Interest(ing) Times

 

In these days of lower or at least sub-optimal, economic growth around the world, there is a concerted attempt to ‘juice the demand’ by keeping interest rates low.  You know this of course, given the great deal of press the topic has been given (Quantitative Easing #3 tampering off here in the USA, Japan’s grand economic stimulus of the same means recently announced).  Notwithstanding how prescient those moves sound, this correspondence will cover some lesser known intended by-product effects, and then how those impact your investments here.

Spoiler alert; they are positive because you DID NOT follow the crowd.

The by-product effect that is not often discussed is what the central banks around the world REALLY want in addition to growth; they want inflation.  Yes, yes, we are aware that all government policies say we need to control inflation, but you will carefully note that they do not say “we don’t want inflation”.  The reasons are twofold;

  1. If you are a holder of substantial amounts of economic debt, as governments are these days, they want inflation because it makes the payback of the debt easier (on the payer, be it them in the form of the boys and girls at the Treasury Department, or from the public, i.e. you).  Inflation makes paying ‘old debt’ cheaper to do because future money is worth less with inflation.  Thus, it’s a hidden stimulus for the future.
  2. Also, keep in mind what a smart public will do if they think prices are going down vs. up; they will not buy today because tomorrow will be cheaper. Logical, Dr. Holmes.  Thus the rub; If you don’t buy today, given the fact we are a consumer driven economy, you don’t generate economic growth or taxes.  Not good.

Thus, behind all these stimulus moves is the desire to draw the inflation bear out of the cave, but not so far that he threatens the town.

The second part of inflation is that it gives an upward sloping yield curve for interest rates.  That mumbo-jumbo simply means I should naturally expect to pay more for borrowing money the longer out I go.  What most of the ‘active investment philosophy’ trading community does is engage in the infamous game of guessing what these moves mean for WHEN interest rates go up.  If you knew, voila, you’re loaded with dough because you out-fox everyone else.  You, however, don’t engage in that game with your investments here as you take a disciplined, long-term, non-speculative approach.  Nonetheless, your biggest fixed income investment is in a special fund called ‘Investment Grade’ (look on your TDAmeritrade statements and you’ll see it).  For your education, but also hugely germane to this dialogue, let’s examine that fund a bit.

This fund is very sophisticated, and actually is made up of 4 separate funds.  Thought the details are too complex to fully explore here, what it does is to CONSTANTLY measure the trade-offs’ evident in the market on the two critical areas of bonds; Term Risk, and Credit Risk.  Term risk means ‘inflation is going to drive interest rates up and I need to be compensated more for it’ (the point discussed immediately above),and Credit Risk which means ‘Government bonds are safe and some corporate guys might go bust so they need to pay me more to take that risk of default’.  Rather than guessing like the highly paid Wall Street people do, it follows strict guidelines on when (and when not to) take (or not take) more Term or Credit Risk.  So, how’d that work for ya?

Through September 30, 2014, this fund was up 4.66%[i].  Through November the return is 5.54%[ii].  When interest rates for savings accounts are running at 1/20th of 1%, that’s not shabby.  But WHY did it work?  The answer is because a year ago there was large expectations that interest rates in 2014 had to be much higher than 2013 as the infamous Quantitative Easing would cease and markets would be frightened.  What do we have instead?  Unemployment down, but not yet robust, oil and gas prices down and inflation mostly absent. Thus, observing the experts proficiency on the predictability of interest rate movements makes the quote from famous economist John Kenneth Galbraith readily understandable;

“We have two classes of forecasters; those who don’t know – and those don’t know they don’t know.”

The upshot; Governments need to be careful what they wish for, but your staying disciplined on financial matters shows why investment strategies are infinitely better than wishes.

I sincerely hope this education on a very complex subject was useful.  It remains my pleasure to serve you.

[i] Dimensional Advisors; Fund Center

[ii] ibid