The Big Picture
“Never try to time the bond market, anyone who claims to know the future of interest rates is certifiable” – Jane Bryan Quinn
Fair enough. However, that has not stopped the majority of investors from continuing to try! I no longer can count the number of conversations had regarding interest rates. Mostly on how they simply have to go up! Over 10 years and counting, we remain low.
So I suppose the question is…
How long can interest rates stay low?
The answer may be so very simple, yet it causes considerable discourse. First, interest rates do not have to go up within any certain time frame. We have had much longer periods of low rates than the present. Some lasting decades. Second, while there are issues with low interest rates, it is a low probability we will see a policy change happen quickly. Interest rates will not all of the sudden rise materially. It is more likely that relatively easy policy will continue. Until an economic or market environment becomes untenable, it tends to persevere. Third, unfortunately raising interest rates only goes smoothly under very favorable conditions. Even then it may still be painful for some areas of the economy.
A result… of questionable decisions past.
Alan Greenspan (Chairman of the Federal Reserve from 1987-2006) testified before Congress after the Great Financial Crisis (GFC) in 2008 discussing what he believed was the primary issue that caused the crisis. He went on to say:
“I discovered a flaw in the model that I perceived is the critical functioning structure that defines how the world works.”
Now that is deep. Greenspan’s statement basically revolved around his belief that financial institutions would always have the best interests of the firm and equity-holders at stake. Sure… And they likely thought they did. However that did not mean actions and decisions wouldn’t lead to ruin. Especially others ruin! There is much to unravel there.
One thing surely missing was a better understanding of the darker sides of human nature. Especially greed. As well as the unintended consequences of policy-makers trying to help the economy!
What does any of this have to do with our topic today? More below…
Have a Plan and a Process!
From the Trenches
“I’ve found a flaw” – Alan Greenspan before Congress 2008
So apparently Il Maestro found a flaw in his predilections of how he expected firms to behave. Well… we are all human and make mistakes.
There has been fairly consistent criticism of policy, especially from the Fed. That is nothing new. That said, what if the flaw in thinking, continues to this day?
Policy is a primary theme in managing market expectations. The policy of “artificially low interest rates”, has dominated for over a decade now.
First, what is an artificially low interest rate? The simplest definition would be a rate that is below the normal rate of inflation. If we take the risk-free rate of interest and subtract the rate of inflation, and end up with a rate close to zero or even negative, this is an artificially low interest rate. While we have seen low inflation for many years now, there is some debate about the calculation of inflation. Actual inflation may be higher than advertised. In some areas of the economy we do see much higher inflation than what is reported.
The problems with low interest rates.
What effect do low interest rates have?
- Asset prices, from stocks to real estate, earn a premium in valuation. And a significant one at that! As interest rates decline, the prices of those assets rise (Some may say “how is this a bad thing?”). Well, many would argue that asset bubbles are created. An observation not easily dismissed.
- Savers, or those more dependent on fixed income, are faced with the decision to either cut spending or increase their risk objectives to potentially earn higher returns. This affects retirees significantly. Not an ideal set of decisions for this demographic.
Fixed income securities become severely miss-priced! Overall traditional fixed income has become a drag on portfolio performance. Especially over the last couple of years as inflation is running well above most fixed yields. The generational impact of this dislocation will very likely prove catastrophic! Investors are left with the conundrum of how to manage their overall risk exposures. While there are solutions, we witness most investors simply increase their risk without fully understanding the undertaking.
Bottom Line: Policy has severely skewed the market environment of risk. The longer these conditions persist, the greatest damage done is to investors beliefs and expectations.
“Creative people tend to pass the responsibility of getting down to the brass tacks to others.” -Theodore Levitt
What Professor Levitt was referring to was the different traits between the creative and the productive. Or the theoretical with the practical. Or as I will refer to it here, the modeled versus the real world. (recall Greenspan’s “model”)
The flaw that I continue to see is policy-maker’s belief that they can achieve their desired outcome after over a decade of trying and failing. The flaw is the model itself! After over 10 years, the results in the real world are quite clear.
- The Fed has not created the growth in the economy desired.
- The Fed has not achieved the inflation level desired.
- The Fed continues to babble on with the nonsense that they will be successful eventually. It’s always right around the corner…
Current Chairman of the Fed, Jerome Powell. Spreading the wealth?
The Flaw here is the continued belief that the same approach will bring an ever-elusive result. Or as Einstein put it, the definition of insanity.
The policy line is yet again approaching with some urgency. The Fed, for the (I can’t recall how many times now) will be considering a tapering (i.e. tightening) policy over the coming months.
Bottom Line: How will Powell turn the tide that his predecessors attempted repeatedly and failed? We shall see soon enough.
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