The news on Friday that the Bank of Japan had joined the ECB in pushing policy rates negative was absorbed with brilliant enthusiasm on Wall Street. At least, much of the attribution for the exceptional rally was given to the BoJ’s move. I find it implausible, arguably silly, to think that a marginal change in monetary policy by a desperate central bank on the other side of the world – however unexpected – would have a massive effect on US stocks. Subsequent trading, which has reversed almost all of that ebullience in two days, suggests that other investors also may agree that just maybe the sorry state of earnings growth rates in this country, combined with a poor economic outlook and still-lofty valuations, should matter more than Kuroda’s gambit.
To be sure, this is a refrain that Ben Bernanke (remember him? Of helicopter infamy?) was singing last month, before the Federal Reserve hiked rates impotently, and clearly the Fed is investigating whether negative rates is a “tool” they should add to their oh-so-expansive toolbox for fighting deflation.
Scratch that. The Fed no longer needs to fight deflation; inflation is at 2.4% and rising. The toolbox the Fed is interested in adding to is the one that contains the tools for goosing growth. That toolbox, judging from historical success rates, is virtually empty. And always has been.
Back to Japan: let me point out that if the BOJ goal has been to extinguish deflation, it has already done so. The chart below (source: Bloomberg) shows core inflation in Japan for the last 20 years or so. Abstracting from the sales-tax-related spike, core inflation has risen fairly steadily from -1.5% to near 1.0% since mid-2010.
They did this, very simply, by working to accelerate money supply growth from the 1.5%-2.0% growth that was the standard in the late pre-crisis period to over 4% by 2014 and 2015 (see chart, source: Bloomberg).
Not rocket science, folks. Monetary science.
Now, recently money supply growth has begun to fall off, so the BoJ likely was concerned by that and wants to find a way to ensure that inflation doesn’t slip back. If that was their intention, then cutting rates was exactly the wrong thing to do. The regression below (source: Bloomberg) illustrates in a different way what I have shown here before: interest rates and money velocity are closely tied (as Friedman explained decades ago). The r-squared of this relationship – assuming that functionally a linear fit is appropriate, which I am not sure of – is a heady 0.822.
You may notice the data is from the US; that’s because Bloomberg doesn’t have a good velocity series for Japan’s M2 but the causal relationship is the same: lower term interest rates imply less reason not to hold cash.
Now, it may be the case that this relationship ceases to apply at negative rates even though the idea is based on the relative difference between cash yielding zero and longer-term investments or consumption alternatives. The reason that velocity might behave differently at sub-zero rates is that people respond asymmetrically to losses and gains. That is, the pleasure of a gain is dominated by the pain of the same-sized loss, in most people. This cognitive bias may cause savers/investors to behave strikingly different if they are charged for deposits than if they are merely paid zero on those deposits (even if zero is lower than other available rates). In that case, we might see a spike in money velocity once rates go through zero as cash balances become hot-potatoes, just as if investment opportunities suddenly appeared. And rates, not just overnight but term rates, just went negative in Japan. The chart below (source: Bloomberg) shows the 5y JGB rate.
- The speculation that sub-zero rates might cause a rise in velocity is just that: speculation. There’s no data to suggest that this effect exists.
- Frankly, I suspect it doesn’t, but it’s possible. However, if it does I would expect it to be a spot discontinuity in the relationship between rates and velocity. That is, the behavior should change between 0% and some negative rate, but then be somewhat linear thereafter. Cognitively, the reaction is both a general loss aversion, which is linear but no different at negative rates from zero, and a behavioral “endowment” reaction that is to the “taking” of money from a person and not necessarily related to the size of the theft.
- If it does exist, it still doesn’t mean that cutting rates to a negative rate was wise. After all, quantitative easing has done a fine job of pushing up inflation, and so there is no reason to take a speculative gamble like this to keep inflation moving higher. Just do more of the same. Lots more.
