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)…
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:
- 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.
- 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.
Source: Yahoo Finance
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