Shaping a portfolio for 2014 (iv): interest rates

the current situation in the US

The first time I visited Taiwan, in 1985, I was struck by the presence of armed soldiers–bayoneted rifles at the ready–at the toll booths on the highways.  It turned out Taiwan had been in an official state of emergency, guarding against possible invasion from the mainland, for a very long time.  The reality of the 1980s, however, was that the Peoples Liberation Army didn’t have enough boats to launch an invasion.  Also, what trucks they had would have broken down on the way to the ports, leaving would-be invaders scattered in small groups around the countryside and forced to hitchhike back to their bases.

Monetary policy in the US is a lot like the Taiwanese state of emergency–except that the Fed, through Quantitative Easing, continues to issue its metaphorical soldiers ever-longer bayonets and more bullets.

It wants to stop doing that, by “tapering,” or decreasing the rate at which it pumps extra amounts of money into the US economy.  It doesn’t want to roll back the state of emergency–by raising short-term interest rates from the current zero to a “normal” 4% or so–for at least two years.  The process of normalization itself will presumably take several years to complete.

economic consequences

The current situation is great for anyone who wants to borrow money.  It’s horrible for savers (read: senior citizens).

The Fed is not maintaining its state of emergency because it thinks the economy is too weak to tolerate higher rates.  Rather, its “dual mandate” from Congress legally binds it to try to fight the current high level of unemployment, a task that normally falls to fiscal policy from the administration and Congress.

The failure of fiscal policy–normally public works construction + worker retraining–means that financial incentives are skewed in a potentially harmful way.  Also, the Fed has nothing left in the tank to respond to any new emergency that may arise before rates are back up to normal.  We’d have to depend on the administration and Congress.  But that’s the world we live in.

investment implications

Two opposing forces:

–the Fed has no intention of raising rates for a long while, but

–raising, earlier this year, the possibility of starting to slowly wean the economy from ever-accelerating expansion of the money supply signaled that the thirty-some year era of continually looser money policy–with its accompanying ever-lower interest rates, ever-higher bond prices–is over.  The next move, when it comes, is a reversal of form.  Higher rates, lower bonds.

My take:

–in past times of post-crisis rate normalization, bonds have gone down, stocks have gone sideways to up

–historically, a turn in the price of any commodity comes in two phases.  The first is anticipatory, as the market perceives a change is likely.  That’s followed by a volatile sideways movement, which ends when the commodity begins to rise in price.  That’s my best guess of what will happen with interest rates and bond prices–trendless volatility.

–the present crop of professional traders don’t strike me as being particularly astute students of history.  Few will have actually experienced during their professional careers an extended period of Fed tightening.  No one has seen a Fed tightening of the peculiar type we will be undergoing in coming years.

We’ve already seen the anticipatory move in bond prices.  The Fed thought it was irrational enough that it spent months unruffling traders’ feathers.  It’s possible that next year the trading community will make the ride bumpier than it needs to be.

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