shrinking global bond yields

valuing bonds   …and stocks

Conventional US financial markets wisdom–maybe glorified common sense–says that the yearly return on financial instruments should consist of protection against inflation plus some additional reward that varies according to the risk taken.  For stocks, the belief is that they should earn the inflation rate + six percentage points for risk annually; ten-year government bonds should return inflation + three percent.

If inflation is 2%+, this means the 10-year Treasury should have an annual yield of 5%+.

Stocks should have a total return (price change + dividend received) on average of 8%+ yearly.

last Friday

the 10-year

Last Friday, the 10-year Treasury yield broke below 2%, to an intra-day low of 1.95%!

Austria

Even weirder, across the Atlantic, the Austrian government is warming up to issue 100-year bonds yielding 1.2%.  Demand appears to be strong, possibly because its issue of century bonds in 2017 at a 2.1% yield is up in price by about 60% since.  Of course, it’s also true that many EU sovereign instruments are trading at negative interest rates–a result of central bank efforts to stimulate economic growth there.

Trumponomics

Odder still, but probably not that surprisingly, Mr. Trump is actively browbeating the Federal Reserve to lower interest rates further, despite the fact that virtually no domestic evidence is calling for further distortion to rates.  I say “virtually,” because there is one contrary–the administration’s policy on trade and immigration.  If there is a master plan behind that, I guess it’s what Mr. Trump believes is needed to assure his reelection.  One issue for him is that the price increases he has put on imported goods have offset almost all of the Federal income tax reduction the average American family got last year.  In addition, the seemingly arbitrariness and changing nature of Trump tariffs–plus the radio silence of Congress tacitly approving of the circus–appear to have slowed domestic capital investment significantly.  More forethought is likely out of the question for the administration   …hence Mr. Trump’s Rube Goldberg-esque call for counterbalancing monetary stimulus.

???

I’ll happily confess that I’m not a bond expert.  For what it’s worth, I don’t like bonds, either.  But the present state of affairs in the bond market–the absence of any return above protection from inflation– seems to me to say that money policy in the US and EU is still enormously stimulative, no longer effective and need of careful handling in extracting us from this situation.  The last thing we need is higher taxation through tariffs and even more distortion of yields.

 

What would make someone want to buy the proposed Austrian century bonds anyway?

…the greater fool theory, i.e., the idea I can sell it at a higher price to someone else (which certainly worked with the 2017 issue)?

…the fact that lots of EU government instruments sport negative yields, so this may be a comparatively good deal?

…I’m a bond fund manager and need coupon payments so my portfolio can pay expenses and management fees to myself?

…I’m shorting negative yield bonds against this long position?

 

global/demographic/government influences on yields

aging populations…

Another general principle:  as people get older and as they get wealthier they become more risk averse.  Put another way, in either situation people shift their investment portfolios away from stocks and toward bonds.

The traditional rule of thumb is that a person’s bond holdings should make up the same percentage of the total portfolio as his age in years.  The remainder goes into stocks.  For example, for a 65-year old, 65% of the portfolio should be in fixed income.  (I don’t think this is a particularly good rule, but it’s simple and it is used.)

What’s important is that the aging of the populations in the US and the EU (which is older than us) is a powerful asset allocation force.  In the US in 2000, for example, (according to the Investment Company Institute) investors held $276 billion in funds, of which 82% was in equity funds.  At the end of last year, the total was $681 billion, of which 40% was in equities.  Over that time, the amount of money in stock funds rose by 20%; bond funds went up by 10x, however; asset allocation funds, which hold both, had 6.5x their 2000 assets.

national economic policy

For as long as I’ve been around, the preferred tool of government economic management has been monetary I can be applied faster than fiscal policy   …and it leaves no fingers pointing at politicians if implement is painful or executed maladroitly.

The chief characteristic of expansive monetary policy is the suppression of interest rates.  The burden of adjustment falls squarely on the shoulders of savers, i.e. older citizens, and the poor, who have no ability to borrow to take advantage of the lower cost of money.

 

More tomorrow.

 

 

 

 

 

 

threatening Federal Reserve independence

trying to intimidate the Fed?

