At this point, all roads lead to inflation. This may be strange given that there are strong deflationary forces brought about by the deleveraging from a balance sheet recession still in the system.
But if you take a step back. The Fed is implicitly (if not explicitly) trying to create it. The third world is experiencing it. Risky asset prices are reflecting it. The markets are beginning to come around to it.
We're playing with fire here.
Most historical studies indicate that inflation is generally positive for risky assets, but too much inflation is bad. Hyperinflation is another thing all together, leading to the wipe out of an existing order/system. But even if we don't see hyperinflation, only inflation, there are assets that provide a better store of value than others. What inflation does is force you to do something. You can't just sit there (and especially not at the moment with cash and bond yields so low).
If it true that all roads lead to inflation, then how can investors best preserve their purchasing power? What stores of value will help protect investors against inflation? How should investors best approach this problem? Investors need to take greater risk with their asset allocation. Being fearful and leaving money in cash or bonds is perhaps the worst thing they can do.
Monday, November 8, 2010
Tuesday, November 2, 2010
Why are bond yields so low?
There are myriad reasons why bond yields are so low. I have found it useful to list them so that I have a framework for seeing the various parts and gauging how they change over time. Here is why bond yields are so low:
(1) Relatively low inflation.
(2) Exceptionally low short term rates (controlled by the Fed).
(3) The investor fearful of deflation.
(4) The investor fearful of equities.
(5) The investor who is simply fearful.
(6) Foreign central bank buyer.
(7) Federal Reserve POMO monetization.
(8) The ride-the-yield curve financial institution buyer.
(9) The front-run the Fed speculative buyer.
(10) The momentum buyer.
(1) Relatively low inflation.
(2) Exceptionally low short term rates (controlled by the Fed).
(3) The investor fearful of deflation.
(4) The investor fearful of equities.
(5) The investor who is simply fearful.
(6) Foreign central bank buyer.
(7) Federal Reserve POMO monetization.
(8) The ride-the-yield curve financial institution buyer.
(9) The front-run the Fed speculative buyer.
(10) The momentum buyer.
The Failure of the System
The primary failure of the system has been the unwillingness to allow markets to clear.
Whether it has been the unwillingness to allow housing to clear, or the unwillingness to let insolvent institutions go bust, or the unwillingness to address structural deficits or unfunded entitlement liabilities, markets must be allowed to clear when they become unbalanced.
Markets get out of whack for a variety of reasons. Whether it is due to externalities (poor regulation and regulators, perverse incentives, the guiding hand of the Fed, moral hazard, etc.), or because they reflect the mass delusion of crowds, markets need to be allowed to clear before they can operate effectively again. By shooting the messenger (thereby trying to prop up prices), authorities are addressing the symptoms rather than the cause.
In many ways, the crisis of the last few years has been a failure of the visible hand, as much as a failure of the invisible hand.
The reasons given for bailing out entities or propping up prices are noble (in a way). To defer, delay, take away the negative social effects/impact of market collapse (usually for political reasons). But there is a cost to artificial intervention, and sometimes the cost is greater than the initial price tag.
It remains to be seen how all of the bail-outs of the recent past will pan out.
Whether it has been the unwillingness to allow housing to clear, or the unwillingness to let insolvent institutions go bust, or the unwillingness to address structural deficits or unfunded entitlement liabilities, markets must be allowed to clear when they become unbalanced.
Markets get out of whack for a variety of reasons. Whether it is due to externalities (poor regulation and regulators, perverse incentives, the guiding hand of the Fed, moral hazard, etc.), or because they reflect the mass delusion of crowds, markets need to be allowed to clear before they can operate effectively again. By shooting the messenger (thereby trying to prop up prices), authorities are addressing the symptoms rather than the cause.
In many ways, the crisis of the last few years has been a failure of the visible hand, as much as a failure of the invisible hand.
The reasons given for bailing out entities or propping up prices are noble (in a way). To defer, delay, take away the negative social effects/impact of market collapse (usually for political reasons). But there is a cost to artificial intervention, and sometimes the cost is greater than the initial price tag.
It remains to be seen how all of the bail-outs of the recent past will pan out.
Money Sloshing Around The System
Excess liquidity must go somewhere! It is like water following the path of least resistance.
Much of it has sat on bank balance sheets as excess reserves. Some of it has wound its way into commodities and precious metals. A little has tentatively ventured back into the stock market.
Sadly, investors have parked a large portion of their hard earned savings in cash and bonds. That is going to end badly.
For two reasons. First, bonds offer very little in the way of a wealth effect. And as a corollary, there are no obvious asset classes where investors can participate in asset appreciation the way they did with their homes. Second, the asset classes showing the most signs of appreciating (energy, commodities, currencies), are also likely to translate that appreciation into inflation, thereby eroding real incomes and real returns.
Not only that, but in the absence of real structural reforms, we are entering another game of chicken in the markets (or, musical chairs - take your pick). That postponed day of reckoning may be 2, 3, 5 years off. But its out there, and once again, market participants are betting they are able to hit the exit button when the time comes. History would indicate otherwise.
Much of it has sat on bank balance sheets as excess reserves. Some of it has wound its way into commodities and precious metals. A little has tentatively ventured back into the stock market.
Sadly, investors have parked a large portion of their hard earned savings in cash and bonds. That is going to end badly.
For two reasons. First, bonds offer very little in the way of a wealth effect. And as a corollary, there are no obvious asset classes where investors can participate in asset appreciation the way they did with their homes. Second, the asset classes showing the most signs of appreciating (energy, commodities, currencies), are also likely to translate that appreciation into inflation, thereby eroding real incomes and real returns.
Not only that, but in the absence of real structural reforms, we are entering another game of chicken in the markets (or, musical chairs - take your pick). That postponed day of reckoning may be 2, 3, 5 years off. But its out there, and once again, market participants are betting they are able to hit the exit button when the time comes. History would indicate otherwise.
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