- More likely, the BoJ is doing this because they believe that negative rates will stimulate growth. This is much more speculative than you might think, and I may be overgenerous in phrasing the point that way. In any case, any growth benefit would stem either from weakening the currency (which QE would also do, with less risk) or from provoking investment in more marginal ventures that become acceptable at lower financing rates. We call that malinvestment, and it isn’t a good thing.
- Whatever the point of the BoJ’s move, the size of any growth effect from currency reactions is utterly dependent on the reaction function of trading counterparties. If other countries seek to devalue their currencies as well, then the whole operation will be inert.
So, will the BoJ’s move save US stocks? Heck, it won’t even save the Japanese economy.
Today I presented our 2016 inflation forecast to the investment committee for a multifamily office, and when I was putting the presentation together I developed one slide that really is a must-see for investors in my opinion.
For some time, TIPS have been too cheap. Really, it has been more than a year that our metrics have shown inflation-linked bonds as not just cheap, but really cheap compared to nominal bonds. I don’t mean that real yields will fall – so this isn’t a statement about whether I am bullish or bearish on fixed-income. Frankly, I am somewhat conflicted on that point at this moment.
Rather, it is a statement about what sort of fixed-income instruments to own, for that part of your portfolio that needs to be in fixed-income. If you are running a diversified portfolio, then you can’t really avoid owning some bonds even if you are bearish on the bond market. For risk-reduction reasons if for no other, it makes sense to own some bonds.
But you don’t have to own fixed-coupon nominal bonds (or, for that matter, floating-coupon nominal bonds which are still exposed to inflation through the principal of the instrument). In fact, right now it is hard for me to imagine betting on nominal bonds for the portion of my portfolio that is in fixed-income.
A picture is worth a thousand words, so here is the picture:
The chart shows rolling, compounded 10-year inflation rates for as far back as we have reasonable data. And it shows the current level of 10-year inflation “breakevens.” What this means is that if you are long Treasuries, rather than TIPS, you will do better over the next ten years if inflation is below 1.34% and above roughly zero. If we have big deflation, TIPS will do just about as well since they are also principal protected; if we have any inflation over 1.34%, TIPS will do better.
And as the chart points out, since the Fed has been formed we have literally had almost zero 10-year periods in which inflation was in the 0-1.34% zone. Perhaps the 10-year periods ending early in the Great Depression, en route to big deflation, or coming out of the Great Depression heading into WWII. But otherwise, inflation has always been either higher or, in a Fed-screw-up scenario, much lower.
Put another way, it means that if you choose to own nominal bonds instead of inflation-linked bonds for the next 10 years, you are short a straddle on inflation, and you’re not being paid much to be short it. (Technically, you’re short a zero-cost ratio call spread since you don’t lose in deflation, but I’m trying to keep it simple!)
There may be tactical reasons to prefer nominal bonds to inflation-linked bonds. But to me, there is no clear strategic reason to be long nominal bonds for that portion of your portfolio that you intend to keep in fixed-income.
Economics is too important to be left to economists, apparently.
When the FOMC minutes were released this afternoon, I saw the headline “Some FOMC Members Saw ‘Considerable’ Risk to Inflation Outlook” and my jaw dropped. Here, finally, was a sign that the Fed is not completely asleep at the wheel! Here, finally, was a glimmer of concern from policymakers themselves that the central bank may be behind the curve!
Alas…my jaw soon returned to its regular position when I realized that the risk to the inflation outlook which concerned the FOMC was the “considerable” risk that it might fall.
A quick review is in order. I know it is a new year and we are still shaking off the eggnog cobwebs. Inflation is caused (only) when money growth is faster than GDP growth. In the short run, that holds imprecisely because of the influence of money velocity, but we also have a pretty good idea of what causes money velocity to ebb and flow: to wit, interest rates (more precisely, investment opportunities, which can be simply modeled by interest rates but more accurately should include things such a P/E multiples, real estate cap rates, and so on). And in the long run, velocity does not continue to move permanently in one direction unless interest rates also continue to move in that direction.
