More on the currency wars and negative real rates
In reading recent notes on central bank policies, I am struck by how accommodative central banks are everywhere. Interest rates that are negative when adjusted for inflation are the norm not the exception. And this is true as much in emerging markets as it is in developed markets. The question is: what should this mean for investors?
In light of Ben Bernanke’s recent press conference, let’s look at this from a US perspective. In the past, you could have expected to get 2 or 3% return on your government bond portfolio after inflation. Over the past quarter-century, with bond yields coming down significantly, you also saw some nice upside in terms of price appreciation as well. Investors could get total returns of about 8% per annum in recent decades – 4 to 5% or so after inflation. But that is no longer true. Short-term rates are zero percent. Central Banks are robbing bond holders. What do you do?
There are a number of strategies one could take on, but they include taking on greater risk and leverage.
Leverage up: Ben Bernanke made it crystal clear that the Fed will not raise rates in 2011. The dollar plummeted on the news. This is actually good news for banks doing the carry trade. As James Galbraith says, banks can borrow for next to nothing and reinvest their borrowings in treasuries at 2 or 3% (only institutions with access to the discount window can do this. You and I can’t). With leverage, that makes a nice return. And now the Fed Chairman has confirmed that you can keep doing this trade for months to come. If you are a financial institution, Bernanke is telling you now is the time to leverage up because the carry trade is risk free.
Move abroad: Strategy number two is to move abroad. This is part of what Bill Gross and PIMCO have been doing. They are shunning Treasuries in order to get yield at a reasonable price in other markets that have good macro fundamentals. You first saw this early in 2010 with Bill Gross and the deficit ring of fire talk. At first, Gross was talking about performance divergence in developed markets, but made the inconsistent argument that American-style capitalism has reached a dead end but buy T-bills anyway. Soon he moved on to emerging markets. And by last month you heard Bill Gross on fiscal profligacy and dumping the negative real yields of treasuries. But, inflation is rising across the emerging markets and a number of markets have building external imbalances. Of course, with the dollar plummeting, that might be a good bet since you can get some extra return on the unhedged portion of the currency appreciation. Caveat emptor.
Move out on the risk curve: You could load up on high yield right now. Defaults have been low and you get an extra few hundred points of pickup. In February, yields moved below 7% though. And managers like Jeffrey Gundlach are cautious on high yield as a result. He doesn’t see high yield outperforming treasuries, which have lower risk. And the bonds issued in 2009 or 2010 were of dubious quality. Gundlach sees defaults coming in the next year or two.
Move into riskier asset classes: As I said a the outset, a lot of the total return from bonds over the past two decades came from the decline in interest rates. Bond guru Bill Gross now has an equity fund going. He’s saying the bond bull market is over. And that makes sense since interest rates are zero percent. So moving into equities is one way to get greater return. However, this means greater risk too.
Move into alternative investments: In the old days, you were compensated for holding cash. The Fed has assured us that cash is trash by cutting rates to zero percent. When it comes to gold, one reason people had been reluctant to own it is because of the lack of yield. Gold pays nothing. However, with cash also paying nothing, gold and silver become more attractive as investments. Moreover, with negative real rates, cash is actually declining in value. That’s a huge incentive to go for gold. There is no opportunity cost any more. Traditionally, people think of gold as an inflation hedge. It is better to think of it as a hedge against currency debasement, meaning it is attractive when real yields are negative as they are today across a wide swathe of countries. The same thinking would also encourage investment in other hard assets like farmland and commodities. And that is exactly what we have seen.
None of these strategies are risk-free but then again the risk-free asset, cash, is being debased. Is it risk free? Bill Gross for one knows this is a Devil’s Bargain.
Now, Gross says "It is still possible to produce 4–5% returns from a conservatively positioned bond portfolio – you just have to do it with a different mix of global assets." Here’s the thing though. Pension funds are huge bond managers and real yields at zero percent or below are not going to cut it. They have liabilities in the form of pension benefits already granted which they must pay for. And their actuarial assumptions are saying 8, 9, 10% nominal yields on investments. How are you going to achieve this in a world of zero percent real bond yields? I don’t see 4-5% returns from ‘conservatively’ positioned bond portfolios as likely. More likely, bond managers will reach for yield by taking on risk and pension funds will re-balance portfolios away from low-yielding bonds into riskier investments. And greater risk doesn’t always mean greater reward. Sometimes risks do materialise in the form of losses. There’s no such thing as a free lunch.
Much of this kind of investing will be further spurred on by Ben Bernanke’s performance yesterday. Clearly he is worried about the economy. Real GDP growth for the last quarter came in at 1.8% today. You should notice that the economic growth rate has steadily declined throughout QE2. So despite what the Fed Chairman says, QE2 des not have a material positive effect on the real economy. But rates are at zero. What else would you do if you were tasked with supporting economic growth as one of your dual mandates? So, Bernanke is saying in effect, "rates will be zero for a long time. Feel free to speculate."
That makes me think a lot about the currency wars. The dollar is tanking right now. The fact that the ECB has increased rates was the first blow. But after Bernanke signalled rates in the U.S. will remain low, the dollar slid even more. The emerging markets have an inflation problem and many of those countries are behind the curve. So you know the policy rate differential between the U.S.’s zero interest rate policy and the rest of the world except Japan will increase. That puts downward pressure on the dollar. But it also puts downward pressure on the Chinese currency because of its dollar peg.
Now that the Fed has confirmed it won’t raise rates and the dollar is dropping, for me it means the currency wars are back on. I suspect this time around China will get the stick instead of the US because of the Dollar peg. What China should do as Chinese inflation spirals ‘out of control’ is not just tinker with reserve requirements and slowly raise rates. They need to revalue much more aggressively. Instead you see China potentially adding fuel to the commodity rally by diversifying reserves out of US dollars, making the inflation problem worse. It doesn’t sound like the Chinese are very serious about their inflation problem. I reckon other emerging markets will see this combined with the plummeting dollar and cry ‘foul.’ And so when the currency wars re-ignite, it will be the Chinese under the gun instead of the US.