Tag Archives: interest rates

Alice and the White Queen

Is the market trying to believe impossible things?

Illustration: John Teniel. Source: Wikipedia

A classic “children’s” book – that isn’t really for children – is Lewis Carrol’s Through the Looking Glass, his sequel to Alice in Wonderland. In the book, Alice and the White Queen have this exchange:

“There’s no use trying,” Alice said. “One can’t believe impossible things.”

“I daresay you haven’t had much practice,” said the Queen. “When I was younger, I always did it for half an hour a day. Why, sometimes I’ve believed as many as six impossible things before breakfast.”

Sometimes the market confronts us with what seems like impossible issues – things that appear to be part of the market’s calculation, but things that we know to be impossible. Here are a few:

The bond market is priced as if low inflation and negative real rates will be with us forever. Negative rates in Europe and Japan are the most egregious examples. In Germany, the 2-year Government bond yields minus 0.75%. In Switzerland it’s minus 1%, in Japan minus 0.1%. But even in emerging markets, stable, low inflation is expected. Colombian 10-year bonds yield 3.5%; Hungary yields 3%; South Korean (bordering a rogue nuclear power) yields 2.1%. The deep and liquid government bond market is assuming that inflation will never come back – even in emerging markets with a history of populism and hyperinflation. Hungary experienced the highest rate of inflation ever recorded in the 1940s: 200% per day.

Photo: Mizerák István. Source: National Museum, Budapest

Second, the Big Five tech stocks are priced as if they are unassailable. In the short run, this is clearly true. Facebook enjoys network effects: people join Facebook because other people are using it. Kids’ sports teams, local VFW Chapters, labor unions, and nonprofits all use Facebook to share information. Google uses information from billions of searches and clicks every day to improve its search algorithm – making it even more attractive as a search engine. Amazon does the same thing with purchase information – making online shopping ever-easier.

But size ultimately defeats itself. Large corporations become bureaucratic and layered. Rules that once made sense in a limited context become institutionalized and universal. And perhaps most importantly, the incentives to work for a large corporation are different than those presented by a small company. That’s why Steve Ballmer left a good job and P&G to be Microsoft’s 30th employee. It’s not about the pay, it’s about the autonomy – and doing something new that can change the world. And eventually big companies run into physical limits to growth. Mark Zuckerberg has said that projects aren’t really interesting unless they can impact at least billion users. But just there aren’t that many billion-consumer projects.

Finally, market participants seem to believe that cash is a source of stability – both in the economy, and within corporations. Certainly, in the short-run, this is true. Cash is a key element of credit risk. If you want a $1 million loan, it’s helpful to have $2 million in cash on hand. And cash is currently quite high, both as a percentage of our economy and total nonfinancial debt.

Source: GMO, Federal Reserve

But in the long run, cash is a source of instability. Among governments, excess cash holdings inspire envy, leading to external threats and internal dissention. Income inequality doesn’t usually bother people when the income is earned. No one singles out entrepreneurs who work hard and create something new as plutocrats. They created something totally new.

Similarly, within corporations, big piles of cash on the balance sheet can lead otherwise sensible managers to do something stupid. They didn’t get to be managers through their timidity – they usually have a healthy combination of charm, ability, and animal spirits. If they’re successful in business, high returns on equity eventually lead to excess cash, posing a temptation to them – or outsiders, who want to “unlock” that value. Accumulated cash is like a dragon’s hoard, inspiring irrational conflict and delusional dreams.

Illustrator: Arthur Rackham. Source: Wikipedia.

In order to believe that the market is truly efficient, you have to believe these “impossible” things. Of course, they aren’t impossible. Just not very probable. Eventually, growth and inflation will come back – especially in the developing world. The temptations of populism and deficits are just too much. Eventually, large companies will yield to small companies as the engines of innovation. Eventually, cash hoards will be dispersed. We just don’t know how long it will take.

It’s not comfortable to consider multiple scenarios with uncertain outcomes in our investment portfolios, but as Voltaire once noted, “Doubt is not a pleasant condition. But certainty is absurd.”

Douglas R. Tengdin, CFA

Dissent and Dysfunction?

Does the Federal Reserve need to do some team-building?

Federal Reserve “Dot Plot.” Source: Federal Reserve

As expected, the Fed did not increase their interest rate target. Instead, they decided to wait for further progress in the economy. In her prepared remarks, Janet Yellen emphasized that their decision doesn’t reflect a lack of confidence in the economy. Rather, she noted, the pace of hiring in the labor market seems to have slowed, and inflation is still running below 2%.

