Cold Fusion: The Latest Insane Idea in Monetary Policy

Cold fusion used to be a zany term in the physics lab for generating endless cheap energy.  Alas, no longer. Now it is the latest nutty idea from economists to create endless amounts of free money. Hold onto your wallets, this is an idea from the twilight zone.

World-wide, central banks have engineered 635 interest-rate cuts since the financial crisis of 2008 and purchased more than $23 trillion of assets, primarily sovereign bonds, according to Bank of America Corp. Nonetheless, the global economy is sliding into recession. Again this month, the IMF and other major international agencies have cut global growth estimates. So, when a policy of flooding the financial system with cheap money clearly doesn’t work, whether in Japan or Europe or America, what do you do? Why, more of the same of course! Are you kidding me?

According to Stephen Englander, global head of currency strategy at Citicorp., the answer is to focus policy more on boosting demand rather than just increasing liquidity in the hope that consumers and companies will find a need for it and borrow more. He advocates what he calls “cold fusion” in which politicians would cut taxes and boost spending with central banks covering the resulting rise in borrowing by purchasing even more bonds. “The next generation of policy tools is likely to be designed to act more directly on final demand, using persistently below target inflation as a lever to justify policies that would be anathema otherwise,” Englander said. I have news for Steve; they are anathema now.

In a similar vein, Hans Redeker, head of global foreign exchange strategy at Morgan Stanley, says it’s time for central banks to begin using Quantitative Easing to buy private assets having previously focused on government debt. “I would actually look into the next step of the monetary toolbox,” Redeker said in a Bloomberg Television interview. “We need to fight demand deficiency.” He wants to put more money directly into the hands of consumers.

Dear reader, please understand what this means. To boost the economy, they are prepared to destroy the currency. What is more, curing the problems of too much debt with more debt is why the economy is slowing down in the first place. Encouraging borrowing and consumption–fighting demand deficiency, as Redeker calls it—is working in precisely the wrong direction. Savings and investment drive growth, not consumption.

Cold fusion= more confusion. My answer is gold, something they can’t print. Keeping money in the bank is a bad idea as I will explain tomorrow.

Interest Rates Rising – the sequel

Mal Spooner is a veteran fund manager and currently teaches at the Humber College School of Business.
Mal Spooner is a veteran fund manager and currently teaches at the Humber College School of Business.

No doubt you’ve noticed about half the industry pundits cautioning that the US Federal Reserve is closer to ‘tightening’ monetary policy.  What this implies for us regular folk is that they will introduce monetary measures that will allow interest rates to rise.  We have enjoyed a very long period of inflation and interest rate stability following the financial crisis (a crisis almost forgotten by many).  Despite a recent slowdown in come economic indicators, efforts by governments around to world to jumpstart an economic recovery did bear some fruit.  The rebound in profitability, employment and growth has been particularly robust in the United States.  Both Europe and China are now making efforts to replicate this success by bolstering liquidity in their financial systems as the US did.

So what’s to worry about?  Savvy investors will have already noticed that interest rates in the world’s strongest economy have already begun to rise, even before the FED has taken any action.  This is what markets do – they anticipate rather than react.  Some forecasters predict that although interest rates are bound to trend upward eventually, there’s no need to panic just yet.  They suggest that there’s enough uncertainty (financial distress in Europe, fallout from falling energy prices, Russia’s military ambitions, slow growth in China) to postpone the threat of rising rates far into the future.

Yield Curves 2015-05-02_15-28-30

What they are ignoring is that the bond markets will anticipate the future, and indeed bond investors out there have already begun to create rising interest rates for longer term fixed-income securities.  The graph illustrates that U.S. yield curves have shifted upward.  The curve shows market yields for US Treasury bonds for various maturities back in February compared to rates more recently.  So what’s the issue?  If investors hang on to their bonds while rates are rising, the market value of those bonds declines.  This often comes as a surprise to people who own bonds to avoid risk.  But professional bond traders and portfolio managers are acutely aware of this phenomenon.  So they begin to sell their bonds (the longer term-to-maturity bonds pose the most risk of declining in value) in order to protect themselves against a future rise in the general level of interest rates.  More sellers than buyers of the bonds pushes down the market price of the bonds, which causes the yields on those same bonds to increase.

Many money managers (including me) have learned  that despite how dramatically the world seems to change, in many respects history does repeat itself.  For example, while writing my CFA exams back in the mid-1980’s, I was provided with sample exams for studying, but they were from the most recent years.  I figured it was unlikely that questions on these sample exams would be used again so soon, and managed to do some digging in order to find much older previous exams.  I reasoned there are only so many questions they could ask, and perhaps older exam questions might be recycled.  I was right! In fact several of the questions on the exam I finally wrote were exactly the same as the ones I’d studied from the old examination papers.

In my experience recent history is not useful at all when devising investment strategy or trying to anticipate the future, but often a consideration of historical events further back in time – especially if trends in important economic drivers are similar – can be very helpful indeed.

The consensus is that interest rates will rise eventually.  But it is human nature to stubbornly hang on to the status quo, and only reluctantly (and belatedly) make adjustments to change.  What if what’s in store for us looks like this:  Consistently increasing interest rates and inflation over the next decade?  This has happened many times before (see graph of rising 10-year Treasury bond yields from 1960-1970).

