Fed Rate Hike

Will they or won't they...hike in July, September...some time this year.

I don't think so. There is no reason to hike. Inflation is low. Growth is subdued. Other countries are cutting their interest rates. Why should the Fed raise rates. The only reason would be if the markets really take off.

Why Are Interest Rates So Low?

Quite frankly, I don't really know and I can't make heads or tails of it. The current environment is a classic case of my habit of missing regime/paradigm shifts. The scales usually drop way after the trend or the event has manifested itself.

There are numerous reasons posited:

• Savings glut (this one is a mystery to me when you look at savings rates relative to history and trends...the argument is the savings glut comes from China/Russia/Brazil).
• Supply deficit (can't quite work this argument out; I think it relates to QE and lack of collateral).
• QE (combination of reduced supply and scramble for collateral).
• Financial repression (combination of debt overhang and distorted price signals from QE).
• Low inflation (yes inflation is low and has been trending down...let's call it declining inflation, but it is still positive and real rates are low). 
• Fears of deflation (I don't see deflation...commodities have taken it on the chin in the last year, but asset prices have gone through the roof and commodity prices are cyclical).
• Fears of market collapse/capital protection (maybe...but those Wally's have all missed the boat).
• Currency wars (fight to the bottom). 

I just can't understand why any investor would settle for a negative interest rate. This makes no sense to me at all. US rates look as attractive as ever relative to European rates. European rates are crazy. What are they telling us? Imminent collapse in the Euro? Maybe!

It should be noted, that you can't talk about why interest rates are so low in the US without taking account as to why they are so low (or even much lower) elsewhere.

A Little Early On That Call - Now Might Be A Better Time To Brush It Off

I wrote a commentary for the SMID cap strategy at the end of 2009 talking about the likely battle to take place over the next 2-5 years between cyclical forces of recovery coming up against secular headwinds. Here is an excerpt:

"Don't get too comfortable. The economy is fragile, and both short term and long term risks abound. A legion of risks are in plain view. At some point, cyclical tailwinds will run into secular headwinds. Structurally we are in many ways worse off after the recession than before. We lack the political will to make the hard and necessary decisions to get things right. We have, once again, failed to allow the market to clear, and so are left with the burden of accumulated deferments. The lesson from this whole mess is that we haven’t learnt the lesson. There is a price to be paid for profligacy and denying the laws of economics. As a country we (many other developed countries are in the same boat) have lived beyond our means and made promises we are unlikely to keep. Those secular headwinds will be reflected in rising inflation and interest rates, lower growth, increased savings, higher taxes, more regulation, and constraints on government spending going forward."

In hindsight it looks as though I was a little early. But I stick by that general view of the forces and factors in play.

If I might be so repetitive. Now is probably a good time to brush that thesis off and deliver it again.

They say a clock is always right at least twice a day. Perhaps I'll be closer to the truth this time around.

All Roads Lead to Inflation

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.

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.

Getting a read on the Fed

The markets focus is upon working out when the Fed will begin its exit from quantitative easing.

Some would say that it has already begun with the dismantling of various "market support" programs. The critical element will be when they begin raising the Fed funds rate.

With the knowledge that any "real" exit could send the economy in the tank again, I wonder whether the reality is that the Fed has little intention of raising rates anytime soon (read that in the next couple of years).

Any increase in rates will weigh heavily upon the economy, the govt's expenditures, and the markets. In many ways, the Fed has no choice, but to try and keep rates at ZIRP until it is patently obvious that the economy is totally recovered. In the same way that the govt is "all-in" on the fiscal side (and is committed to doing whatever is necessary to keep things from going back down), the Fed is in a similar boat. In spite of it's credibility and reputation being on the line, the Fed has little choice, but to keep rates low. Any removal of the foot from the pedal stands a high likelihood of choking off recovery (all that ZIRP for nothing). It has to go "all-in" on the monetary side. Failure to put the economy back on an even keel means we are left in a worse position than when we started.

With the Fed's priority upon the recovery of the economy, it has to risk inflation and the debasement of the currency in order to get us through this period.

A tough circle to square

Is global infrastructure an asset class? Don't know, don't care.

It doesn't matter. What matters is that there are great hopes and great needs to build out and support infrastructure (water, power, transportation) around the world over the next 20-30 years. I saw in one place that they estimated global infrastructure spending at around $35 trillion over the next 20 years. Even if it is half that amount (which is probably more likely), it is a substantial amount of money.

Quite apart from the obvious need and the potential investment opportunity, the case for global infrastructure development begs the question. Who is going to sponsor the development? Where are the funds going to come from to pay for it? and, What will be the cost of those funds?

Infrastructure sponsorship is generally the domain of government. But governments the world over are going to be balance sheet and budget constrained as they pay out on the accumulated obligations of the past while trying to meet the generous promises of the future. Consumers (at least developed country consumers) will be going through their own weight loss program, but at least in cutting back they are likely to be saving a little more and so provide a source of funds (although it will be constrained because they are going to be tapped out by higher taxes to pay for everything and higher costs associated with paying for the new/improved services - not much discretionary spending in the future). Finally, corporations. They are going to be only too happy to provide the product/services to develop infrastructure, but don't have the independent financial capacity to borrow sufficiently to fund projects. A conundrum.