It is worth pointing out, in this regard, that money growth continues to swell at a 6.2% domestically over the last 12 months, and nothing the Fed is currently contemplating is likely to slow that growth since there are ample excess reserves to support any lending that banks care to do. But it is also worth pointing out that inflation is currently at 7-year highs and rising, as the chart below (source: Bloomberg) shows.
Core inflation is also rising in Japan (0.9%, ex-food and energy, up from -0.9% in Feb 2013), the Eurozone (0.9% ex-food and energy, up from 0.6% in January 2015), and recently even in the UK where core is up to 1.2% after bottoming at 0.8% six months ago. In short, everywhere we have seen an acceleration in money growth rates, we are now seeing inflation. The only question is “why has it taken so long,” and the answer to that is “because central banks held interest rates, and hence velocity, down.”
In other words, as we head towards what looks very likely to be a global recession (albeit not as bad as the last one), we are likely to see inflation rates rising rather than falling. The only caveat is that if interest rates remain low, then the uptick in inflation will not be terrible. And interest rates are likely to remain relatively low everywhere, especially if the Fed operates on the basis of its expectations rather than on the basis of its eyeballs and holds off on further “tightenings.”
Because the Fed has really put itself in the position where most of the things it would normally do are either ineffective (such as draining reserves to raise interest rates) or harmful (raising rates without draining reserves, which would raise velocity and not slow money growth) if the purpose is to restrain inflation. It would be best if the Fed simply worked to drain reserves while slack in the economy holds interest rates (and thus velocity) down. But that is the sort of thinking you won’t see from economists but rather from engineers looking to get Apollo 13 safely home.
Want to try and get Apollo 13 safely back home? Go to the MV≡PQ calculator on the Enduring Investments website and come up with your own M (money supply growth), V (velocity change), and Q (real growth) scenarios. The calculator will give you a grid of outcomes for the average inflation rate over the period you have selected. Remember that this is an identity – if you get the inputs right, the output will be right by definition. Some numbers to remember:
- Current velocity is 1.49 or so; prior to the crisis it was 1.90 and that is also the average over the last 20 years. The all-time low in velocity prior to this episode was in the 1960s, at about 1.60; the high in the 1990s was 2.20.
- As for money supply growth, the y/y rate plunged to 1.1% or so after the crisis and it got to zero in 1995, but the average since 1980 including those periods is roughly 6% where it is currently. Rolling 3-year money growth has been between 4% and 9% since the late 1990s, but in the early 80s was over 10% and it declined in the mid-1990s to around 1%.
- Rolling 3-year GDP growth has been between 0% and 5% since the 1980s. In the four recessions, the lows in rolling 3-year GDP were 0.2%, 1.7%, 1.7%, and -0.4%. The average was about 3.9% in the 1980s, about 3.2% in the 1990s, about 2.7% in the 2000s, and 1.8% (so far) in the 2010s.
Remember, the output is annualized inflation. Start by assuming average GDP, money growth, and ending velocity for some period, and then look at what annualized inflation would work out to be; then, figure out what it would have to be to get stable inflation or deflation. You will find, I think, that you can only get disinflation if money growth slows remarkably (and unexpectedly) and velocity remains unchanged or goes to new record lows. Try putting in some “normal” figures and then ask yourself if the Fed really wants to get back to normal.
And then ask yourself whether you would want Greenspan, Bernanke, and Yellen in charge of getting our boys back from the moon.
I almost never do this, but I am posting here some remarks from another writer. My friend Andy Fately writes a daily commentary on the FX markets as part of his role at RBC as head of US corporate FX sales. In his remarks this morning, he summed up Yellen’s speech from yesterday more adroitly than I ever could. I am including a couple of his paragraphs here, with his permission.