Just before Christmas, news reports surfaced that President Trump was discussing how to go about firing Jerome Powell, Chairman of the Federal Reserve, ten months after having him appointed to the post.  The purported reason:  Mr. Trump was blaming stock market turbulence–not on his tax bill, which failed to reform the system and increased the government deficit, nor on the negative effect of his tariffs–but on Mr. Powell’s continuing to gradually raise short-term interest rates from their financial crisis lows back toward normal.

Ironically, the S&P 500 plunged by about 10%, making what I think will be seen as an important low, as the president’s deliberations became public.

why this is scary

The highest-level economic aim of the US is maximum sustainable GDP growth, with low inflation.  In today’s world, the burden of achieving this falls almost entirely on the Fed (even I realize I write this too much, but: the rest of Washington is dysfunctional).  The unwritten agreement within government is that the Fed will do things that are economically necessary but not politically popular, accepting associated blame, and the rest of Washington will leave it alone.

Mr. Trump seems, despite his Wharton diploma, not to have gotten the memo.  This despite the likelihood that his strange mix of crony-oriented tax cuts and trade protection has made so few negative ripples in financial markets because participants believe the Fed will act as an economic stabilizer.

What happens, though, if the Fed is politicized in the way Mr. Trump appears to want?

The straightforward US example is the 1970s, when the Fed succumbed to Nixonian pressure for a too-easy monetary policy.  That resulted in runaway inflation and a plunging currency.  By 1978, foreigners were requiring that Treasury bonds be denominated in German marks or Swiss francs rather than dollars before they would purchase.   The Fed Funds rate rose 20% in 1981 as the monetary authority struggled to get inflation under control.

The point is the negative effects are very bad and happen surprisingly quickly.  This is more problematic for the US than for, say, Japan because about half the Treasuries in public hands are owned by foreigners, for who currency effects are immediately apparent.

 

 

 

 

 

 

the Fed’s next move

The highest economic policy objective of the US is achieving maximum sustainable growth in the economy consistent with annual inflation around 2%.

If growth deviates from this desired path, either through overheating or recession, the government has two tools it can use to nudge the economy back toward trend:

monetary policy, controlled by the Federal Reserve, which can relatively quickly alter the rate of growth of the money supply and thereby either energize or cool down activity

fiscal policy–government taxing and spending–controlled by the administration and Congress, and which may be thought of as more strategic than tactical, since there are typically long lags between need and any legislative action.

As a matter of fact, the Fed has been calling for fiscal stimulus from Congress and the administration for several years–worrying that continuing monetary stimulus is increasingly less effective and even potentially harmful to the economy.  Its pleas have fallen on deaf ears.

The Fed has been using two methods to keep rates low:

–it has kept the Federal Funds rate, the interest rate it sets for overnight bank deposits, at/near zero, and

–it has taken the unconventional step of putting downward pressure on rates of long-maturity instruments by buying a total of $4 trillion+ of government securities in the open market.  This is called quantitative easing.

Donald Trump was the only candidate to address the problem of fiscal policy inaction, by promising giant fiscal stimulus through lower corporate tax rates plus a massive spending program to repair/improve infrastructure.

After Mr. Trump’s surprise win last November, the Fed seems to have breathed a sigh of relief and aanounced a series of interest rate hikes that would begin to return monetary policy closer to a normal amount of stimulus–based on the idea that Washington would also provide serious fiscal policy stimlus in 2017.

We’re now in month nine since the election, without the slightest sign of any action on the fiscal front, despite the fact that the Republicans hold the Oval Office and both houses of Congress.  Senator Pat Toomey (R-Pa) remarked last week that this is because no one expected Mr. Trump to win, so Congress made no plans to implement his platform.   It hasn’t helped that, despite his campaign rhetoric, Mr. Trump has shown little grasp of, or interest in, the issue.

This leaves the Fed in an awkward position.

I think its solution will be to shift from raising the Fed funds rate to slowing down or stopping its purchases of securities farther along the yield curve.  Although in a sense the Fed is already no longer buying new government bonds, it is taking the money it receives in interest payments and principal return from its current holdings and reinvesting that in new securities.

