Wednesday, 4 April 2012

Fed Policy, Bond Yield and the Investment Cycle

There's a soundbite doing the rounds which sees the build-up of undistributed corporate profits in the US as being a function of the Fed's policy of keeping rates close to zero, and of artificially depressing bond yields. The argument is that the Fed's policy, and its public advocacy by Mr Bernanke, sends businesses the unequivocal message that there's no growth to be expected, so why bother investing. As a result, the US is seeing only a shallow capex upturn characterised only by investment by marginal companies which will evaporate like morning mists as bond yields rise to reasonable levels.

Though I'm no fan of Mr Bernanke's public mugging of Taylor rule earlier this year to allow a phony theoretical justification for any decision the Fed may wish to take, it's worth taking the few minutes needed to nail this argument. First, companies clearly are stockpiling cash, but they are also investing: last year, the annualized growth in private nonresidential investment averaged 8.3%, roughly five times the annualized rate of GDP growth. Second, private nonresidential investment in 2012 accounted for 10.8% of GDP, which is precisely the average contribution since 2000. The numbers simply don't bear out the characterization of a shallow capex upturn.

Moreover, when business leaders are surveyed, they do not seem to echo Mr Bernanke's pessimism. Among large corporations, by February and March the CEO Confidence index had recovered to early 2011 levels, with nearly 73.5% of those surveyed expecting revenue growth this year, and 52% expecting to raise capex budgets. For small businesses, the story of recovered confidence is very similar, with the NFIB Small Business Optimism Index recovering to the highest levels since 2007. True, in historic terms, that's still not very optimistic, but the improving trajectory seems undeniable.

Surveys and opinions can change. What needs challenging is the notion that the Fed's work to keep bond yields artificially low can be expected to actually scare away investment. On the face of it, it seems a silly argument. And when we look at the history, it seems even sillier.

In an earlier post, I constructed a 'fair value model' for US treasury yields normalized for growth, inflation and policy rates, and looked at the deviation of actual yields from those 'fair value yields'. When yields were lower than 'fair value' they represented bad value as investments, when they were higher than 'fair value' they represented good value as investments. I then showed that artificially low bond yields have seemed to have a predictable impact on savings levels and savings surpluses: when bonds represented significantly bad value, savings did indeed dwindle, and when bond yields represented good value, they rose in response.  

Using the model, we can look at how bond yields being lower or higher than 'fair value' has been associated with changes in investment behaviour. The argument being made is that artificially low bond yields will depress investment because of the signal being given out about likely future growth. The alternative possibility is that artificially low bond yields will stimulate investment. So which is it to be?
The graph tracks both deviations from 'fair value' for US 10yr treasuries and deviations from long-term trends for private non-residential investment spending. There's really no doubt about the result:  historically when bond yields have fallen below fair value investment has tended to recover to above-trend, and conversely, when bonds are yielding more than their fair value, investment spending has tended to be choked off. Do not be worried that the relationship is being manufactured by a clever manipulation of axes – there's a negative correlation between movements of the two which is significant at the 1% level.

In short, Mr Bernanke's policy is innocent of this charge, at least. And, oh yes, we should expect the current capex recovery to continue to gather pace this year.   

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