US Treasury Yields 1960 - 1970

Before you rant that things today are nothing like they were then (and I do agree for the most part) consider the following: Is the boy band One Direction so different today compared to The Monkeys then?  And wasn’t the Cold War simply Russia testing the fortitudes of Europe and America just like the country is doing today?  Weren’t nuclear capabilities (today it’s Iran and North Korea) always in the news?

Yes there have been quantum leaps in applied technology, brand new industry leaders in brand new industries.  China’s influence economically was a small fraction of what it is today.  So where is the commonality? The potential for rising interest rates coming out of a recession.  The US government began raising rates in 1959, which caused a recession that lasted about 10 months from 1960 – 1961.  From that point until 1969 the US economy did well despite rising interest rates and international crises.  But which asset classes did well in the environment?

Growth of $100 - 1960 to 1970

Could the disappointing 1st quarter economic data be hinting that we might also be entering a similar transitioning period?  Inflation is bad only for those unable to pass higher prices along to customers.  If the economy is strong and growing then real estate and stock markets provide better returns.  Since the cumulative rate of inflation between 1960 and 1970 was about 31%, investors essentially lost money in constant dollars (returns below the rate of price inflation) by being invested in the bond market.  They would have done better by simply rolling over short-term T-Bills.  An average house in the US cost about $12,700 in 1960 and by 1970 cost $23,450 – beating inflation handsomely.

Do I believe we will see a repeat of the 60’s in terms of financial developments?  Yes and no!  There will be important similarities – especially in terms of stock markets likely performing well enough and the poor prospects for the bond market. There will be differences too.  The outlook for real estate is clouded by the high level of indebtedness that has been encouraged by extremely depressed interest rates over the past few years.  Higher rates mean higher mortgage payments which might serve to put a lid on real estate pricing, or cause prices to fall significantly for a period of time before recovering.

Companies that have substantially financed their acquisition binges with low-cost debt will soon find that unless they can pass along inflation to their customers their profit margins will be squeezed.  Who will benefit?  Commodity producers have had to significantly reduce their indebtedness – commodity prices tend to stagnate when inflation is low, and even decline when economies are growing slowly.  In a global context, these companies have had a rough time of it.  It is quite possible that their fortunes are about to improve.  If Europe and China begin to enjoy a rebound then demand will grow and producers will have more pricing power – perhaps even enjoying price increases above the rate of inflation.

Do I believe any of this retrospection will prove useful?  I hope so.  The first signs that a different environment is emerging are usually evident pretty quickly.  If there were a zero chance of inflation creeping back then why are some key commodity prices showing signs of strength now?

recent aluminum price recent copper price data

If we begin to see inflationary pressures in the US before Europe and Asia, then the $US will depreciate relative to their currencies.  In other words, what might or might not be different this time is which countries benefit and which countries struggle. Globalization has indeed made the world economy much more difficult to come to grips with.  Nevertheless, there are some trends that seem to be recurring over the years.

There will be recessions and growth spurts.  In recessions and periods of slower growth, some formerly stronger industries and companies begin to lose steam as a paradigm shift takes place, but then other industries and companies gather momentum if the new reality is helping their cause.  This is why I’ve biased my own TFSA with commodity-biased mutual funds (resource industries, including energy) and a European tilt.  You guessed it – no bonds.

Any success I enjoyed while I was a money manager in terms of performance was because exercises like this one help me avoid following the mainstream (buying into things that have already done well) and identifying things that will do well.

 

 

 

 

 

 

 

Monetary Policy

The QE 1,2 and 3 series, by creating vast sums of new money, coupled with artificially low interest rates, has injected capital into the equity markets and thus raised stock prices. This is seen as a major victory by the Keynesians.
The trick will be how the FED (eCB, BofJ) can withdraw these funds if interest rates begin to raise. The world is awash with newly created money, most of it being held either privately (corporations, companies, and individuals) or governments (held because of future risk.) The only way open is for the FED to begin to sell government securities thus drawing money back into the FED where it can be sterilized (if possible, that will depend upon the immediate demands of the federal debt picture.) However, attracting potential buyers of new government debt will depend upon the interest rate offered, and now the picture becomes murky. Most government debt is now short term, and must be rapidly turned over, increases in the interest rate means the cost of that debt will skyrocket upwards, meaning the government must again raise taxes or borrow more from the private markets at exactly the same time that it is trying to draw down their capital reserves through new purchases. These amounts are staggering in size.
As Maultin and Tepper note, in “Endgame”, there are only a few options. One is, of course inflation. That may sound strange because of the deflationary influences that have gripped most world economies. But with the exception of Japan, most deflationary periods have ended within a reasonable amount of time, and if the world is awash with newly created money, that money will go somewhere. If we inflate we must also realize that enormous sums of American money is held overseas. If inflation causes that money to lose value those cash-holders will not continue to hold their reserves but will flood the world with it, thus causing even more inflation.
We must also remember that debt, after a certain point, reduces growth. It does so in private life as well as corporate bodies and governments. “This Time It Is Different” empirically explores the relationship of governmentally held debt with growth rates. Their conclusion is that at near 100% debt to GDP growth suffers a 1% diminishment, thus the traditional 2.5-3% growth rates goes down to 1.5-2%.
So we have entered into a new economic world, one our country has never encountered. We have largely followed the Keynesian game-pan, not just in the U.S. but in Europe and Japan, and the result is clear.