April 2016: Negative Interest Rates: Central Bank Omnipotence Fading


Central banks seem to be in some sort of perverse competition, vying to see who can push the limits of deranged, untested, monetary policies derived from theories that have no empirical evidence to support them. 

"If crazy doesn't work, try crazier!" – John Mauldin

In the U.S., the first wave of unconventional monetary policy suppressed short-term interest rates to near-zero levels eight years ago.  Next, from November 2008 through October 2014, it was multiple rounds of Quantitative Easing whereby the U.S. Federal Reserve (the “Fed”) siphoned $4.5 trillion of bonds and mortgaged-backed securities out of circulation and replaced them with zero-interest-rate cash.  Now, the Federal Reserve is considering following in the footsteps of Europe and Japan, adopting a negative interest rate policy. 

Why negative interest rates? The theory is that lower interest rates will encourage borrowing for additional investment that will increase the output of goods and services.  Unfortunately, however, negative interest rate policies are simply a different version of earlier failed policies.  Somehow, central bankers think if they adopt even more outrageous measures—that is, take interest rates into negative territory—this will miraculously lead to the productive use of capital. 

There will be unintended consequences that accompany these dramatic policies.  Paying no interest to depositors, or charging them interest, increases the penalty imposed on individuals and institutions for saving.  This sends investors and savers a dire message: Central banks are becoming increasingly desperate because their policies to stimulate the economy are not working. Instead of motivating people to spend money, this is a prescription for making people want to hang on to their money.     

"Desperate times call for desperate measures" – from the Latin proverb "extremis malis extrema remedia"

After six years of crazy policies followed by crazier policies, and a still tepid economy, central banks are revealing their desperation. They are grasping at anything that might improve economic growth, employment, and investment.  Desperate times call for desperate measures.

Central Bank Omnipotence Fading

The Federal Reserve has cultivated an image of being all-knowing, all-powerful and the guardian of financial markets. But, even Superman has his limits.  Perhaps the Federal Reserve has run into its own version of kryptonite? 

If everything is under control, and the economy is healthy and growing stronger, like the Fed says it is, why does the Fed feel it is still necessary to maintain near-zero interest rates? The Fed’s announcement to return to “normalized” interest rates was more than a year ago.  Yet, so far we’ve seen one tiny increase (0.25% in December 2015) followed by more reasons to delay further increases.

"Action speaks louder than words but not nearly as often." – Mark Twain

Perhaps things really aren’t so hunky-dory after all.  The Fed’s narrative of confidence and “all is well” simply doesn’t gibe with their actions.  Holding interest rates at crisis levels implies continued financial weakness and vulnerability, not economic strength and confidence. 

The radical polices of central bankers carry the implicit assumption that they can produce economic growth.  After reviewing the questionable results of six years of increasingly radical, experimental monetary policies, the omnipotence of the Fed is being questioned, and rightly so.  

Investor behavior has been influenced and shaped from a false sense of comfort surrounding the popular myth that, “Everybody knows the Federal Reserve is all-powerful and won’t let the stock market decline. They have my back.”   Alas, if only that were true the 49% stock market decline in 2000-2002 and 57% decline in 2007-2009 could have been averted.  Perhaps the Monetary Kings (central bankers) of the world have no clothes after all. 

Investor folklore, if repeated often enough, becomes “conventional wisdom”… at least, until it fails in an obvious way. The myth of the Fed being all-powerful and in control, and the resultant confidence people place in the Fed (and government in general), is eroding. Like any confidence game, once confidence starts to diminish, it further erodes the power and effectiveness of the manipulator Federal Reserve.  As skepticism gains momentum, the confidence game disintegrates.

"In a time of deceit, telling the truth is a revolutionary act." – George Orwell

Here’s a revolutionary idea!  We believe that the Federal Reserve’s confidence game has peaked and is now declining. 

The Fed is not omnipotent, and neither are other central banks around the world.  In fact, based on their increasingly desperate policies, they are running scared.  Further, investors are wising up to the difference between artificially boosting prices associated with the means of producing goods and services (i.e., stock and bond prices) versus genuine economic growth that increases the production of goods and services and personal income.  Asset price increases are not the same as increases in the production of goods and services. Sure, everyone loves a lofty stock market.  But, when risk-seeking investing morphs into risk-aversion (and it will as the confidence game crumbles), lower stock prices will be needed to persuade risk-averse buyers to come to the table.

Investing for Profits and Capital Preservation

This is not an easy environment for investors, especially investors like us who are seeking income and protection of capital.  In today’s world of ultra-low interest rates, little income can be collected from stocks, bonds, money market funds or bank deposits. Ten-year U.S. Treasury bonds yield just 1.8%, and dividends for the 500 largest U.S. companies (the Standard & Poor’s 500) average a scant 2.2%. Further, the stock market (S&P 500) has made no progress in over a year, ending the first quarter at the same level seen in November 2014.

While that’s the way it is now, it won’t always be that way. Stocks (and bonds) go up and they go down.  Our portfolio allocations are not fixed in stone; we are not required to hold a constant, fixed percentage of stocks in our portfolios.  Instead, we have the latitude to adjust your portfolio stock allocation higher or lower depending on how attractive or unattractive stocks are at the time. 

Our managed portfolios currently have a below-average stock allocation of roughly 47%.  The other 53% is in bonds and cash.  A low stock allocation today potentially provides two sizable advantages: (1) you can better weather a stock market decline, and (2) you have ample reserves needed to buy stocks at lower prices.   

Prices will eventually become more reasonable and offer the potential for higher returns with less risk. Obviously, you and we would like this to occur sooner than later.  Although we don’t have control over when that opportunity will arrive, we do have the ability to be patient and wait for it.

At the right valuations, we plan to boost your stock holdings by as much as half, possibly increasing them from 47% to as much as 75%.  Think of it this way—you have a low percentage of your portfolio in stocks now when prices and valuations are high, but you have the means (53% in cash and bonds) to increase your stock allocation when prices are low and valuations become attractive.  You have the potential to enjoy the best of both worlds—low stock exposure on the downside and high stock exposure on the upside.     

We can’t change the investment environment, but we can and do adjust portfolios accordingly. Patience is essential for prudent investors that want to preserve their capital and capture gains without taking undue risk.  We think the rewards will be well worth it.  Thank you for your support and for your patience.  ***

 © Asset Allocation Advisors, Inc. 2016