Friday, January 27, 2012

The Interest Rate Policy Wall

Click to enlarge.

Today's interest rate on the 10-year treasury is 1.93%.

Let's use the formula for the trend line to see what happens.

y = 0.6903x + 0.0264

0.0193 = 0.6903x + 0.0264

x = (0.0193 - 0.0264) / 0.6903

x = -0.0103

If all we knew was that today's 10-year treasury yield was 1.93% then we could make an educated guess that the fed funds rate would be somewhere in the ballpark of -1%.

The fed fund rate isn't -1%. It hit the 0% wall and can go no lower. That said, I'm reasonably confident that Bernanke would set it at -1% if he could. The seasonally adjusted CPI has flatlined for the last three months.

January 27, 2012
Bernanke to Income-Starved Retirees: Tough Luck

If it wasn’t clear already, it is now: securing decent retirement income in a low-yield environment is going to be a problem for a long time.

It certainly wasn't clear to Jeremy Siegel back in February. He seemed to think that the economy would generate ample biscuits and gravy for us all, just like it had done for 200+ years.

In August, Bernanke said the Fed would keep rates down through the middle of 2013. Now, in his most recent remarks he has extended that pledge to late 2014.

Let's put this another way.

In August 2011, Bernanke said that the Fed would keep rates down for roughly two years.

In January 2012, Bernanke said that the Fed would keep rates down for roughly two years.

Bernanke is consistent with his two year predictions. I'll give him that. Perhaps rate hikes will be two years away for many, many years. That's the way it worked out in Japan after their housing bubble popped in the 1990s. As a saver, that is and was my primary concern.

That's why I locked in a real yield at the very time Jeremy Siegel was advising the opposite. Unlike Japan, I opted for the inflation protection. That's neither here nor there though. The added inflation protection has neither helped nor hurt me. Inflation expectations haven't budged. The only thing that's moved are the
real yields and in the direction that I feared.

It is becoming increasingly difficult to make money off of money. This has been a
central theme of my blog since the very beginning. Expecting future investment returns to mimic past investment returns is a symptom of the illusion of prosperity. Economists like Jeremy Siegel continue to cling to the prosperity dream in spite of all concrete evidence to the contrary.


My bad. Bernanke actually went from 2 years to 3 years. In order to be consistent his next prediction will be that he raises rates in 4 years. You know, if the trend is our friend. Sigh.

Source Data:
St. Louis Fed: 10-Year Treasury
St. Louis Fed: Federal Funds Rate


Parker Bohn said...

The middle class is shrinking, and asset yields are meager.

It is harder to save money, and at the same time necessary to save more money.

I feel bad for anyone in or rapidly approaching retirement who was planning on getting an actual (real) return on bond investments.

I am in my 30's, so I feel comfortable putting my savings into stocks, which I don't expect will perform anything like their historical average, but should outperform bonds/treasuries by a wide margin over the next 10 or 20 years.

fried said...

"It is harder to save money, and at the same time necessary to save more money."

True. I'm in my 50s, and I can vouch for that. The game now is to hold on to what you have, and even that is tough. Even so, the people I know here in Manhattan, mostly docs and lawyers, the next tier down from financial sorts, are only deleveraging slightly. They seem to be waiting for normal to reappear. I wish them all good luck, but scaling way back, saving more and trying to keep what you have above water seems to me the only viable option.

Mr Slippery said...

Awesome chart, Mark!

It is becoming increasingly difficult to make money off of money.

I'm with you there. But with long term ZIRP, I am convinced you can make money off of rocks. I started add buying more rocks in December and that has worked out. Even my nickels are approaching 6 cents in metal value again.

I think Bernanke's policies, and the government debt load leave no other options, will transfer a lot of wealth from people holding dollars to those holding tangible assets.

TIPS and i-Bonds should be relative winners, too, preserving purchasing power.

Stagflationary Mark said...

Parker Bohn,

It is harder to save money, and at the same time necessary to save more money.

Yes! That is the key. ZIRP is intended to make me spend more money but as a retired saver it is having the exact opposite effect (at least on me).

I am in my 30's, so I feel comfortable putting my savings into stocks, which I don't expect will perform anything like their historical average, but should outperform bonds/treasuries by a wide margin over the next 10 or 20 years.

I'm not convinced that stocks should outperform bonds by a wide margin. I would therefore change your "should" to "could" personally. Here's my thinking.

1. I'm a complete believer in your "necessary to save more money" theory. It implies that people will necessarily spend less. Spending less could be very hard on the stock market, even at these depressed levels. Put another way, if the majority of people became as frugal as I am then, well, you know.

