Monday, February 25, 2013

The Race to Zero

The Race to Zero

Bert Whitehead, M.B.A., J.D. ©2013

The government is printing too much money!

We have all heard the clamor raised by concerns that U.S. monetary policy (called "Quantitative Easing") will trigger inflation by causing 'too many dollars to chase too few goods and services.' The U.S. Treasury is issuing U.S. Government bonds at a faster rate than our economic growth. These surplus bonds are purchased by the Federal Reserve Bank, creating money that can be lent to businesses, etc. and so presumably help the economy expand.

There have been a couple problems with this strategy. First, the banks (and corporations) already have too much cash so they are not borrowing it from the Fed as expected. Next, we are still cleaning up the last mess when mortgages were made to virtually anyone. Since the excess money being issued is not being lent out or circulating, it keeps interest rates low. It also depresses the value of the dollar in the international market, since dollars are so plentiful. The good news is that this helps make our exports cheaper for other countries and keeps Americans working.

Ironically, other countries have caught on to this strategy, although not always as aggressively as the U.S. The European Union has been inflating its money supply as a tactic to avoid collapse of the weaker members (Spain, Italy, Portugal, etc.) and to make their exports cheaper. China has had a bout of inflation triggered by a growing labor movement and skyrocketing urban real estate prices. It has been printing more Yuan to reduce its value and make its exports cheaper. And even though Japan is still largely in a deflationary spiral, they have decided that printing more Yen will make their exports more competitive. Even Switzerland, the bastion of conservative economics with the strongest currency in the world, has started printing more Swiss Francs because no one in other countries can afford to buy Swiss watches.

This bloated international money supply is the result of the battle for increasing exports. Lowering interest rates through global expansion of the money supply is ultimately expanding the next inflation bubble. These low rates may give some countries an export advantage, perhaps for another decade or even longer. How can this bubble persist without creating inflation now? There are three factors which can temper inflationary pressures for awhile:

1. Increasing global trade brings down production costs. Just as water seeks the lowest level, free trade enables producers to move to lower cost environments. It also pushes prices down globally which moderates inflation.

2. Technology has brought unparalleled increases in worker productivity worldwide which keeps prices down. Computers, robots, and other smart technologies lower the costs of production dramatically.

3. Consumer savings has increased significantly worldwide as a result of the economic volatility of the past decade. When people feel vulnerable they react by spending less and saving more. This is particularly evident in Japan where people save 6-9% of their income, spurred by their aging demographics and concern that the government's safety net may not be effective when they retire. This savings takes money out of the consumer economy and reduces the amount of money that chases the available goods and services.

Most economists recognize that eventually inflation will catch up with us. But no one knows when or how. Will a smaller, poorer nation default on its debt, or will large investors be scared away from bond auctions as markets lose faith in governments' ability to repay debt? Whether it will be triggered by a 'black swan' event like a war or a natural disaster or simply the gradual erosion of investor confidence, it will likely ignite a global domino effect of hyper-inflation that could engulf most developed countries.

We know it will happen, but we can’t know when. It is critical to prepare by adhering to the one take-away lesson from the history of inflation: you must emphasize safety in bond investments.

This is not easy to accept when you consider that it is likely that interest rates will remain low or continue to drop for another decade, just as they have been dropping in Japan for over 20 years. While a 2% return now on 10-year U.S. Treasury bonds seems skimpy now, it could well be 1% in a few years (which is the current yield on Japan's 10-year sovereign debt). People are saying that interest rates can't possibly go any lower, but they have insisted on that since 1994 when 10-year Treasury rates were at 7%!

It is tempting to be dissatisfied with today’s apparent race to zero interest rates. It impels many of us to want to grasp for higher returns. But higher returns always entail higher risks and it is folly to try to offset lower yields by taking more risks. High yield bonds offer dramatically higher returns than a safe haven, like treasuries, but the risk cuts both ways: when interest rates begin to rise, the value of high yield bonds drops. This is also true of Treasuries, but at least you can be assured of getting your money back at maturity, unlike junk bonds. In addition, when the music stops, holders of junk bonds face significant risk of default. In Functional Asset Allocation theory, which is the centerpiece of our financial planning theory, the function of bonds and cash in your portfolio is to assure consistent cash flow, so it is critical that this part of the portfolio be absolutely safe.

Before you stretch for a higher yield, keep in mind there is a strong likelihood that we very possibly will see continuing low interest rates for a long time. Meanwhile the "Race to Zero" is the harbinger of the next bubble to burst.

(Cf. My blog dated Sept. 4, 2012: Finding "Real Returns" in the Bond Market.)
Special thanks to those who collaborated on this post: Chip Simon, an ACA colleague from Poughkeepsie, N.Y., and Shari Cohen who was the copy editor.

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