had trouble clearing and weren’t functioning properly.

If you’re at the Fed, you step back and you see the trillions of dollars of issuance that’s coming. You see several trillion being added to the federal rolls through Treasury issuance to fund the CARES Act and other programs, you see corporate issuance which already this year is over $1 trillion, and you think about the amount of funding that state and local governments have to do to just survive the shutdown. You begin to realize — the market cannot absorb it on its own. If you rely on the markets on their own to absorb the trillions of dollars of issuance, not just in the U.S., but globally, prices are going to go down a lot, or yields are going to go up a lot. That certainly doesn’t help a recovery.

BC: You mention a strategy of co-investing with central banks, including buying U.S. investment-grade corporate bonds. Analysts for years were warning that corporate America was too overleveraged. Why is taking on more debt an answer? 

BM: We saw what happens when that backstop isn’t there. Yields just rise indiscriminately and suddenly it becomes unaffordable for companies and municipalities to take on leverage and work their way through.

My biggest concern is that the decision-making tree will be something like Hertz. Which is, you have some access to credit — Avis funded itself a month ago at 11.3% — you could get funding through the CARES Act, but it comes with strings attached. Even still, you think, adding one or two more turns of leverage to our balance sheet, is it worth it? Or at some point do you realize you’ll never be able to pay back that debt, so might as well start the restructuring process now? I think access to credit is one thing, but the affordability of credit is probably more important.

BC: So far, the Fed has just purchased ETFs through its credit facilities. Do you expect it will ultimately buy individual company bonds?

BM: They’ve done some decorative amounts of ETFs, mostly to ensure that the plumbing is working and just show the market that they are serious about buying credit. But I think with the amount of issuance coming and with the data we’re yet to see that will rattle investors, we’ll need the backstop from the Fed.

BC: What kind of upside is there with investment-grade yields near all-time lows?

BM: You end up looking at both the investment-grade market and the Treasury market as your anchor in the storm. At some point, they’ll be maintained at a pretty expensive level. 

It all goes back to what you think is the ultimate endgame here. I think whether implicitly or explicitly, the Fed is fixing the rate of funding across the economy. The reality is their signal that the markets weren’t functioning properly was that yields went up and prices went down. How we got there — because broker-dealer balance sheets were clogged or there was risk-aversion — it doesn’t really matter. Restoring functionality to the market means that you diminish the liquidity premium that’s priced into the market, first and foremost, and also any sort of volatility premium. If you remove those things, then the price of bonds goes up. I know they talk in circles around market functionality, but it is implicitly reducing the cost of credit.

BC: Do you expect the Fed to implement some form of yield-curve control?

BM: I think it’s inevitable. I think by the way the Fed is doing it implicitly anyway.

If the yield curve ever steepened a lot and the cost to the federal government for the next couple trillion of issuance is too high, they’ll step in and bring it down. I see an environment where the front end of the curve is going to be fixed pretty much around 0% to 0.25%. When you get out to the 10-year, I think 0.5% to 0.75% gets them pretty comfortable. Then you leave the 30-year for pension funds and insurance companies.

The same thing is happening with investment-grade credit. I think credit spreads will come in to a point where the average cost of funding for an investment-grade borrower in the U.S. will be no greater than 2%. Then you start playing that through the municipal market, and again, just them backstopping the market and removing that uncertainty lowers the cost of funding for all of these borrowers.

BC: Inflation is always a concern for bond investors, especially with yields so low across the world. Where do you come down on the inflation versus deflation debate?

BM: This is probably the most emotional conversation I have with clients currently. Our view is the amount of debt being ladened on top of not only the U.S. economy, but the global economy, is deflationary, and it’s creating such a large output gap that it will take about 10 years to close that output gap and return inflation to something that looks normal. Clients just push back, think I’m nuts, think that the amount of stimulus being poured onto the economy, and the amount of borrowing and money printing is all very inflationary. 

That amount of debt is just outright disinflationary, if not deflationary, because a lot of the output of the economy going forward has to be used to service that debt and start to pay it down. It doesn’t get used more productively through cap-ex or investment. 

We’re absolutely firm that we’re going to be in a very low inflation environment for a long period of time.

BC: Do you see the Fed resorting to  negative interest rates?

BM: I completely agree with the Fed that negative interest rate policy is just a bridge too far. It creates structural problems that are difficult to extract yourself from.

Could I see the 10-year Treasury go down to zero or slightly negative? Sure. It won’t be driven by the Fed, it will be driven by the next risk-off environment, where the money that’s in the negative-yielding markets will come flooding into the U.S. because they’ll see a positive yield, they won’t care about hedging the currency back because they’ll want the safety of the dollar, and they’ll see some capital appreciation. But I don’t see this Fed ever bringing rates down to negative territory. If a couple years from now, Jay Powell gets replaced, depending on who replaces him, they may open the door to that. But for now I just don’t see the Fed going to negative yields.

BC: To circle back to where we started — financial repression. Is there any way out?

BM: The trillions of dollars of borrowing, we view it as aid and assistance and support, not stimulus. I know it’s semantics, but it’s very different. There’s lost economic activity, and this debt is being used to replace lost income to households and to businesses. It’s just helping to fill in the hole. I struggle with aid and assistance being called stimulus. 

What would get me more optimistic is if on the other side of this, you did see borrowing that was actual stimulus. In the first year or so of this administration, there was talk of a trillion-dollar infrastructure spend, spread out over 10 years, and people got excited. What if that happens this time, and it’s spent over three to five years, not 10? That’s actual stimulus. It’s creating jobs and aggregate final demand and helping support household income.

If the government is willing to borrow more to invest in things like infrastructure and companies are willing to borrow more to invest in cap-ex, that is what would be different than the great financial crisis, when everyone was focused on austerity and trying to re-strengthen their balance sheet.

At this point, the debt burden is so high, what’s another trillion on top of the federal deficit? And if you’re a company and you have a chance to borrow at record-low rates, especially somewhat subsidized by the Fed, why not do it and think about the future? Perhaps we’ve all learned that the economy needs to be retooled to better suit a work-from-home model. Maybe parts of the healthcare system need to be retooled. There are things that need to be addressed that create some spending and aggregate final demand. And for me, that hasn’t been fully discussed yet.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.

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