Short-term interest rates remain frozen near the sub-zero mark. And it feels like a very frigid winter coming. So much time has passed, Ben Bernanke, the savior of our financial system in 2008, has now been reduced to the thorn of savers across the country; if this situation continues he’ll be burned in effigy on the steps of the stately and dignified Federal Reserve Building in Washington, D.C.
And in a way, if you consider the media and most of the population with checking and/or savings accounts, he already has been burned at the stake for keeping rates artificially low for so long. People ask: Has he lost it? What possibly could be the reasons to keep the foot on the gas of easy money for the longest period in U.S. history?
From CNBC pundit and former Federal Reserve Staff Economist Larry Kudlow to your Aunt Marie shaking her finger at a bank employee (if you can find one) for daring to suggest she tie her money up in a six-month certificate of deposit for – come again – a quarter-percent interest (maybe), Mr. Bernanke appears to be less palatable to the American public than Congress. Sorry Ben.
Oh, if you thought Greenspan was a man with a conundrum, this Fed President appears to be a mystery case even Sherlock Holmes would need to close unsolved. Although he’s trying to be clear with intentions, and media communications, one can’t help but believe Bernanke is hiding something. Or he believes economic conditions are much worse than any of us have imagined.
One thing we know for sure: Economic recovery as measured by the GDP output gap, business, residential loan growth, retail sales (compared to pre-financial crisis 2008) and employment has been poor to weak, to say the least. Yes, there’s been improvement post-crisis as time has a way to work through these obstacles as households slowly grow healthier by paying down debt.
There’s no doubt Fed has been positive for stock market returns. However, each “dose” of Federal Reserve action leads to less of a stimulus effect. Consider the stock market as a junkie; each dose of stimulus (drug) must be larger, administered more creatively and the positive effects lessen with each injection.
The above chart is from well-known bond manager Jeffrey Gundlach in a presentation from April 2012. Notice how the positive stock market effect (in blue) of each Fed easing program shortens with each dosage. Obviously, QE1 was most successful, which makes sense since market valuations were extremely attractive at lows of March 2009.
The timing and boldness of the latest program “QE3” initiated in September was a surprise to many experts (us included) and central bank followers. U.S. stock markets were performing well (hit a high on September 14) at the time, the junkie didn’t require a fix. Perhaps Bernanke was more concerned about the dampening animal spirits around fiscal cliff discussions earlier than most pundits.
So what was up with the strange timing of the last injection? Notice how the Fed typically takes action when markets are declining not rising (even though Bernanke would tell you that stock market performance is not a Fed priority).
What concerned the Fed Chairman enough to pull the trigger early on the latest easing program? Again, could have been the ominous fiscal cliff. He says it was to stimulate employment. Ok. One of the Fed’s mandates is to foster “full” employment.
During “normal” recessions, lower rates can spur credit creation, demand for goods and services and ostensibly decrease unemployment. The aftermath of the worst economic contraction since the Great Depression has been marked by anemic job growth and admittedly there’s been improvement (albeit weak) so, after all the stimulus programs, isn’t it clear that monetary policy has had little effect on job growth through this cycle? I’m sure it hasn’t hurt it, but has it really helped? No.
The red line in Bill McBride’s legendary display above shows how damaging the last recession was to jobs. Close to 58 months later, clearly there’s still a lot of work to do when it comes to job creation.
To keep rates low (non-existent) for what feels like an eternity is believed to be a necessary evil right now. It’s also understandable how frustrated you are as a saver, with the embarrassingly dismal yield on your money market fund. Unless the Fed really begins to push short-term rates aggressively higher, gaining an additional .25% from a Fed rate hike just isn’t worth the financial or psychological outcome that could arise from it. Any increase in interest rates, or language that would preclude it would cause
Don’t think so? Think again.
If you participate in a 401(k) for example, whether it’s invested in bonds, or stocks, or gold, the Fed’s accumulation of treasury and/or mortgage-backed bonds, forces the yields you can earn on more conservative investments lower and channels money to flow to more aggressive assets.