Yesterday, Janet Yellen helped cement the view that the Fed is going to raise rates at the next FOMC meeting with her speech to the Washington Economic Club. Here was the key paragraph:
“However, we must also take into account the well-documented lags in the effects of monetary policy. Were the FOMC to delay the start of policy normalization for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession. Moreover, holding the federal funds rate at its current level for too long could also encourage excessive risk-taking and thus undermine financial stability.” (Emphasis added).
So after nearly seven years of zero interest rates and massive inflation in the size of the Fed balance sheet, the last five of which were in place after the end of the Financial Crisis induced recession, the Fed is now concerned about encouraging excessive risk-taking? Really? REALLY? That may be the most disingenuous statement ever made by a Fed Chair. Remember, the entire thesis of QE was that it would help encourage economic growth through the ‘portfolio rebalancing channel’, which was a fancy way of saying that if the Fed bought up all the available Treasuries and drove yields to historic lows, then other investors would be forced to buy either equities or lower rated debt thus enhancing capital flow toward business, and theoretically impelling growth higher. Of course, what we observed was a massive rally in the equity market that was based largely, if not entirely, on the financial engineering by companies issuing cheap debt and buying back their own shares. Capex and R&D spending have both lagged, and top-line growth at many companies remains hugely constrained. And the Fed has been the driver of this entire outcome. And now, suddenly, Yellen is concerned that there might be excessive risk-taking. Sheesh!
Like Andy, I have been skeptical that uber-dove Yellen would be willing to raise rates unless dragged kicking and screaming to that action. And, like Andy, I think the Chairman has let the market assume for too long that rates will rise this month to be able to postpone the action further. Unless something dramatic happens between now and the FOMC meeting this month, we should assume the Fed will raise rates. And then the dramatic stuff will happen afterwards. Actually I wouldn’t normally expect much drama from a well-telegraphed move, but in an illiquid market made more illiquid by the calendar in the latter half of December, I would be cutting risk no matter which direction I was trading the market. I expect others will too, which itself might lead to some volatility.
There is also the problem of an initial move of any kind after a long period of monetary policy quiescence. In February 1994, the Fed tightened to 3.25% after what was to that point a record period of inaction: nearly one and a half years of rates at 3%. In April 1994, Procter & Gamble reported a $102 million charge on a swap done with Bankers Trust – what some at the time said “may be the largest ever” swaps charge at a US industrial company. And later in 1994, in the largest municipal bankruptcy to that point, Orange County reported large losses on reverse repurchase agreements done with the Street. Robert Citron had seen easy money betting that rates wouldn’t rise, and for a while they did not. Until they did. (It is sweetly sentimental to think of how the media called reverse repos “derivatives” and were up in arms about the leverage that this manager was allowed to deploy. Cute.)
The point of that trip down memory lane is just this: telegraphed or not (it wasn’t like the tightening in 1994 was a complete shocker), there will be some firms that are over-levered to the wrong outcome, or are betting on the tightening path being more gradual or less gradual than it will actually turn out to be. Once the Fed starts to raise rates, the tide will be going out and we will find out who has been swimming naked.
And the lesson of history is that some risk-taker is always swimming naked.
Whoever is selling stocks these days is really appreciative of those who are pushing the market higher. Thanks to overnight rallies in China and Japan on Tuesday night, US stocks launched higher at the open on Wednesday. Now, neither the modest rally in Shanghai (led by official buying) and the bigger rally in Japan (on Prime Minister Abe’s pledge to cut corporate taxes next year) had the slightest thing to do with items that impact the US, but the rally led a wave that rolled through futures markets around the globe until about seven minutes after traditional stock trading hours opened in New York, when the high of the day was set. The next six-and-a-half hours saw a 440-point decline in the Dow and around 50 in the S&P to a net loss of about 1.4% on the day.
“Gee, thanks!” said the pension fund guys who got to unload stocks about 3% higher than they otherwise would have. Who says the fast money monkeys don’t have salutatory effects?
