Friday, January 8, 2016
The "Reach for yield" has turned into the "stretch to safety"
The post-crisis zero interest rate period was all about the reach for yield. One of the purposes of the Fed's zero rate policy was to get people to spend their money and not save. For those that still wanted to save, the objective was to get investors to put their money to use through riskier investments. Get money out the mattress of safety and into new investments that will serve as a catalyst for growth.
Zero rates are now over, so the discount rate for any investment project should be higher and the present value should be lower. Projects that seemed worthy as a stretch for yield now do not seem to make as much sense. If the Fed policy states that rates are to be normalized, then the marginal project should be rejected and current investments may not seem as economical. There is less reach and the movement should in the opposite direction. Investors will stretch for safer investments.
Interest rates represent the time value of money and the price of risk. If the Fed keeps rates too low, then the price of risk is distorted and the time value of money does not make sense. Higher rates means that the price of risk should go up because rates are not be artificially held at zero. Of course, there is still the issue of what is the neutral rate and whether it is or should be below zero, but the price of risk should always be positive.
We are seeing the effects of the change in Fed policy. The price of risk for junk has gone up. The price of risk in the stock market has gone up. The investments that were a reach for yield have reversed. We should also see this start to occur in real estate. The stretch will be for safety until top-line cash flow growth seems appropriate for the new price of risk.