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.
Friday, September 24, 2010
Breakout
Technically we broke out earlier in the week, but then we went back and tested the new support line. Today's big move is a confirmation of the breakout and is likely to draw shorts and cautionaries back into the fray. A comment by David Tepper that we're in a win-win situation (if the economy recovers, the market goes up, and if the economy tanks, the Fed will intervene and the market goes up), looks to have got things going. Volume is still enemic, but breadth is humongous. Even though we may be entering a new range, I doubt we're out of the woods and this could all be a little premature. Having said that, if the market gets its courage up, it could have a real nice end of year rally.
If you're looking for a fundamental spin on the breakout, about the best I can surmise is that some of the leading edges may have started looking beyond the current soft patch, and are anticipating greater recovery in the future (leading to sustainable earnings growth and expanding multiples). Right now, all we have are expanding multiples (risk on).
If you're looking for a fundamental spin on the breakout, about the best I can surmise is that some of the leading edges may have started looking beyond the current soft patch, and are anticipating greater recovery in the future (leading to sustainable earnings growth and expanding multiples). Right now, all we have are expanding multiples (risk on).
The Idea Behind POMO's
I don't think the Fed would articulate their monetary policy quite this way, but it seems to me that the theory behind their non-sterilized permanent open market operations (POMOs) is that by juicing asset markets they are promoting greater confidence in the future (via the wealth effect), thereby leading to increased consumption and greater business investment (economic growth).
Twill be interesting to see if any parts of that transmission mechanism misfire.
Twill be interesting to see if any parts of that transmission mechanism misfire.
Friday, September 17, 2010
Big picture update
Things unchanged.
Since the crisis, the authorities have propped the system up through QE and fiscal stimulus. But even that failed to stop asset price deflation. Into the bargain, people are still unemployed resulting in contracted incomes, and scared witless consumers. Worse than that, we have seen no credible attempts to address the real flaws in the system (global structural imbalances, unfunded entitlement liabilities, financial moral hazard).
Recovery will ensue, but it will be a languid, stop-start affair. Even as the recovery takes hold and confidence returns, the economy will be racked by secular headwinds (interest rate unwind, higher taxes, delevering consumer, fiscal belt-tightening). None of which means that equities will necessarily be a bad place to reside (they'll be solid because we're starting from a low base, they just won't be spectacular).
The costs of the artificial pumping will be bourne by current taxpayers and future generations.
Implications: multi-year stagnation.
Since the crisis, the authorities have propped the system up through QE and fiscal stimulus. But even that failed to stop asset price deflation. Into the bargain, people are still unemployed resulting in contracted incomes, and scared witless consumers. Worse than that, we have seen no credible attempts to address the real flaws in the system (global structural imbalances, unfunded entitlement liabilities, financial moral hazard).
Recovery will ensue, but it will be a languid, stop-start affair. Even as the recovery takes hold and confidence returns, the economy will be racked by secular headwinds (interest rate unwind, higher taxes, delevering consumer, fiscal belt-tightening). None of which means that equities will necessarily be a bad place to reside (they'll be solid because we're starting from a low base, they just won't be spectacular).
The costs of the artificial pumping will be bourne by current taxpayers and future generations.
Implications: multi-year stagnation.
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