Interest Rates Archives

Cash Is An Asset Class

In a recent Op-Ed for the Wall Street Journal, Charles Schwab homes in on the biggest problems in the US economy today…the impact of artificially low interest rates. For most investors, economists and politicians, the idea that there is something wrong with low interest rates is on a par with the old saw that “one can never be too rich or too thin”.

Does that mean that Charles Schwab is crazy? After all, he is advocating allowing interest rates to find their equilibrium level (likely higher than the current Quantitative Easing inspired rates) at a time when economic growth is running well below potential. What does Mr. Schwab see that others have missed? What he has zeroed in on is that Money is an Asset Class. The sooner we treat it as one, the sooner we should see a return to trend economic growth.

The Price of Money – Supply

The first thing Mr. Schwab sees is that the supply of money, from a pricing point of view, is not exactly the same thing as “money supply” (aka. M1, M2 or M3). Money as a commodity can only add to GDP when it changes hands. Therefore, velocity of money has to be considered when evaluating the price of money.

To get velocity, divide the numbers on the top line of this table:


Source: Bureau of Economic Analysis

By these numbers (or choose M1, M2 or M3 from Shadowstats)…

Base Money

Source: St. Louis Federal Reserve Bank

The second important point that Mr. Schwab touches upon is the nature of the transactions. To put it simply, some types of transactions create money and others destroy money. When you pay for groceries with your credit card, you create money in the system. When you pay off your credit balance in full at the end of the money, you destroy money in the system. Also, if you fail to pay your credit card and the bank closes your account and writes off the balance, money is also destroyed. So, to maintain a healthy growing GDP (which is politically desirable), the Fed must monitor the supply of new money created and destroyed in the system and the velocity of that money. If something changes to drastically, the Fed is empowered to add or draw liquidity from the short end of the interest rate curve to influence the overall chain of events. However, it seems that the Fed may have overstepped from fine-tuning to dominating the market.

The Price of Money – Demand

But what happens when the banks borrow money from the Fed at 0% to 0.25% and turn around to buy Treasuries to earn the spread (yield curve)? In the long run, the profits earned will be used to shore up the bank balance sheets and allow them to slowly write assets (loans) down to their real values. No one can say for sure whether this will be a net creative or destructive exercise in terms of money supply but one thing is for sure, the money is not finding its way into the real economy (except as staff compensation and dividends) so the net impact on velocity is a drag. Can we blame the banks for acting rationally? Not really as they are looking at the risk and cost of acquiring assets vs. the spread that they can earn. The risk and cost of attracting new credit card, home equity business, construction and small business loans (assets from the bank point of view) has risen dramatically over the past two years while the spread has shrunk (due primarily to government intervention, regulation and threatened regulation). The risk and cost of flipping Treasuries with the Federal Reserve has fallen to practically nothing while spread remains very attractive (particularly on a geared basis).
So, by enacting the Quantitative Easing program, the Federal Reserve has saved the banking patients from the worst effects of the Global Financial Crisis. However, by continuing to increase the base money supply and hold interest rates at artificially low levels with its Quantitative Easing program, the Federal Reserve has disrupted the market setting mechanism for money.

What Mr. Schwab has missed is that savers, the ultimate suppliers of capital, are not being tricked into high risk assets because of the low interest rate. They are rationally taking their cue from the biggest, most committed and least price sensitive buyer in the market (the Federal Reserve). In fact, many have been all too happy to chase and profit from the bubble. How can we measure the bubble? Well, just invert the yield on a ten year treasury. At the end of March, the yield touched 4% or a Price/Earnings ratio of 25x. The latest reading is 2.54% which doesn’t sound dramatic until you realize that number translates into a Price/Earnings ratio of 39x. Sounds pricey until you realize that there was good money to be made in that trade. What Mr. Schwab is actually concerned about is the sustainability of the rally and how much his investors are going to give back when the bubble pops or deflates (ie. interest rates start to rise).

How will we know when to change gears?

The current circumstances are politically maintained so a large part of the change will have to be political. The US mid-term elections are a potential catalyst. But, there may also be international events which drive changes in thinking over at the Fed and in the White House.

The comparison with Japan over the last 20 years is instructive:

  1. On the downside, the Quantitative Easing experiment in the US has proven that the advice American policy makers gave Japan 10, 15 and 20 years ago works no better in the US than it did in Japan as a long term policy.
  2. On the upside, the US political tradition is not as consensus and faction driven as Japan’s. There is every reason to believe that the political winds in the US will change in far less than the two decades in which Japan has tolerated its current economic malaise.

How can the Fund King System help?

The Fund King System is a risk seeking asset timing model but it is structured against excessive volatility. As such, it can offer a good method for approaching the markets. For example, if you had followed the ranking changes from July 12th to now, you would have allocated some of your capital into TLH, the ETF that invests in 10-20 year US Treasuries. As you can see from the Yahoo Finance chart below, you would have made a not too shabby 5.4% in just under 3 months…a return that happens to coincide with the far more volatile S&P500 (represented here by the SPY ETF). During that period, TLH remained in one of the top ranking slots while SPY languished in the bottom half. The difference was the extra volatility which weighed against SPY in the Fund King System.

Yahoo Finance Chart

Source: Yahoo Finance

If you have not done so already, go to our PortfolioSelect feature and set up your own system today.

BubbleWatch: US Treasuries

Over the weekend, I met up with a couple of friends at a local bar. One of them was chatting intently with a financial advisor who had tagged along. The financial advisor was pushing the concept of bonds quite strongly to my friend. There was nothing particularly wrong with his arguments except for the fact that they were very one sided. Knowing how hard the bond market had run (bond funds have outperformed equity funds for a 23 year record of 30 straight months), I was reminded of the urban legend of the shoeshine boy giving tips to Joe Kennedy in 1929. It seemed a good time to check in on where the biggest bond market is today.

