Are low interest rates bad for your health? Do they lead to the global misallocation of funds? Do they encourage conservative investors to speculate? Do they create asset bubbles and encourage ill-advised carry trades?
The loose monetary policy being pursued by the Federal Reserve Bank is an attempt to maintain the slow progress in fighting the recession. This is no mystery. The recovery is certainly taking place but it is still very fragile. Investors are nervous and nobody wants to be the first one to blink. Those that have commited themselves have their eyes wide open waiting for signs of a moving herd. Hence the mild panic when the Fed raised the Discount Rate. Was this a signal of things to come?
Even if the Fed does intend to loosen monetary policy and mop up the excess liquidity left over from the massive recovery programme created to fight an all out crisis, such a process would be long and slow. Nevertheless the markets are anxious for any sign that the days of cheap money might be over. Because then, times might get really tough.
Be that as it may, what are the effects of this low discount rate? Are low interest rates encouraging speculation? Some say yes. Take a billion dollars and try and decide what to do with it. Where is the Alpha? Equity markets, bond markets, commodities, precious metals? Where to invest? Basically, with the bond markets you are likely to get a pitiful if not negative real return and this will push you to look further afield to find that extra few per cent that makes investing a worthwhile proposition.
However, this carries a danger with it as this situation is pushing investors, despite themselves, to allocate capital in a dysfunctional manner. You are a conservative investor and you want to buy Treasury bonds because they make you feel safe and they should offer a decent if modest yield – but currently they do not. So you become audacious despite your better self. This is pushing people to treat real estate, emerging markets and precious metals as grade A investments simply for the lack of an alternative. Traditional risk management flies out the window simply for lack of a sensible alternative.
When inflation starts to rise as a result of the massive spending and quantative easing to fight the recession, US Treasury bonds may well end up offering 4% but inflation might well be double that figure in 3 years time. This is making conservative investors edgy. This does not just apply to individual investors but fund managers too. How do they explain the pitiful returns they are making to their Chief Investment Officer? They are pushing the boundaries of risk management to save their jobs.
The markets function well when financing is being allocated logically, in theory the markets act as a filter, weeding out the bad propositions and rewarding successful management with investment. In the current situation the market is doing the exact opposite, low interest rates are encouraging borrowing, particularly in cheap dollars, and this money is seeking out speculative assets that are creating a misallocation of funds on the global markets creating distortions and asset bubbles with too much money piling into a limited allocation space, the wrong space.
It is cheap to get your hands on dollars and that situation may continue with the dollar continuing to slide in the medium term. This in itself is creating an implicit carry trade where investors are piling into dollars and hoping to get out before the currency rebounds (just like last time). This is an asset run in the making.
So is it a question of second guessing the profitable sectors of tomorrow or just avoiding the next asset bubble? The playing field gets less level by the day with money being allocated in an illogical fashion in a desperate search for a decent yield.
It will be interesting to see who gets it right. Emerging markets look like the prime candidate but already the doom and gloom merchants are already heralding a bubble there. Real estate? Maybe, If you are in for the long haul. Commodities? Could be, oil will probably stay put until the dollar starts to take off again so the oil price might well stay put barring any geo-political drama.
Professional investors are waiting for the first clues, the random stories that when pieced together make up a logical narrative. It is a game of interpretation and the first person to make up a good story may be the locomotive we are looking for.
1st March 2010