Since the bottom in March 2009, stock markets are higher by over 100 percent. Yes, corporate profits have recovered nicely and that counts. However, thank Mr. Bernanke for the majority of the recovery in your retirement plan account balances.
A recent study conducted by Fidelity Investments, the nation’s number one 401(k) provider outlined how average 401(k) balances are at the highest level they’ve been since they began tracking the data over twelve years ago. Welcomed, encouraging news – Partially it’s due to healthier employer contributions over the last five years. Employee contribution growth was up an anemic 7.3% over the same five-year period although there were more participants increasing savings than decreasing (which is positive). I didn’t catch the accolades for Mr. Bernanke even though stock and bond price appreciation was also responsible for the increase in balances.
Ben Bernanke as a student of the Great Depression understands today’s fairly precarious nature of the global financial system even after it appears to many that the great crisis of 2008 and early 2009 has passed. But is the crisis over? It’s amazing what a decent stock market will do to the memory.
Structural problems become masked by easy money, but after the money dries up and the mask comes off, well, even the Phantom of the Opera looks like Brad Pitt. Unfortunately, Bernanke sticking to his quixotic notion that suppressing the interest rate curve will lower unemployment has created even more instability within a fragile system. A recent article in the Financial Times outlines the dilemma.
It’s 2007 again, thanks to the US Fed – FT.com
And what does liquidity mean to the economy? A lot. How long can you live without liquid? Bernanke raising rates here would do absolutely nothing but move the economy further away from the watering hole. At the least, extracting even a drop of liquidity from the system can upset a delicate balance.
The rate at which money is changing hands or “circulating,” is at the slowest level since 1959 so dollars in the system today are relatively stagnant, not circulating throughout the economic system. For inflation to heat up you need to experience some form of friction or “too many” dollars dispersed throughout the economy.
“Healthy” money per se, multiplies. You need to have it, spend it, the place you spent it ostensibly spends it, so money turns over – it circulates. What’s going on today reminds the Clarity Team of something British economist Maynard Keynes said during the Great Depression: “Increasing the quantity of money is like trying to get fat by buying a bigger belt.”
You can have all the money you want stacked up on a table or hoarded on the books of the Fed by member banks as excess reserves, but until these institutions are willing to lend and you’re willing to borrow, liquidity will remain strained. Banks don’t require reserves to lend, so let’s say credit activity is weak due to less of a willingness to create debt, take on debt and a desire by households to pay down debt, which long term will be a positive.
Usually, at the time of recession or worse, the Federal Reserve employs a two-barrel gun to jump start the economy: It can lower short-term rates to stimulate lending and credit creation; the Fed also conducts open market operations whereby government securities (treasuries) are purchased in the open market thus providing cash or liquidity to the financial system. During this economic cycle, it’s apparent any liquidity in the system gets soaked up and never shared.
For example, you come into the Clarity office and right there on the conference room table there are several high stacks of dollar bills. Mind you this is for illustrative purposes only – we usually don’t have this kind of cash lying around. Question: Would you consider this inflationary? It wouldn’t appear to be. If the money is sitting around, it’s merely paper that may be mistaken for lunch napkins. If it’s not circulating (velocity) there’s little if any risk of inflation.
Nobody at Clarity wants banks to lend indiscriminately (sort of got us into trouble in the first place), however, even those individuals and businesses qualified to obtain loans are having a difficult or impossible time. As banks sit on their toxic assets, i.e; mortgages and mortgage-backed securities awaiting them to flourish, we all pay the price as a result.
This great “incubation” as banks wait for these assets to “hatch,” can take a generation. Ben Bernanke understands this nesting: Raising interest rates now would do nothing to move this process along. If anything it would slow down the healing or cleansing of these toxic assets. Low rates buy time. Time leads to healing.
The formulas behind inflation, or consumer prices per some critics, are incorrect and do not take into account what we all really pay for the daily courtesy of living our lives. And to some degree, this is valid. Anyone believe health care or college costs actually decrease every year?