Its first step will be to reduce or eliminate such reinvestment–which will presumably nudge longer-term interest rates upward.  Since the process is being so well advertised in advance by the Fed, it’s likely that most of the upward movement in rates will have occurred before the Fed begins to act.  The most likely date for the Fed to more is in September.

 

interest rates and economic growth

Over the past few days, I’ve written about two approaches to the question of the appropriate level for interest rates.

fixed income as an investment on its own

The first considers fixed income as an investment, with no reference to current economic conditions or to use of rates as a government policy tool.  According to it, holders of short-term fixed income instruments receive protection against inflation + a small real return; holders of long-term instruments receive inflation + a real return of 3% or so + an extra return if the instrument carries higher risk.

rates and economic policy

The second looks at short-term interest rates as a tool of economic that aims at steering growth along the preferred path of a given nation’s government.  The monetary authority slows the economy down and speeds it up by raising/lowering rates as circumstances dictate.  In the US, the recent preferred metric for judging success has been the employment figures.

quantity of money

There is a third, admittedly subjective, approach to this topic, one that many professional investors have traditionally used to gauge the tone of financial markets.  The idea is that the economy requires a certain amount of liquidity (i.e., money) in order to operate efficiently.  This is to maintain inventories, pay salaries and fund new investments.   It operates best when it has precisely that amount.

In a period like the current one of continuous radical supply chain and financial innovation, it may be hard to judge when too little money is available, and therefore activity is constrained and rates are too high.

On the other hand, adherents to this idea think that when money is too abundant, the excess inevitably finds its way into economically destructive financial speculation.  The signs that rates are too low are easier to spot:  soaring housing prices, bubble-level stock PEs and high-risk, nevertheless covenantless, junk bonds.

recent financial market worries

This third idea is the basis for the recent conversation in financial markets that ultra-low interest rates have passed their best-by date and are now doing more harm than good.  The strongest evidence that this is the case is in the junk bond market, I think.  However,  if there’s speculation in one corner of the financial markets, it must also be at work in the others.

politics and the Federal Reserve

In my post last Friday on the Labor Department’s most recent Employment Situation report, I commented that I thought it unlikely that the Fed would raise short-term interest rates before the election in November.  How so?   …because the Fed worries about accusations that it would be intruding into the electoral process.

A reader commented that he thought such worries would be silly, either on my part or the Fed’s or both.  I thought I’d respond here.

I agree that it makes little difference for the economy whether the Fed Funds rate is at 0.25% or 0.50%.  In fact, one could easily make the argument that extreme money stimulus is no longer needed and that the US would be better off with higher rates rather than lower.

 

A generation ago, when controlling nominal short-term interest rates was the Fed’s sole policy tool, it was the norm for the sitting President to pressure the Fed in an election year to lower rates, or refrain from raising rates, in order to keep his party in power.  It was also normal for the Fed to acquiesce.  Monetary policy lore says that Gerald Ford was the first president not to do so–and he lost his reelection race.  This behavior also gave rise to the belief that an election year would usually be an up year for stocks, followed by difficulties during the first year of the next term, as the new president removed the extra stimulus.

 

The appointment of Paul Volcker as Chairman of the Fed with a mandate to get the runaway inflation of the late Seventies under control changed this situation, making the Fed the de facto government mechanism for implementing economically necessary but politically toxic decisions to slow the pace of growth.

 

Seeking not to return to its role as a tool of one political party or another, the Fed seems to outsiders to have developed a rule that it will not act within, say, four or five months prior to a presidential election, to either raise or lower rates.  One might otherwise argue that it is giving an economic boost to–or at least signalling its approval of–the sitting president by lowering rates.  It would signal disapproval by raising them.

 

However, as Alan Kaplan points out, the Fed is political.  One could easily maintain that the Fed has enabled the continuing failure of Congress to enact sensible fiscal measures to support economic growth.  (The other side of the argument would likely be that although members of Congress may have cultural agendas, the ones who show up at briefings by the Fed are shockingly ignorant about basic economics.  So they have no idea of how to craft prudent fiscal stimulus.)