When demand is greater than supply, prices go up. With government needs for funding set to rise, massive global works projects waiting in the wings, it only makes sense that the price of money goes up.

The Cash Dilemma

What do you do as an investor if you have cash sitting in the bank gathering dust, the markets are running, and you see inflation in the outlook?

What do you do if you are a corporate with cash burning a hole in the balance sheet, shareholders demanding a return on investment, and you see inflation in the outlook?

You deploy your cash.

ZIRP forces cash from the sidelines into the market, almost irrespective of the fundamental outlook.

Investors are scarred and highly skeptical of the markets, and are not surprisingly reluctant to leave those sidelines. But many have no option. That cash is slowly but surely getting squeezed back into the markets.

What happens if/when that cash is redeployed and the market fesses up to reality? A potential disaster waiting to happen.

An important article on deflation and hyperinflation

Here is a link to an article I found very useful in describing the relationship between deflation and hyperinflation.

The article is titled, How Deflation Creates Hyperinflation and is by Eric deCarbonnel.

What I found most interesting was the description of how hyperinflation takes hold, and how the accelerating velocity of money signals not animal spirits, but increasingly fearful spirits. We could do with a little increase in the velocity of money right now to unclog the system. But, be careful what you wish for. I doubt that we will undergo hyperinflation here (hyperinflation is generally only associated with failed states), but the possibility of heightened inflation (10%-15%) is not out of the question. Much depends upon the strength, the courage and the independence of the Fed, and its commitment to fight inflation. On the basis described in the article, I would say that Japan is a potential candidate for hyperinflation at some point in the future (although the demon of demographic deflation will serve as a counterweight...much will depend upon whether all those seniors retain their faith in the existing order).

Note: Somewhat strangely I think it could be argued that the American penchant for cynicism toward big government makes it a greater candidate culturally for hyperinflation compared to the more conforming Japanese culture. Only time will tell.

Controlling The Hydrant

Will the Fed act quickly enough to reduce bank reserves when the velocity of money normalizes? If they are like anyone else in the market, they won't. The problem is not a lack of knowledge or vision related to the risk (they are fully conversant of the risk). The problem will be a failure of timing due to human nature and political pressures. Just as most market participants failed to time their exit from the market with a crisis looming (and their entrance back into the market by the looks of things), the Fed is likely to fail in its attempt to time the withdrawal of reserves from the system.

The Fed is playing a high risk poker game. One that they have demonstrated little aptitude for based on historical precedent. The problem is compounded all the more by the ongoing decline in the duration of government liabilities and the split personality of balancing inflation with employment. The result is, they have a smaller window of opportunity to get things right before the the market dings them, and the costs of failure mount.

Inflation v Deflation? Yes!

Is it possible that we could get inflation in "hard" assets, and deflation in consumer prices?

I guess so.

It is hard to reconcile these two contrasting effects, but it may be possible. After all, all things are possible, but not all things are probable.

That having been said, a case could be made that monetary profligacy needs an outlet, and hard assets appear to be the place of choice. Conversely, it is also possible that a deleveraging economy based on a crippled consumer could lead to declining consumer prices.

We've already seen significant asset deflation (a 60% haircut is not much fun), but not much of an effect in consumer prices (stripping out energy and housing if you follow the core numbers...which I think is a joke but it suits the argument I am making here). With the market having bounced 39%, that looks like a correction to an overreaction, but we are still to see the follow-on deflationary effect on consumer prices take hold. I think its coming though. Rising unemployment, rising foreclosures (across the credit spectrum), less access to credit, rising savings all point to lower consumption.

Lower demand points to lower prices. After all it is still a competitive economy (just).

Where There Is Smoke, There Is Fire

Excellent Weekend Interview in the WSJ, highlighting the rot (basically poor structure, corrupt practices, and perverse incentives...sound familiar) that exists within the US legal system ("He Fought the Tort Bar - and Won").

Given our recent experience of an unsustainable imbalance (financial crisis), it reminded me of the importance of identifying other areas in the system that are rotten. These will be ruled by Stein's law "if something can't go up forever, it will stop."

There is a price to be paid for corruption. And, there is a day of reckoning. Getting a handle on how and when it will play itself out is the hard part. But first you must identify where the problems lay.

Here are a few suggestions of unsustainable imbalances:

Political/democratic process and systems - perverted by money
Healthcare - perverted by vested interests
Tertiary Education - 10% pa inflation unsustainable
Defense spending - military/industrial complex + political ideology
Unfunded Entitlement Liabilities - self-evident
Fiscal Deficit, Current Account Deficit, Govt Indebtedness - not sustainable, but...

I think that each will have their "Minsky Moment" but the damage from their fallout, in most cases, will be less severe than an overly leveraged financial system (the multipliers there are huge).

I will talk much more about these things at another time, as well as possible ideas as to how each of their unravelings may play out.

P.S. While we are essentially on the subject of systemic risk factors, here are two other substantive risk factors with systemic possibilities - inflation and deflation. More on those at another time also.