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Bernanke's Easy Money Death Spiral

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QE is impeding capital investment by raising cost of capital volatility risk. Here's why the more easy money we get, the longer it will take to build a sustainable recovery.

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I ran my own chart on Bloomberg of capital expenditures as a ratio of GDP to see if I could find a positive correlation between low interest rates and higher capital investment. Using the Federal Reserve's own Flow of Funds data I plotted the Nonfinancial Business Capital Expenditures Fixed Investment divided by nominal GDP. After overlaying the chart with a couple of different interest rate relationships both real and nominal, I found a pretty tight inverse correlation with the slope of the yield curve going back 40 years. When the curve flattened, capital expenditures tended to rise; conversely, when the curve steepened, capital expenditures tended to fall.

In order to explain why this correlation might exist, I want to drill down a bit deeper and explore two different decades: The 1990s, which can be generally characterized as a period of tight money, and the 2000s, which generally has been considered a period of easy money.

In 1992, the Fed funds (US Department of Treasury) rate was 3% and the spread between the daily 5-year (5YR) and 10-year yield (10YR) curve rates was 100bps. When Greenspan began normalizing monetary policy after the recent recession, the curve flattened from 100bp to 0bps as he took the funds rate to from 3% to 6% by 1995. Basically, between late 1994 up until the tech bubble imploded in 2000, the Fed funds rate remained relatively stable at 5.50% plus or minus 50bps. Over that same time frame, the yield curve measured by the 5YR/10YR spread was equally as stable, trading between 0bps and 25bps until going negative in 2000 as Greenspan tightened into the tech bubble.

As you can see on Grantham's chart over that time period, capital investment as a percent of GDP rose from 5% to nearly 10% in 2000.

While the 1990s generally saw a flat and tame yield curve the following decade would be the opposite seeing a volatile and steep curve. Between 2000 and 2010, the Fed lowered the funds rate from 6.50% to 1.00% back up to 5.25% and down to zero in 2009. Over the same time frame the 5YR/10YR spread was equally as volatile steepening from -25bps to 100bps back down to zero and back up to and unprecedented 125bps as the Fed funds hit zero.

Looking back at Grantham's chart you can see this period corresponded with a collapse in capital spending as the Bonus Culture emerges. As Grantham notes, "This currently reduced investment level appears to be about 4% below anything that can be explained by the decline in the growth trend."

What is going on here?

The term structure embedded in the yield curve is the bond market's discount for inflation. Under tight monetary policy, the curve tends to flatten, discounting low inflation pressure; under easy monetary policy, the curve tends to steepen, discounting high inflation pressure.

In addition to discounting inflation pressures, the slope of the yield curve often manifests in the slope of the risk curve. When the yield curve is narrow, risk premiums are lower; when the yield curve steepens, risk premiums are higher. Higher inflation discounts produce lower market multiples, which translates into higher costs of capital. The market doesn't pay a higher multiple for inflated cash flows.

The secular nature of this decline in capital investment has to be related to something that is also secular causing this risk aversion. In other words, it's not just a product of a bunch of greedy CEOs who are scared to deploy capital for fear of risking their stock options.

I think there is a reason for the correlation between yield curve volatility and capital expenditures. I think that this era of uber-easy monetary policy driving yield curve and thus risk curve volatility is behind the collapse in capital investment due to the uncertainty in the cost of capital for which to invest.
No positions in stocks mentioned.
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