monetary policy

Burning Up Money

© Can Stock Photo / ancientimages

No doubt you probably noticed the turmoil in the stock market over the past several weeks. You might have assumed, if you watched the stock indexes hit a low of more than 10% below their peak, that some particularly ugly piece of news had hit the market.

If so, you would probably be surprised to hear that the biggest news stories leading to the correction were that the economy was booming and unemployment was at record lows. So why were investors panicking at this seemingly positive news? The answer is inflation.

You see, as the economy grows, increasing wealth leads to increasing demand. This means higher prices–or, in economic terms, inflation. This creates a couple of problems for the stock market. In the long term, rising prices make it harder to maintain economic growth and may contribute to an eventual crash. In the short term, both economic growth and inflation increase the pressure on the Federal Reserve to raise interest rates, making bonds and other interest-driven investments more attractive relative to stocks.

We are deeply skeptical of this short-term rationale. While bond investors may salivate at the prospect of higher interest rates in the future, we think this is short-sighted. Tomorrow’s higher interest bonds may sound attractive, but you would be foolish to buy them if the interest rate is going to be even higher the day after. On February 5th, when the stock market was posting headline-grabbing declines fueled by interest rate paranoia, investors were actually buying up bonds–bonds that stood to lose purchasing power as soon as better, higher interest bonds started being issued!

The longer term concern, that inflation may spell the beginning of the end of the current economic boom, is a bigger threat. We have warned for a long time that the Federal Reserve was likely to wind up overshooting the mark on its 2% inflation rate target. We think this is even more likely now that the government has passed a very stimulus-minded tax package. Cutting taxes during the middle of a boom is likely just throwing gasoline on the fire: it is possible we may see some explosive growth, so in the short run we are excited about the market, but in the long run the economy may just burn out that much faster.

Clients, many of you have been in business with us long enough to remember the roller-coaster years we saw around 2007. The dip at the start of February may potentially be forgotten as the market forges on ahead, but it will not be the last one. The roller coaster is coming back, and although we look forward to the ride we will keep a mindful eye for the day we may need to think about getting off. Call us if you have any questions about the market and the broader economic outlook.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

All investing involves risk including loss of principal. No strategy assures success or protects against loss.

The Medicine is Worse than the Disease

© Can Stock Photo Inc. / nebari

Monetary authorities took extreme measures during and after the financial crisis. These policies failed in their stated goal. More importantly, they have the potential for much mischief in the portfolios of the unwary in the months and years ahead.

Fed Chairman Ben Bernanke made it clear that the role of zero interest rates and Quantitative Easing was to push money into productive investments (or “risk assets”) that would help the economy grow. Instead, the biggest tidal wave of money ever flooded into supposedly safe assets, like Treasury bonds. Money flows into US stocks disappeared in the crisis, and basically have never come back. Zero interest worked exactly opposite the way it was supposed to. This obvious reality is totally ignored by the central bankers.

Current Federal Reserve Chair Janet Yellen continues to parrot the party line. Progress toward undoing the mistaken crisis policies has been excruciatingly slow. And the potential for damage to safety-seeking investors continues to mount. Similar policies, or worse, are in effect around the world.

Standard & Poor’s recently issued a report stating that corporate debt would grow from a little over $50 trillion now to $75 trillion by 2021, globally. Bonds are the largest single form of corporate debt, which is how investors are affected. This isn’t happening because corporations are investing so much money in new plants and equipment and research. It is merely meeting the demand of safety-seeking investors for places to put money. We think of this as “the safety bubble.” It appears to be the biggest bubble in history.

Standard & Poor’s is warning of future defaults from companies that borrowed too much money at these artificially low interest rates. Our concern is that when interest rates inevitably rise, people locked into low interest investments will see large market value losses even if their bonds are ultimately repaid.

We’ve written about the impact of higher inflation on today’s supposedly safe investments. Now the warning from S&P highlights another risk. The distortions created by counter-productive monetary policy are growing.

Of course, we believe our portfolios are constructed to defend against these risks, and to profit from the artificially low interest rates. We will continue to monitor these and other developments. If you have questions or comments, please email or call us.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Not All That Glitters is Gold

© www.canstockphoto.com / scanrail

The gold standard is a seductive idea that tends to emerge in times of economic confusion. We see this today with the anxiety surrounding the Federal Reserve’s long-anticipated rate increase. Gold is synonymous with wealth, and a gold-based currency represents stability in a world of economic uncertainty… or so we think.

Unfortunately the reality is more complex. The value of a currency is based on two things: the amount of that currency, and the amount of economic wealth it represents. If our supply of currency increases at the same rate as the supply of “stuff” for it to buy, prices remain stable.

If the supply of currency grows faster than the supply of “stuff”, it takes more currency to buy the same amount. Prices rise, and then we have inflation. The gold standard is not a guarantee against this: sudden increases in the gold supply (such as from a mining boom) can create spikes of inflation in a gold-based economy. This risk decreases as we accumulate more gold stockpiles, but gold supplies can still be manipulated by currency speculators in the open market, doing serious damage to gold-based economies.

Worse, even if we could keep the supply of gold stable, the supply of “stuff” is not. If a large amount of wealth is wiped out (by wars, natural disasters, or economic collapse) then we have inflation again as there is now too much currency for the shrinking amount of stuff, creating a “double whammy” of inflation on top of economic hardship.

If the currency supply fails to keep up with the “stuff” supply (as is likely when mineral gold reserves become depleted), it’s just as bad. In this case, the currency becomes more valuable and prices decrease. We have deflation, the opposite of inflation. This sounds fantastic at first: all our money becomes more valuable! But then we have a problem, because who wants to spend money today if they know it will be more valuable tomorrow? Everyone begins hoarding money instead of spending or investing it, creating an economic slowdown.

We don’t always agree with the Fed’s policies. However, we believe that having someone influencing the money supply on purpose is a better way to stabilize prices than crossing our fingers and hoping that our supply of shiny metals just happens to expand and contract itself as needed.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Investing involves risk including loss of principal. No strategy assures success or protects against loss.