The Bond Conundrum

By Matt Ahrens

There is an old saying in the investment world “Don’t Fight the Fed.”  This saying has been gospel truth since 2009 as the Federal Reserve has made investing in equities relatively easy.  Anytime the market started to pull back the Fed would step in and announce more quantitative easing or bond purchasing.  All of these methods were designed to push investors into riskier assets because bonds were delivering such little income.  While those methods were successful in pushing investors into stocks, we are starting to see other countries deploy methods that investors have never seen before…EVER.

Japan, the European Union and several smaller European countries have all gone to negative interest rates.  Remember that the central banks are used by our banks to hold money overnight.  The original intent was again to push investors into riskier assets and force banks to start lending their money.  After all, if the bank must choose between loaning consumers money at 3% or parking their excess reserves at the central bank and losing money, one would think this decision should be easy.  Remember, however, that banks must leave some money in reserves and since they’re now paying their central bank to hold the reserves, these banks started charging consumers on the money they had in checking or savings at the bank.  You can imagine how well that went over.

In Japan, it is nearly impossible to find a safe that you can purchase for your home.  Consumers didn’t want to be charged to hold their money at the bank so they started pulling their money out and keeping cash at home in their own safe.  This, of course, was an unintended consequence of negative interest rates and it has had the opposite effect that the Bank of Japan was hoping to achieve.

Let’s say I want to make my wife happy and remodel our kitchen.  In this example, I’ll take out a home equity line of credit rather than use my cash reserves.  So I am borrowing money from the bank and paying that money to contractors, a floor company, Home Depot, plumbers, etc.  Each of those entities takes my money and pays their employees or uses my money to buy equipment.  Every time that money is changing hands it is creating a bigger impact on the economy.  Economists call this measuring the velocity of money and the higher the better.  In the example of Japan above, because consumers are pulling their money out of their bank accounts the bank doesn’t have the ability to loan it out.  Therefore, the velocity of money is being drastically reduced because it is being stopped before it can ever get started.

So where do investors in Japan go when they need income?  The United States of course.  International investors continue to pile money into US corporate and government bonds, because it is one of the few places to make money.  When international investors buy these bonds, they’re usually buying bonds that mature in 10 years or more, which effectively lowers the yield on long-dated bonds.

If you’re still with me (and I wouldn’t blame you if you fell asleep), then here is where we realize the conundrum.  The Federal Reserve has control over short-term bonds.  Remember I mentioned above that their rate is the rate banks earn on cash reserves held overnight.  The Federal Reserve has indicated they want to raise rates.  However, long-term rates are being pushed down by international investors.  As I am writing this, the 10-year treasury is paying 1.56% in interest.  If the Federal Reserve raises rates so much that the short-term interest rate exceeds the long-term interest rate, then we have a real problem.  Why would banks lend out money to you or I and take a risk that we might not pay back our loan when the Federal Reserve is giving them a guaranteed deal with greater return?  Credit markets would lock up as banks stop loaning money and the economy stalls.

After reading this, it may be a surprise to you that I am still optimistic that we will see positive equity returns for at least two more years.  The reasoning is that as long as the long-term rates stay low, then the Federal Reserve’s hands are tied on raising rates significantly.  This creates a “risk-on” moment where investors can continue to invest in riskier assets and should experience decent returns.  We’ll likely see more volatility and we may even see a correction of 10% or more, but those should be buying opportunities in the near term.  Investment vehicles always hit bumps in the road, but as we continue to add alternative and tactical investments to accounts, we can hopefully experience a smoother ride to higher returns.

Brexit: An Update for Investors

Nearly two months ago, on June 23, citizens of the United Kingdom voted to leave the European Union in a close vote known as “Brexit.”  Financial markets reacted swiftly--and negatively--the following day, but then rebounded in part shortly afterward.  However, the British pound and the U.K. economy as a whole continue to face major challenges as the U.K.’s full withdrawal from the EU plays out, a process that could take several years.

This video looks at Brexit’s potential to spark continued market volatility.

Brexit Update 

 

 

 

 

Quotes

“Caution, not exuberance, should be our fiscal motto.”

                   John Chafee

“Caution is not cowardly. Carelessness is not courage.”

                   Unknown

Quotes selected by the IAG staff

“Kindness is the one commodity of which you should spend more than you earn.”

                   T.N. Tiemeyer

“Well, you know, success is a terrible thing and a wonderful thing.  If you can enjoy it, it’s wonderful.  If it starts eating away at you and they’re waiting for more from me or what can I do to top this, then you’re in trouble.  Just do what you love.  That’s all I want to do.”

                   Gene Wilder

 

Tony Moeller, CPA

The information listed in this commentary is a compilation of various publicly available sources and is for informational purposes only. It is not a recommendation or solicitation of any particular investment or strategy. A risk of loss is involved with investments in the stock and bond markets.

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