2. Few would have thought that Japan's ZIRP bonds would have outperformed Japanese stocks over the long-term after their housing bubble popped, perhaps myself included. History shows otherwise though.

That said, stocks could outperform bonds by a wide margin. I'm not suggesting that they couldn't. It is just not something I'd feel comfortable betting on. Unlike you, I'm not in my 30's and I do not have a job to fall back on.

I also don't feel the need to load up the truck on nominal long-term treasuries. We are not Japan. I prefer to have the limited inflation protection that TIPS and I-Bonds offer.

Inflation could remain tame and probably will. Heaven help us all if it doesn't though.

And lastly, if stocks outperform bonds by a wide margin then I suspect that we have a LOT more pain coming. About the only way I see this happening is if stocks do very poorly but nominal bonds do even worse. It could happen. I do have stagflationary in my name.

In that event, I suspect I Bonds will do much better than stocks.

Stagflationary Mark said...


They seem to be waiting for normal to reappear.

Perhaps they are spending too much time reading and rereading the 4th edition of Jeremy Siegel's Stocks for the Long Run. You will note that it was released on November 27, 2007. He got it in just a few days before the great recession hit, lol. Sigh.

Stagflationary Mark said...

Mr Slippery,

I'm clearly not as convinced that tangible assets that have experienced terrific upside price appreciation (relative to their inflation adjusted historical norms) will save us. I point to real estate as the obvious example of Tangible Assets Gone Wild!

Monex would like us own its gold at any price.

Nobody will ever tell us that this is the perfect time to stock up on toilet paper (relative to other investments and savings options). That's at least one reason why I have. Sigh.

Parker Bohn said...

Re: Stocks vs fixed income.

No matter how I slice it, its hard for me to come up with a long run return on stocks that is below 3% or 4% real.

Let's say 2% from dividends, & 1.5% from GDP growth, that's 3.5% right there.

What about inflation? If I own stock in Wal-mart, & there is inflation, then pretty much by definition WMT is raising prices - in the long run, stocks should be reasonable inflation protection.

Of course, all this 'optimism' about 3-4% real returns is assuming we don't Mad Max ourselves one way or another!

Stagflationary Mark said...

Parker Bohn,

I have an easier time coming up with unfavorable scenarios.

1. 1.5% GDP growth is not a given.
2. 1.5% GDP growth does not necessarily translate into profit growth. It is possible for competition in rough times to soak up a great deal of profits (especially if we continue to generate recessions, which I think the government is powerless to stop).
3. Inflation can be VERY bad for stocks as the inflationary tapeworm eats.

And most American businesses are currently “bad” businesses economically - producing less for their individual investors after-tax than the tax-exempt passive rate of return on money.


But inflation takes us through the looking glass into the upside-down world of Alice in Wonderland. When prices continuously rise, the “bad” business must retain every nickel that it can. Not because it is attractive as a repository for equity capital, but precisely because it is so unattractive, the low-return business must follow a high retention policy. If it wishes to continue operating in the future as it has in the past - and most entities, including businesses, do - it simply has no choice.

For inflation acts as a gigantic corporate tapeworm. That tapeworm preemptively consumes its requisite daily diet of investment dollars regardless of the health of the host organism. Whatever the level of reported profits (even if nil), more dollars for receivables, inventory and fixed assets are continuously required by the business in order to merely match the unit volume of the previous year. The less prosperous the enterprise, the greater the proportion of available sustenance claimed by the tapeworm.

Under present conditions, a business earning 8% or 10% on equity often has no leftovers for expansion, debt reduction or “real” dividends. The tapeworm of inflation simply cleans the plate.
- Warren Buffett, 1981

Stagflationary Mark said...

I should add that the inflationary tapeworm between 1980 and 2000 was not bad for stocks.

Stocks benefited from the inflation from 1980 and 2000. That's where the money went... into stocks.

One need merely look at the falling price of oil in that era to see that it was not the same thing that we're experiencing now. I do not think it is a coincidence that oil bottomed about the same time that stocks peaked (in real inflation adjusted terms).

I would bet all that I own that we will never see the 1939 to 2000 era repeat. The real question will be what happens when the reality of that sinks in for most. Will they turn as frugal as I am?

Stagflationary Mark said...

Here's a bonus chart to consider about long-term GDP growth trends.

Charles Kiting said...

mostly docs and lawyers

You do realize that those two professions are notorious for being the most economically illiterate in relation to their education levels.

Stagflationary Mark said...

Charles Kiting,

I blame ambulances. One group spends all of its time chasing them and the other spends all of its time trying to fix what's inside.

There just isn't enough time for anything else. ;)