The clue that today’s rally was not going to be sustained was actually in the energy markets. Prior equity oscillations had been mirrored with quite reasonable fidelity in the last week or two, but this morning energy markets were noticeably flat-to-down. Equities soon joined them.
Now, yesterday I mentioned that real yields are near their highest levels of the last five years, and that nominal yields are essentially in the middle of that range. I didn’t illustrate the latter point; but see below (source: Bloomberg).
So it is clear, to me, where you would rather place your bets in fixed-income: with real yields around 65bps and nominal yields at 2.20, you only want to own nominal bonds if inflation is less than 1.55% for ten years. Note that if inflation is negative, then you do approximately the same with TIPS as with nominal bonds, since in both cases your nominal principal is preserved. So it is a narrow set of circumstances in which you do better owning nominals, and you don’t do much better. On the other hand, there are long tails on the other side: ways that by owning TIPS you will do dramatically better.
I mention this, even though both nominal bonds and TIPS offer poor prospective returns, because it is the time of year when seasonally it is difficult to lose by owning fixed-income. The chart below (source: Bloomberg) shows the average change in nominal 10-year yields over the course of a calendar year for the last 30 years (gold), 10 years (white), and 5 years (red). Note that this isn’t a pure seasonal chart because it doesn’t correct for the average drift over the course of the year, but it suffices to show that buying bonds after the early-September backup has been a good strategy for many years…really, until the last five years, and even then it was a push between mid-Sep and mid-Nov.
So what I want to do in a period of uncertainty, headed into the fourth quarter, is to own TIPS, either outright or via an ETF like TIP. If the market comes unglued, then all interest rates should decline; if the market drops because real growth is weakening, then real rates should fall more than nominal rates (and in any event, owning TIPS gives you the positive tail exposure I mentioned above). If the market turns around and rallies, then energy probably recovers somewhat and this will help TIPS compared to nominals. But in any event, I am reducing risk into a very risky period.
Let us begin with this: there is nothing inherently healthy about a series of +2% and -2% days within a range.
Having some grey hair (just a little!) is helpful in times like these because markets go through repetitive phases and it helps to have some historical comparisons to be able to guide an investor. At the same time, experience can be limiting if we try to force everything we are seeing into a particular historical comparison.
So, for example, I never view with anything but amusement the charts of day-by-day comparisons between this year’s market action with, say, that of 1929. Or, as another example I have seen: comparing a market to the Nikkei crash in the early 1990s. These are interesting an amusing market parallels, but there is no road map to markets. There is only a contour map.
The contours of this market are reminiscent to me of the end of the tech-led bull market in 2000. The valuation parallels are obvious, but I am not talking about that. In 2000, as the market crested in March and began to head lower, we started to have very large overnight moves – sometimes higher, sometimes lower – followed often by a sharp open, directionless trading during the day, and often a sharp move at the close. This was the signature of fast money, which tends to get more timid during the daylight but which enjoys monkeying about with buy and sell stops overnight. In general, as the market headed lower, it seemed like Mondays tended to be pretty good, and Fridays tended to be pretty bad as no one wanted the weekend risk. There was a lot of volatility, and some spectacular up days. But month after month, the market was more likely to end the month lower than it began.
I think we are in that mode again, although it is hard to tell if we have anything like that kind of bear market ahead of us. Certainly, we can make that point valuation-wise. Also, interest rates have much more room to move higher from here than to move lower. While I think the economy is slowing, and any Fed action is likely to be small, tentative, and probably delayed, my point is that interest rates are not likely to provide a following wind to valuations.
Indeed, while nominal interest rates are still locked near 2% on the 10-year note, real interest rates are near the highest levels in five years (see chart of 10-year real interest rates, source Bloomberg).
The flip side of stable nominal interest rates and rising real rates, of course, is declining inflation expectations. By our calculations, the market is currently implying core inflation to be below the Fed’s target for at least a decade. And this is despite the fact that, measured by median inflation, it is already at target.