In their projections for economic growth, the Fed downgraded 2016 from 2.0% to 1.8%. That’s a nod to reality. So far this year we’ve grown at less than 1%. It’s not likely that the economy will boom in the second half of the year. Indeed, read GDP looks decidedly soft.

Source: Bureau of Economic Analysis

Despite our “blah” economy, three FOMC members dissented: Esther George–who always seems to want tighter money—along with Boston Fed President Eric Rosengren and Cleveland President Loretta Mester. Rosengren has been saying he’s concerned that the Fed will get behind the curve on inflation, and have to hike rates rapidly—as they did in 1994. That would be much more disruptive than a more gradual increase. Mester’s dissent is interesting: it reminds us that she’s generally hawkish, and would have voted to raise rates in June if not for the Brexit vote.

Despite Fed and press efforts to play down the disagreement, three dissents at a Fed meeting is a big deal. It’s the most that I’ve ever seen—and a far cry from the consensus-driven Fed that characterized the Greenspan era. All three dissenters wanted to raise rates. As one observer put it, this is as close the Fed could come to raising rates without raising them.

Source: St. Louis Fed

Looking at all the materials it’s clear that there are three hawks on the board—yesterday’s dissenters. But they’re balanced by three strong doves: Brainard, Powell, and Tarullo. That leaves only six FOMC members in the middle—not even a majority.

The Fed isn’t the Supreme Court: decisions aren’t just yes-or-no, and dissenters don’t have to explain their opinions. But Janet Yellen is leading the most contentious Fed in decades. She noted in her press conference that the Fed doesn’t suffer from group-think. That’s an understatement.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Irrelevant Federal Reserve

What if they had a Fed meeting and nobody cared?

Janet Yellen at her press conference. Source: Federal Reserve

The FOMC had been trying to talk up rates for the past two months. Some notable policy doves were commenting that the market had it wrong—that interest rate expectations were too low, and that we should expect two or three rate hikes this year. Even Chair Yellen got in on the act. In May, she noted that long as the economy continues on-track, the Fed would continue to normalize rates.

FOMC Member “Dot Plot” 6-15-16. Source: Federal Reserve

That was then, this is now. The employment report threw a big bucket of cold water on those plans. The latest report was “disappointing,” Yellen noted. There has been a loss of economic momentum. While we shouldn’t pay too much attention to one data point, they can’t ignore broad economic indicators that are cautionary. Yellen claims that the Fed is data-dependent. So when dovish data come in, they have to re-think their position.

So who’s in charge? During a two-minute period in her press conference, she used the word “uncertain” or “uncertainty” at least five times. The Fed and the market are on the dance floor, but neither knows whether to put their hand on their partner’s shoulder or around their waist. No one knows who’s leading.

Illustration: Henriq Bastos. Source: Morguefile

All the Fed officials have been talking about normalizing rates. But their talk is aspirational: it’s more about the Fed’s hopes, and less about their plans. They aren’t leading, but they do have a $5 trillion balance sheet and an unlimited checkbook. That’s more than anyone else. We don’t want to get on the wrong side of that.

As long as we’re stuck in a slow-growth economy with no growth in manufacturing, mining, and energy jobs, we’ll feel unsettled. Janet Yellen claimed yesterday that every meeting is live, that rate changes are always possible. But given the lack of leadership, it seems that the Fed is increasingly irrelevant.

Douglas R. Tengdin, CFA

Chief Investment Officer

Pension Problems

What’s wrong with our retirement system?

State pension funding ratios. Source: Governing.com

It used to be that firms offered pensions as an employment benefit. They were structured to reward employee loyalty—the longer you stayed at a company, the higher the payout ratio when you retired. Then came the ‘70s and ‘80s, with massive restructuring and layoffs. What good was loyalty when the firm wasn’t loyal to you? Workers lost a good deal of their benefits, through no fault of their own.

So pensions and retirement savings became mobile, through IRAs and 401(k)s. Now retirement savings follows the workers, and the only penalty comes if you withdraw the funds early. The main source of pensions is now the government—an employer not subject to leveraged buyouts or a hostile takeover—we hope.

But there’s a problem with public pensions. The States haven’t set aside enough money to fund them. Different states vary by how responsible they’ve been—Illinois is the worst, and Wisconsin and Washington the best, as can be seen above. New Hampshire’s funding level is pretty bad. Why is this?

