Yield Spreads & Market Reversions

Over the last few days, I have been discussing the very wide deviations in price from long term moving averages and other signs of bullish excess.  As of late, even the“bullishly biased” mainstream media has begun to at least question the eerie calm that has overcome the financial markets as volume and volatility have all but disappeared. 

I found it very interesting that several market commentators all made similar statements when asked about the “market calm.” 

“Where else are investors going to go to get yield.”

The “chase for yield” was the desired result by the Federal Reserve when they dropped rates to record lows and announced, in 2010, that supporting asset prices to boost consumer confidence had become a “third mandate.” However, they may have gotten more than they bargained for as several Fed officials have now voiced concerns over potential financial instability.  To wit:

Fed’s Kocherlakota Urges 5 More Years Of Low Interest Rates via Reuters

“Kocherlakota acknowledged that keeping rates low for so long can lead to conditions that signal financial instability, including high asset prices, volatile returns on assets, and frantic levels of merger activity as businesses and individuals strive to take advantage of low interest rates.

But that is a risk, he suggested, the Fed should be willing to take.“

Fed’s Williams Says Central Banks Need To Realize Investor’s Aren’t Rational via The Wall Street Journal

“In a world of rational expectations, asset prices adjust and that’s it, but if one allows for limited information, the resulting bull market may cause investors to get ‘carried away’ over time and confuse what is a one-time, perhaps transitory, shift in fundamentals for a new paradigm of rising asset prices.”

This “exuberance” can be clearly seen in bond yields. In normal times, the interest rate paid on a loan is driven by the potential for a default on repayment of the principal. For example, a person with a credit score of 500 is going to pay a substantially higher interest rate on a loan than an individual with a 700+ credit score. The “risk” of a potential repayment default is offset to some degree by a higher interest rate. If a loan of $100,000 is made with an interest rate of 10% for 30 years, the principal is recouped after the first 10 years.  The real risk is that the loan defaults within the first 1/3 of its term.