Monday, June 23, 2014

Some Thoughts on Interest Rates

  • Remember first and second level thinking. First level thinking is that loose monetary policy leads to inflation so buy metals and stocks and short bonds. 
  • The second level thought is that loose monetary policy leads to some goods increasing in price, mostly the hoard-able primary inputs like energy and base metals. Much of the causation is psychological. The input price increase squeezes producers who can't raise their prices as much to compensate for rising input costs. Maybe they even go out of business or layoff workers. Overall, society is poorer thanks to the misallocation of resources. Also, fear of loose monetary policy causes investors to sell bonds and interest rates rise. Both the rising input costs and rising interest rates choke off the economy; the inflationary policy is self-limiting because of the damage it does.
  • In general, bond bears who are long stocks don't realize that they would be hurt by interest rate increases too. Stocks compete with bonds; interest rate increases would make low dividend yields even less attractive in comparison. Also, many companies' business models are interest rate sensitive - think what would happen to car sales if bond bears got their rising interest rates. We already saw in 2013-2014 what an interest rate rise did to housing sales.
  • Being long credit and short duration is absolutely consensus, as in this Morgan Stanley research: "As rates rise, we expect a reversal of the YTD outperformance of longer-duration credit. We like credit over rates, and prefer High Yield over Investment Grade credit, as we believe the biggest risk to investors today is rate driven, rather than credit driven." They take it as a given that rates will rise! They also believe that rates are the biggest risk even though credit spreads are at all time lows!
  • Cliff Asness has a smarter thought on bonds: "[T]ake US government bonds. They are without a doubt priced to offer a lower prospective real return now than at most times in the past (as, in my view, are equities). But could it work out? With an unchanged yield curve, which is certainly possible, you would make a very comfortable 4%+ nominal (call it 1%–2% real) a year now on a 10-year US bond, and to find a case where bonds worked out from similar levels, one only has to utter the word 'Japan.' Does this make bonds a particularly good investment right now? No. Does it show that they do not satisfy the criteria for the word bubble, thereby demonstrating how the word is overused? Yes." But also, note that tepid dislike of bonds passes for bullishness in the current environment.


Anonymous said...

Trade idea: Long the US ten-year at 2.62% and short the Spanish ten-year at 2.69%. No way that's sustainable.

CP said...

Agreed. The 10y US is not that low compared to other countries' yields.

Based on the stuff Bernanke has said since leaving the Fed, he knows that this is a demographic problem and that we are following Japan's course.

The deflation speech in 2002 was both an acknowledgement that they knew about the problem and it was also just bluster.

Only modern monetarist bloggers are dumb enough to think that firing money out of cannons would work.

whydibuy said...

Oh, the U.S. is just like Japan???

HHHMMMMM. Looks like our stock market is climbing nicely whereas Japan's fell for 20 years.
What are you talking about, sir?
Interest rates are low the world over. Does the entire world have a demographic problem?
BTW, where is that huge drop in the market you promised us,lol?