Regardless, there is inflation that heats up and cools off on a regular basis. For instance, gas prices increase during summer driving season then typically back off, commodity price levels move higher and lower based on supply, demand and yes, speculation. Speculation on commodity prices is not a new concept. There is marked evidence of speculation as far back as the 1930’s.
The components of inflation which encompass food and gas prices change rapidly. However, there is an element to inflation which is considered “sticky.” The inflation that stays around has to do with wages. Part of the reason inflation remained elevated in the 1970’s was higher wages bestowed to union workers. Anybody you know get a raise lately? Cost-of-living increase? No. Inflation remains a shadow of its former self.
Your income is a shadow of its former self too as real median household incomes have not gained in a decade and reflects an 8.1% decrease in true buying power.
This chart, courtesy of Doug Short at www.advisorperpectives.com shows the breathtaking drop-off since the financial crisis.
In the face of excess capacity in manufacturing, very little or no pricing power by companies and asset prices, Clarity finds it hard to digest the hyperinflation mongers at this time. Ben Bernanke understands this and knows raising short-term rates is like fighting an enemy that yet doesn’t even appear on the horizon. We haven’t seen this type of anemic inflation “core” inflation or inflation that strips out food and energy prices, since Elvis Presley burst onto the scene in the 1950’s.
A primer: The Fed sets monetary policy, the government sets what we call, fiscal policy. Most likely one of the prevalent reasons Mr. Bernanke does not touch rates at this time is his study of the double-dip contraction suffered during 1937 after it appeared we were on the road to recovery. Ben is in a very tough place politically. It wouldn’t be proper to call a President out on the carpet for fiscal inaction.
Depression redux began in the spring of 1937. At the time, Roosevelt was on a tour of rhetoric bashing financial institutions. Fooled by the improvement in wages, production and profits even though unemployment remained at uncomfortably high levels, the administration decided to attempt to “balance” the budget by cutting spending and raising taxes deeming the “worst was over.”
In 1937 the Federal Reserve began to tighten the money supply at one of the worst possible times- a point Ben Bernanke outlines in 2004 remarks at the H.Parker Willis Lecture in Economic Policy at Washington & Lee University in Virginia. He references the Milton Friedman and Anna Schwartz publication of 1963-“A Monetary History of the United States, 1867-1960.”
In the Fed Chairman’s words: “Friedman and Schwartz discuss other episodes and policy actions as well, such as the Federal Reserve’s misguided tightening of policy in 1937-38 which contributed to a new recession in those years. However, the four episodes I have described capture the gist of the Friedman and Schwartz argument that, for a variety of reasons, monetary policy was unnecessarily tight, both before the Depression began and during its most dramatic downward phase.
As I have mentioned, Friedman and Schwartz had produced evidence from other historical periods that suggested that contractionary monetary policies can lead to declining prices and output. Friedman and Schwartz concluded therefore that they had found the smoking gun, evidence that much of the severity of the Great Depression could be attributed to monetary forces.”
It’s not difficult to see where Ben is coming from. If Obama is compelled to follow the Roosevelt path, Mr. Bernanke is not motivated to tag along with restrictive monetary policy and so he dutifully bears the brunt of admonishment, he takes the heat from the savers, but yet he sticks to his guns at a time when fiscal policy appears to be growing increasingly austere.
Mr. Bernanke may run out to walk the dog, or wash the car to avoid the question we’re all asking: When will interest rates go up? One thing is certain: He’s certainly not going to walk the line with the administration. If austerity measures head our way in the United States and it appears to becoming more of a reality, expect another “QE” stimulus program from the Fed next year. For now, your Clarity team believes that interest rates are not going to change anytime in the near future.
As a matter of fact, they may remain lower for much longer than anyone can fathom especially as the Fed has places concerns (paranoia) about inflation on the backburner and is now primarily focused on the current state of unemployment.
