Last week, 401(k) Specialist published Institutional Investors Both Optimistic, Pessimistic Post-Pandemic. I believe that paranoia is more appropriate than schizophrenia at this time, and that optimistic statements are gaslighting, tricking investors into ignoring current realities.
As stock markets continue their meteoric rise, optimism currently prevails, driven in large part by investor biases. But investors should consider what might spoil the party. The most likely spoiler is the termination of Zero Interest Rate Policy (ZIRP) since rising interest rates decimate stock and bond values. The reduction in bond values is straightforward because bond prices fall when yields rise.
The impact on stock prices is more nuanced. Investment analysts estimate a fair stock value by projecting earnings and then discounting those back to today.
So, if interest rates rise, the discounted present value of future earnings declines, making a stock worth less. In fact, current low-interest rates (ZIRP) are the common justification for high stock prices, implying that stock prices would be lower if interest rates were higher.
Will ZIRP ever end?
Most want to believe that the Federal Reserve controls ZIRP and can make it last for as long as it wants, so alarms went off when the Fed indicated in its August 18 open market meeting that it will probably start tapering bond purchases this year. Investors have been warned/alerted.
But is the Fed simply getting ahead of the inevitable? Is it important for the Fed to appear to be in control of interest rates? The Fed cannot continue to suppress bond yields by buoying up bond prices because serious inflation — more than 2% — is on the horizon and some foreign governments pay much higher yields on bonds that are comparable in quality to US bonds.
Inflation
The classic definition of inflation is “Too much money chasing too few goods.” The United States government started an experiment in 2008, printing $4 trillion in Quantitative Easing (QE) to ward off a recession. It worked because this printing headed off recession and apparently did not cause inflation, so the appetite is there for more.
But recent money printing for COVID relief and other expenses is poking the inflation bear—testing to see what will cause inflation. As shown in the following picture, the M1 money supply has quintupled overnight.
No surprise, this money flood is showing up in consumer prices, but optimists assure us that this is transitory, and the result of recovering from the pandemic.
Please note that the mechanism for removing all this money from the economy is taxes, so inflation will be transitory if taxes are raised a lot and soon.
The other pressure on ZIRP is foreign competition for high-quality government debt.
Foreign competition
Investors searching for safe yields will find it in 10 foreign countries. Of course, you might want to hedge currency risk if you think the almighty dollar is stronger than the currency of another country. Or you could buy the bonds of all 10 countries to diversify both credit and currency risk.
The following exhibit shows 10 countries that are paying higher yields than the U.S. on their 10-year government bonds, all with high A-or-above credit ratings. For example, China pays 2.9% on their 10-year government bond rated A+, more than twice the U.S. yield of 1.2% rated AA+. The average yield across all 10 countries is 2.5%, more than double the Unites States.
In this global economy, money is free to flow to its most productive uses. Foreign competition is another reason that the Fed cannot control long-term bond yields if the Treasury wants to sell 10-year bonds.
ZIRP cannot last forever because it requires an exorbitant amount of money to achieve the required manipulation. At some point, there will not be the will or the means to continue. When it ends, look out below.
Ron Surz is CEO of Target Date Solutions (TDS), co-host of the Baby Boomer Investing Show (BBIS), and author of the book "Baby Boomer Investing in the Perilous Decade of the 2020s." TDS licenses target-date fund usage of Ron’s patented Safe Landing Glide Path® (SLGP) that actually protects beneficiaries as they approach retirement. Individual investors can follow the SLGP at Age Sage, an educational interactive website. The BBIS educates baby boomers on the risks and rewards in contemporary investing, and Ron’s book is a tour of these shows. He can be reached at Ron@TargetDateSolutions.com.
Very good points that I had not considered especially other countries bonds.Watching the market closely since I agree with the author about inflation and interest rate increases causing the bubble to burst and cancelling all my gains