Source: Conversable Economist

All pensions are local, but the States now find themselves in the position they were in the early ‘50s. The unfunded liabilities, in aggregate, are equal to about 80% of annual revenue. That’s a lot. And the pensions are fixed obligations—similar to debt in terms of payment priority.

Pension funding worsened dramatically after the 2008 financial crisis partially because the stock market went down, but also because interest rates fell. When rates fall, the future obligation goes up. After the dot-com boom, States should have re-allocated their investments into a lot of 30-year government bonds. Instead, we saw everyone jumping on the alternative investment—hedge fund—private equity—venture capital train. Bonds were boring. But if they had gone with boring bonds, we’d all be a lot better off.

S&P 500 and Gov’t bond returns since 12/31/99. Source: Bloomberg

What’s to be done, now? Different States will approach the problem in different ways. Some folks have floated pension obligation bonds, borrowing from the bond market to invest in the stock market. That may work, long-term, since rates are so low now, but it’s risky. And it doesn’t’ satisfy any immediate revenue needs. One approach would be to apply a “pension surtax” to other revenue sources—to recognize that unfunded obligations are obligations, and you can’t borrow your way to prosperity. But there’s not much political consensus around new taxes. Or, the States could try to privatize their pensions—paying the present value into retirement savings accounts. But that would be another political nightmare.

We’ve got a problem: stormy markets ahead, low interest rates inflating future benefit obligations, and limited prospects for more revenue. We have to remember, though: we—through our leaders—made these pension promises. We have to keep them.

Douglas R. Tengdin, CFA

Chief Investment Officer

Interest Rates, Janet Yellen, and The Bard

What did the Fed just do?

Narrowly considered, the Fed simply changed the wording in their periodic statement, announcing that the range for inter-bank interest rates—Fed Funds—would go from zero to .25% to .25% to .5%. In other words, the rate will move from “essentially zero” to “almost zero.” Practically, if a bank borrows $1mm from another bank overnight, they’ll have to pay $13.89 rather than $6.94. You could almost call this the “Macbeth” interest rate move: full of sound and fury, signifying—nothing.

But it’s not really nothing. Rate increases are like potato chips: the Fed can’t do just one. They’ve started to raise rates 12 times since World War II. In 11 of those 12 times, they’ve kept going until the economy tanked. That’s why Chair Yellen was at pains to emphasize the moderate pace of rate increases she and the Committee expect to take. Between the official statement, her opening remarks, and the subsequent Q&A session, Yellen used the world “gradual” or “gradually” at least 10 times. Message sent.

And it appears that the message was received. Normally, the stock market falls when the Fed raises rates. But this time stocks rallied: the Dow rose over 200 points; the S&P and Nasdaq went up 1.5%; stocks in Europe and Asia rose over 2%. Even bonds did well. After some volatility, the 10-year US Treasury note now yields roughly what it did three days ago, and less than it did a month ago.

What’s next? It all depends on the economy. If we continue to live in a slow-growth, low-inflation world, nothing much will change. Consumers will keep spending, companies will keep hiring, markets will expand. But it never works out that way. Something unexpected will come along that shocks us. How efficiently our economy adjusts, how resilient we are—to borrow another line from Shakespeare—that is the question.

Douglas R. Tengdin, CFA

Chief Investment Officer

“We Have Liftoff”?

“We Have Liftoff?”

What happens when the Fed starts to raise rates?

Photo: Kim Shiflett. Source: NASA

Many investors are worried about the value of their bond portfolios. When interest rates rise, bond prices fall. It’s simple mathematics: bonds have a contractual future payment stream, and that payment stream isn’t worth as much when the discount rate rises. With the Fed now poised to raise rates, their portfolios may be at risk. As a result, many investors have shifted to short-term bonds, because short-term bonds are less sensitive to interest rates than long-term bonds.

But just because some interest rates rise doesn’t mean they’ll all go up. It depends on the type of bond, the credit quality, and when the bond matures. All bonds carry a certain degree of credit risk; there’s always a chance that the issuer won’t be able to pay its obligations on time. As the economy improves, the risk of default goes down. And long term bonds are different than short term bonds. Inflation risk is a much bigger issue. When the Fed lifts rates, the risk of inflation may actually go down. So even if rates rise in one part of the yield curve, they may not go up elsewhere.

We saw this play the last time the Fed raised rates. Between the end of 2003 and 2006 the Fed increased interbank rates from 1% to 5.25% over the course of two years. The economy was recovering from the dot-com crash, and the Fed moved from an easy policy to a fairly restrictive stance. This was a pretty aggressive set of moves on the Fed’s part.

