The 25 basis point cut in interest rates, the past week, showed the determination of the Federal Reserve to keep deflation at bay. It is taking advantage of an environment of low inflation todiminish the risk of deflation with aggressive interest rate cuts. However US interest rates are close to the bottom now and the bond market bubble may soon be ending.The 25 basis point cut ininterest rates, the past week, showed the determination of the Federal Reserve to keep deflation at bay. It is taking advantage of an environment of low inflation to diminish the risk of deflationwith aggressive interest rate cuts. However US interest rates are close to the bottom now and the bond market bubble may soon be ending.
The buoyancy of the bond markets is partly a result of the fear of deflation but largely because investors have sought a safe harbor from volatile equity markets. The net result is that credit spreads have fallen across the board.
Low interest rates have made debt more affordable for companies and helped reduce the default rate. Corporate leverage, when measured by book value, however does not appear to have decreased significantly which means that the situation could worsen dramatically when interest rates start to move. To make matters increasingly complicated if the Fed is unable to prevent deflation the real value of debt increases, profits diminish and defaults rise. In either scenario the euphoria in the fixed income market appears untenable.
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Disclaimer: Leena Nehru-Schimert is a director at Arbitrage Capital Management, which manages the Arbitrage Capital Management Fund, LP. Ms. Nehru-Schimert’s columns are not intended to constitute investment advice or a recommendation to buy, sell, or hold any security.