One other issue.  The emergency-low interest rate policy we’ve had in place for eight years places the interests of borrowers ahead of those of savers.  Another political decision.  A generation or two ago the latter would have been the ultra-wealthy.  In today’s world, savers are Baby Boomer retirees, whose ability to establish a secure stream of interest income to support their lifestyles has been diminished by government policy.

 

the FT: America’s reading problem

I like Gillian Tett, the US managing editor for the Financial Times.  It’s partly because she has a PhD in Anthropology, partly because she has a wide breadth of interests that allow her to write much more interesting columns than the average journalist.

Her latest is about “America’s Reading Problem,” an article that contains the results of Department of Education research documenting the fact that ” 14 per cent of the adult population (or 32 million people) cannot read properly, while 21 per cent read below a level required in the fifth grade. And 19 per cent of high-school graduates cannot read.”

Hartnell College, a community college in Salinas, CA has a powerpoint online that contains a more detailed version of the same information.

Ms. Tett points out that this reading deficit, which has persisted in the US for a long time, tends to reinforce the distinction between haves and have-nots.

I have two thoughts:

–if government economic policy is reliant totally on monetary measures and not on education reform, no wonder 0% interest rates + quantitative easing for a long time have been necessary to  provide the (low skill) jobs that will shrink the unemployment rate.  Imagine what those jobs must be like.  It also seems to me very likely that higher rates will make jobs for the illiterate disappear very quickly.

–I’ve been unable to find the original government source document referred to, although the results are in the Tett article and in many others that pop up through an online search.   The only Department of Education report I can find says simply that literacy rates in the US are similar to those elsewhere in the OECD.

How odd.

I normally search government websites several times a week, so that’s maybe a thousand instances.  This is the first time something like this has happened.

 

why the Fed is looking at/for wage gains

This is Jackson Hole week, when the world’s central bankers convene in Grand Teton National Park in Wyoming to compare notes.  From their meetings, we’ll get a better sense of what the architects of the current emergency-easy money policy are thinking and planning.

Conventional wisdom  is that in times of economic stress the central bank should lower interest rates to a point significantly below the rate of inflation–and keep them there until people and companies borrow the “free” money and invest in large enough amounts to launch an economic rebound.

One indicator that the Fed is watching carefully is the rate at which wages are rising.  In theory, employers only raise wages a lot when they’ve run out of available unemployed workers and can expand only by headhunting away people who are already employed elsewhere.  So wage increases at a faster clip than inflation mean it’s high time to tighten money policy;  sub-inflation wage gains–the kind we have now–mean there’s no rush.

Policymakers appear to be giving this rule of thumb a rethink, however.

For one thing, short-term interest rates have been at effectively zero for over half a decade.  You’d think unequivocal signs of economic strength should have been evident long before now.

There’s no sign I can see that central bankers have any sympathy for the plight of savers (read: the Baby Boom and the elderly), whose desire for safe and stable fixed income investments has been the chief casualty of the economic rescue effort.  However, they do seem to be concerned that the search for yield in a zero-interest-rate world has caused savers to buy exotic instruments (hundred-year bonds, contingent convertibles, for instance) that will likely suffer wicked losses as rates begin to eventually rise toward a normal 3.5% or so.  Is the cure worse than the disease, at this point?

Lately, the money authorities seem to be expressing a second worry.  Suppose the emergence of inflation-beating wage gains isn’t the reliable indicator it’s thought to be.  If so, the Fed may be distorting the fixed income market–and buying trouble down the road–for no good reason.

Why would sub-inflation wage gains be the norm, even in an expanding economy?

Maybe in past economic cycles, high wage gains were caused mostly by the tendency of union contracts to index wages for inflation, not by overworking headhunters.  Maybe the psychology of managements penciling in inflation-plus or simply inflation-matching annual wage increases for the workforce has gone by the boards in a world that has experienced two ugly recessions–the more recent one an epic decline–since the turn of the century.  …sort of in the way inflationary expectations have disappeared from the minds of current workers.  Again, if so, maybe interest-rate normalization should happen at a faster pace than currently planned.

We’ll likely hear more on this topic as this week’s meeting gets under way.