I once believed that the Fed could not really control long-term interest rates, although at least in principle they can control Treasury rates like they did in WWII, by simply buying or selling whatever it takes to keep rates at their target (it was easier then, as the market was a lot smaller!). And I guess that, deep in my gut, I still believe that. But I must admit that the evidence that they can control nominal interest rates, at least in normal times (that is, when the weight of the market doesn’t strenuously disagree), is starting to look pretty strong. There is absolutely no rationale for 10-year nominal interest rates at 2% in an environment where real interest rates are 0.65%, current inflation is 2.3%, and there is a large amount of money in circulation – with no plans in place to drain it.
(For anyone claiming a fear of deflation, I just shake my head in disbelief. Choose: Do you want to be a monetarist, in which case you have to construct a case for deflation from 6+% money growth and money velocity that is already at levels below any previously measured; or do you want to be a Keynesian and explain how you get deflation with unemployment at 5.1%? The third way is hand-waving, claiming that large amounts of debt lead mystically to deflation. But large amounts of public debt have never led to deflation in the past, and there is no obvious mechanism for it to do so.)
My reading of the contour map suggests a market valley ahead. It is a deep valley, but the good news is that there is a mountain on the other side of it. There always is.
I may have the lay of the land wrong, but I have been over this ground before. Watch your step.
I really enjoy reading, and listening to, Rob Arnott of Research Affiliates. He is one of those few people – Cliff Asness is another – who is both really smart, in a cutting-edge-research sense, and really connected to the real world of investing. There are only a handful of these sorts of guys, and you want to align yourself with them when you can.
Rob has written and spoken a number of times over the last few years about the investing implications of the toppling of the demographic pyramid in developed markets. He has made the rather compelling point that much of the strong growth of the last half-century in the US can be attributed to the fact that the population as a whole was moving through its peak production years. Thus, if “natural” real growth was something like 2%, then with the demographic dividend we were able to sustain a faster pace, say 3% (I am making up the numbers here for illustration). The unfortunate side of the story is that as the center of gravity of the population, age-wise, gets closer to retirement, this tailwind becomes a headwind. So, for example, he figures that Japan’s sustainable growth rate over the next few decades is probably about zero. And ours is probably considerably less than 2%.
He wrote a piece that appeared this spring in the first quarter’s Conference Proceedings of the CFA Institute, called “Whither Bonds, After the Demographic Dividend?” It is the first time I have seen him tackle the question from the standpoint of a fixed-income investor, as opposed to an equity investor. I find it a compelling read, and strongly recommend it.
Don’t miss the “Question and Answer Session” after the article itself. You would think that someone who sees a demographic time bomb would be in the ‘deflation’ camp, but as I said Rob is a very thoughtful person and he reaches reasonable conclusions that are drawn not from knee-jerk hunches but from analytical insights. So, when asked about whether he sees an inflation problem, or continued disinflation, or deflation over the next five years, he says:
“I am not at all concerned about deflation. Any determined central banker can defeat deflation. All that is needed is a printing press. Japan has proven that. Japan is mired in what could only be described as a near depression, and it still has 1.5% inflation. So, if a central bank prints enough money, it can create inflation in an economy that is near a depression.”
This, more than anything else, explains why keeping interest rates low to avert deflation is a silly policy. If deflation happens, it is a problem that can be solved. Inflation is a much more difficult problem to solve because collapsing the money supply growth rate runs counter to political realities. I don’t think this Fed is worried about inflation at all, and they’re probably not worried too much about deflation either any longer. But they believe they can force growth higher with accommodative monetary policy, when all available evidence suggests they cannot. Moreover, Arnott’s analysis suggests that we are probably already growing at something near to, or even above, the probable maximum sustainable growth rate in this demographic reality.
Maybe we can get Arnott on the Federal Reserve Board? Probably not – no one who is truly qualified for that job would actually want it.
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