Unfortunately, as we outlined, it’s going to take much more than monetary policy to fulfill this objective. The Fed can only do so much and generally, its policies are more effective during recessions of the ordinary variety. Accommodative policy measures are Bernanke’s way to stand aside, not cause trouble – buy time.
What you should you consider as a fixed-income investor? How should you position your bond allocation today?
We consistently monitor our investment positions at Clarity. Here are several observations that can help you with your personal portfolio strategy:
1). Stocks & bonds hold equal risk in today’s environment. Most asset managers are reluctant to say it or believe it. We’re not. If or when interest rates rise, fixed income investors are going to be in for a rude awakening as they lose more principal than they can currently imagine (after all, bonds are safe, right?) Bond markets are more volatile, more fragile today than they were in the past; as the markets move quickly to position for higher rates, there could be a lot of damage as individual investors panic and sell along to preserve capital.
Nobody truly knows how an interest rate-strategy “unwind” or increase will play itself out in markets as we’ve never had the Federal Reserve hold this stance before. Using the historic ten-year Treasury as an example, if rates head back to the average of 5.25% (going back to 1926), then holders of those bonds will lose roughly 40% of their capital.
Yes, if the bonds were purchased at par, and held to maturity, owners would receive full return of principal. The question becomes will an individual investor who holds a bond paying 1.6% stay with it while others are enjoying yields greater than 5%? Or will they just give in and sell? Our thought is many investors will sell and suffer losses.
And what if you own bond mutual funds? Yes, they will be easier to liquidate, but losses have a greater chance of becoming reality since there aren’t maturity dates and return of principal. With stock & bond risk pretty much on an even playing field, bond and fixed income portfolios in general, must be monitored and adjusted quickly to avoid carnage. It’s ok to invest in bonds. They’re working now. However, understand the risk. Make sure your advisor understands the risks, too. Then you’ll both be aware of dangers that lie ahead and open to adjusting accordingly.
2). Don’t be surprised if Treasuries perform well through the first quarter of 2013. Along with high-quality corporate bonds, strong demand should remain as European markets remain in or close to, recession, corporate profits are beginning to slow, U.S. exports are down and we’re about to embark on some combination of higher taxes and weaker spending which can have a negative impact on GDP growth next year. A sweet spot should be MBS or mortgage-backed securities as the Fed will continue their bond buying program if economic conditions weaken. Based on the direction we’re headed fiscally, it appears Bernanke is going to need to try and save the day again and that action portends well for MBS.
3). Be careful of junk bonds at this juncture. Currently, they’re expensive as investors desperately search out yield, driving junk bond prices higher. Keep in mind, junk bonds act more like stocks than bonds so from a diversification perspective, they’re not effective. At the right price/yield, they could be considered a proper addition to a portfolio. Desperate for Returns, Investors Pour Into Junk.
4). Hire a professional. Before the financial crisis it was easy to “set them and forget them.” In other words, you could purchase bonds, hold them to maturity and frankly, not spend much time monitoring them. This is not the case today. First, prices are dangerously high for the return and income received. Second, individual investors are at a relative disadvantage as large institutions that have the power to purchase with big dollars, scoop up appetizing issues first leaving less appealing remnants for the rest of us to pick through.
Granted, we’re not convinced even the most seasoned of bond managers know how rising interest rates from historic lows are going to fully impact the fixed income markets, however there are many who are studying and receptive enough to be proactive and make changes to minimize loss to principal.
Overall, we stress again that bond markets and stock markets share equal amounts of risk for the reward they provide. For now, bonds in general are providing diversification benefits. In other words, they “zig” when stocks “zag.” In times of crisis, or in a period of rising rates, the diversification benefits can be greatly minimized. We are on constant watch for change in present conditions.
The Clarity Team is here to partner with you. Objectivity, portfolio personalization, customization, low fees, robust technology, proactive communication, are required now.
We are committed to those mandates.
Contact us at 281-501-1791 for a free consultation. Send us an e-mail at contact@myclarityfinancial.com if you have questions.
Clear Thought Central 
December 10, 2012
Fiscal Cliff, The Macro View