Fed Funds Rate from 12/31/02 to 12/31/07. Source: Bloomberg

But interest rates didn’t move up uniformly across the curve. The Fed had been pretty clear about its intentions. Then, as now, they were anxious to return monetary policy to a more normal stance. There had been lots of speeches and comments by FOMC members. So the market had largely anticipated rising rates.

Consequently, as the Fed began to increase rates, long-term rates didn’t go up very much. In fact, long-term corporate bond yields actually fell a little bit. It’s hard not to look back at those rates with a little bit of nostalgia: investors could actually receive over 6.5% for a 15-year corporate bond!

BBB Corporate Bonds from 5/31/04 to 7/31/06. Source: Bloomberg

Similar to back then, the Fed has been especially clear about their intentions lately: they want to return monetary policy to a more normal stance, with short-term interest rates close to the rate of inflation. So the bond market has largely anticipated their expected policy actions. Currently, Fed Fund futures imply a 76% probability that the Fed will lift rates at their next meeting.

If they do, it’s quite possible that longer rates will remain stable or even fall. The yield curve could flatten. Sometimes, what seems riskier is actually safer.

Douglas R. Tengdin, CFA

Chief Investment Officer

Money for Nothing Forever?

Why are interest rates so low?

Source: Morguefile

It’s easy to see our ultra-low interest rates and blame the Fed. After all, they set short-term rates; they’re the ones managing the money supply; they’re the ones that oversee the banking system. But interest rates are low everywhere—not just in the US. And real interest rates—the difference between interest rates and inflation—have been falling for decades. Well before the financial crisis, long-term bond yields around the world began falling from 4% above inflation to roughly equal to inflation.

Source: Bank Underground

The low rates we see today would have been unimaginable a generation ago. I remember a friend in the early ‘80s who was thrilled to get a mortgage for only 8%: “We’ll never see that rate again,” her banker told her. Now, however, governments, corporations, and consumers around the world can get money for almost nothing. On the flip side, though, savers get almost nothing for their money. What’s causing this?

There are lots of possible culprits: technology, productivity, slower global growth. But the explanation that makes the most sense to me is one suggested by Ben Bernanke a decade ago: there’s a global savings glut: more people are setting more money aside and there aren’t enough productive ways to put that money to work.

What’s causing this? I see three major issues. First, demographics: people live longer but don’t necessarily work longer. Our life expectancy has risen, but our retirement age hasn’t gone up as much. That means more has to be set aside to pay for a longer retirement period. Second, global wealth: the rising middle class in emerging economies is generating significant amounts of new wealth. Rich and middle-class people save more than poor people. Finally, technology: the infrastructure of economic growth has changed. New industries don’t need as much capital as older industries. It takes more investment to produce concrete and steel than software and fiber optics. Also, code doesn’t pollute the environment—and doesn’t need to be cleaned up.

These are global, long-term trends. They aren’t likely to turn around any time soon—you can’t put the demographic, financial, and technological toothpaste back in the tube. Ultra-low real rates are going to be with us for a long, long time.

Douglas R. Tengdin, CFA

Chief Investment Officer

Going Negative

What’s up with negative interest rates?

Source: CNN

Temperatures aren’t the only thing below zero these days. Around the world bond yields have gone negative. It started a few years ago in the US, when ultra-short Treasury Bills would go negative right around quarter-end. That was understandable as a combination of the Fed’s Zero Interest Rate Policy and institutions needing Treasuries for collateral on swap contracts.

Continue reading Going Negative

Carry On, Mister Trader

Why are bond yields so low?

Source: Daily Telegraph

One of the most surprising market moves of 2014 was the persistent rally in US Treasury Bonds. It wasn’t supposed to be this way. Starting in April of 2013, rates were supposed to normalize. That’s when Ben Bernanke signaled that the Fed would gradually end its bond-buying program known as Quantitative Easing. Continue reading Carry On, Mister Trader

Getting it Right

What did people get wrong in 2014?


Source: Wikipedia

By far the most popular wrong-headed call last year was on interest rates. In late 2013 almost all market-watchers predicted that a stronger US economy and more restrictive Federal Reserve would lead to rising bond yields. Boy, was that a mistake. A year ago 10-year Treasury Notes yielded almost 3%. Now they yield 2 1/4%. So while the stock market in the US has grown by 15% this year, treasuries have risen 5%, corporates 7%, and muni bonds returned almost 9%.

Continue reading Getting it Right