Bonds in general and US Treasuries in particular have had a good run since 2000 relative to the equity markets. That run is an extension of the bull market that has prevailed since 1981.

US Treasury bubble

Source: The Big Picture, chart from Bloomberg

With charts like this (and interest rates at record lows), it is easy to see why some smart investors may be getting a little nervous. The 30 year bond is trading at an implied inflation expectation of 1.93%…not an outcome anyone who remembers the 1970’s would like to bet on.

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The Price of Money

The markets are flopping around aimlessly. Investors are confused. The media is having more and more trouble trying to whip up enthusiasm or maintaining credibility: the latest doozy to float through the market was the Hindenburg Omen (a technical formation which predicts equity crashes 25% of the time).

What is going on? Why are the markets so directionless? Are we staring into the abyss of deflation plus the second part of a double dip recession or will we have to dust off the 1970’s era Misery Index to describe the upcoming years of stagflation? With warning signs of both inflation and deflation in the economy, there is little wonder that professional and individual investors alike are confused by the signals.

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US Banks – Watch the Revenue Line

A long interview with Meredith Whitney but she brings up some key points about the US Financial Sector in this CNBC interview. Chief among them that the latest earnings improvements are masking a serious structural weakness in the revenue line. We have seen recent news of Fairholm buying big into financials…perhaps this is the news item one should be paying attention to:

If you want to see the key members of the SPDR Financial ETF and how they rank, go to this link

Keep Your Powder Dry

The financial markets are definitely not showing much direction overall but the relatively calm surface is hiding turbulent and conflicting currents not far beneath the surface. The Fund King System remains in a “risk off” stance with recommendations across our main portfolios all tending towards US government bonds (TLH & TLT), cash, gold and silver. None of the readings on these individual asset classes are particularly compelling…but they are positive. So, as we wait to see just how awful US 3Q GDP numbers might be, the System is not recommending any risky positions. What currencies do you want to be in? It looks like the US Dollar and Japanese Yen are the best for now. The Euro has staged a bit of a comeback on the completion of EU wide bank “stress tests” but is still weak. A bet on the Euro is certainly a bet on the health of the European Banking system which remains overly dependent on potentially fickle wholesale financing (as opposed to deposits). The Australian Dollar is also a bit weak largely due to a potential economic slowdown in Mainland China (a huge consumer of Australian minerals).

The currents underneath the surface derive from the powerful forces that are struggling to define the next phase of global economic development.

Option 1: Deflation

Long Term US Government Paper is attracting money from those who see the current lack of consumer demand growth as an intermediate trend and a signal that we will enter a period of sustained deflation. When the Global Financial Crisis started in 2008, analysts who suggested that the US or European economies might experience some of the deflation and stagnation that Japan has endured since 1990 were summarily dismissed. However, that dismissal now seems to have been premature. Even in the early 90’s, investors had a hard time believing that Japan would not shake off the slump in short order. The country that had given us the economic miracle, just in time inventory, quality circles and firms that could buy up Rockefeller Center and Pebble Beach would surely continue their inexorable rise as the leader of the dawning “Pacific Century” (now redubbed the “Asian Century”). Deflationary fears are also driven by the evidence that massive government stimulus combined with very accommodating monetary policies has not delivered as advertised. If the Fed is “pushing on a string”, then perhaps it has run low on viable options. With Middle Class America taking serious hits on income (high unemployment) and wealth (underwater mortgages), the deflation camp is betting on continued sluggish consumer demand. The main risk to a deflation geared portfolio is a change in consumer demand. Signs of a positive change in consumer demand will send investors scrambling out of Treasuries (and the US dollar) and back into riskier assets (High Yield, Equities and eventually Commodities).

Option 2: Inflation

On the other side of the debate are those who see governments (particularly in the US but also in Europe and Asia) increasing their weight in their respective economies. Governments are beholden to voters and usually choose paths that lead to the least amount of pain in the short term. That suggests a risk of currency debasement and sustained inflation. Debtors prefer to pay back money far in the future after inflation has worn away the value of future dollars. Since the big debtors include most of the G7 Governments and their Mortgage Paying Electorate, there is no doubt about which way political will is positioned. The fear of currency debasement is at the core of the Gold Trade. So, while both Gold and Treasuries have been moving up together over the past few years, their performance should diverge sharply once it becomes clear whether we are heading into deflation or inflation.

Option 3: Healthy Global Growth

And what about the middle road between these two outcomes…decent growth with inflation at 2-4%? That outcome is the only one on which very little is being wagered because it seems the least likely. This recession is different from what most of us are used to because it is due to a financial crisis, not the usual manufacturing inventory overstock. The NBER, the official arbiter of recession timing, has yet to declare an end to the recession which started at the end of 2007. Perhaps their caution, which was criticized toward the end of 2009, was justified after all.

What should investors do?

For now, one would be wise to follow the advice first given by Oliver Cromwell:

“Put your trust in God; but mind to keep your powder dry.”

There is no reason to embark on risky or illiquid trades now. Avoiding a nasty drop is just as important as participating in market rallies to the overall health of your portfolio. At best, you will rack up a big commission bill, at worst, you could get stuck in a position that looks wrong footed in the autumn. Despite all the promises from internet penny stock newsletters, this is not the right time to go chasing after “the next big thing” with any more than a few percentage points of your portfolio.

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