Oh boy. That red line sure is getting close to Reaganomics. I said it when the crisis first started, that we’d end up with 1980s unemployment levels. Today’s print makes it clearer to me that this is likely, and that the economy is going to take a turn south. As I’ve been saying for a few days now, I think the likeliest outcomes here are still that the economy turns further south, the Fed fires up a new round of QE, unemployment keeps rising, the dollar keeps on sliding against pretty much everything (except GBP & EUR), Congress passes another stimulus, gold rallies still more and other commodities (except oil) keep inflating.

Market action today is surprisingly subdued on the news, with nothing really moving that much. Maybe this means the bullish sentiment was so strong that there’s some wait-and-see happening, or maybe it means that late December pop so many markets saw was feeling rich to a lot of folks (yours truly included–I plan to start building my S&P short next week). And bonds have predictably rallied, though not as much, again, as I’d have expected.

The other funny thing about the news is that everyone seems to be pretty sanguine about the fact that underemployment is now stable at 17%, 26-week unemployment cleared 4%, and the likely course from here is that the numbers rise–either the economy is getting healther, and  the folks who’ve given up come back, raising the rate, or the economy gets worse and more people lose jobs. While many European countries with more robust welfare states have run long-term unemployment at levels like that, the US never has. There’s something of a “chaos trade” to make there. If the unemployment rates get too much higher, you really could start to see some breakdown of order in places.

Finally, this chart is just kind of fun. I’m not sure that it means anything useful, but it’s good for the ol’ shock value:

That’s right, we’re in the worst job drawdown since the Depression. We’re not out of the woods yet folks. Practically everyone I read seems to think that 2010 is going to be a slow growth year, but that we’re basically fine on the depression risk, and that asset markets aren’t really at risk of seizure anymore. I’m not so sure. There’s still a nonzero possibility that what happened for the last 2/3 of 2009 was nothing more than a big bear rally, not unlike several that occurred during the Depression (or for that matter in Japan, which still of course isn’t anywhere close to it’s pre-collapse peak.) I expect the talking head cycle with turn over at some point in the next few weeks and we’ll see a renewed bout of pessimism and concern.

Duh. Of course they did. They’re going to do it. Because the economy isn’t as strong as it needs to be. And we’re issuing a crapload of debt. And housing prices are still going to go down. Despite the one member who seems to think things are actually turning around for real:

“A few members noted that resource slack was expected to diminish only slowly and observed that it might become desirable at some point in the future to provide more policy stimulus by expanding the planned scale of the Committee’s large-scale asset purchases and continuing them beyond the first quarter, especially if the outlook for economic growth were to weaken or if mortgage market functioning were to deteriorate. One member thought that the improvement in financial market conditions and the economic outlook suggested that the quantity of planned asset purchases could be scaled back, and that it might become appropriate to begin reducing the Federal Reserve’s holdings of longer-term assets if the recovery gains strength over time.”

Also of note, the Fed doesn’t know any more than the rest of us about disinflation versus inflation. ‘Resource slack’ seems to be their big focus–but this cycle I think cap-u isn’t the right metric to watch. It’s the credit numbers, and then the unemployment numbers which will follow, that matter most right now. Anyway here’s the inflation views:

“Overall, many participants viewed the risks to their inflation outlooks as being roughly balanced. Some saw inflation risks as tilted to the downside, reflecting the quite elevated level of economic slack and the possibility that inflation expectations could begin to decline in response to the low level of actual inflation. But others felt that inflation risks were tilted to the upside, particularly in the medium term, because of the possibility that inflation expectations could rise as a result of the public’s concerns about extraordinary monetary policy stimulus and large federal budget deficits.”

Sounds a lot like, oh, the basic question for the market right now.

Watch, the next set of articles will be about how the Fed’s internal confusion means the Fed might start tightening.

I guess the good news is that the Fed is allegedly going “to clearly communicate its ability and intent to begin withdrawing monetary policy accommodation at the appropriate time and place”. Thank God for the nice guys in DC telling us exactly what they’re going to do. Without their guidance I’m quite sure the capital markets would fail to function. No, really. That’s pretty much where we still are. Don’t be fooled into thinking otherwise. And that’s why there’s going to be some more QE.

A nice piece from GS that covers the big issues of uncertainty with respect to US macro conditions. Some quick-take views of my own:

1. Have house prices bottomed? No. Not close in many markets. Because the stimulus will fade, unemployment will keep rising, and credit will stay tight, I’d bet 15%+ more to go down (bigger than the GS take). If the economy shows sustaining growth, then this will be the housing bottom.

2. Will banks become more willing to lend? No. The balance sheets aren’t as cleared up as they need to be. With the yield curve at record steepness we’ve still not really seen a rebound in lending. The banks aren’t Japan-bad, but several are zombies. The CRE collapse has yet to hit, and the number of corporates to roll loans in 2010 is big. I agree with GS take, again, I think it’ll be worse.

3. Will small business activity pick up? This question to me is just “what’s the economy going to do.” GS is saying they haven’t seen what they expect–duh. That’s why things are going to be worse than expected.

4. Will hiring revive? And even more so than the small business sector, this is the nuts right now. Until jobs come back and there’s income to slow down the too-much-debt problem, you’re not going to see a recovery. I agree with GS, though the excess layoffs thing I think may be more real than they do. It is very clear from corporate free cash yields through the crisis that companies curtailed capex to unsustainable levels in addition to curtailing labor, and that capex rebound should flow through to employment eventually (someone’s capex is someone else’s revenues). That said, it would be a very unusual state of affairs for capex to lead out of a recession, so I don’t put too much weight on this idea.

5. Does the savings rate have further to rise? Again, agree with GS. It certainly does in the DM world. However, there’s a meaningful chance it won’t if the Fed is successful at keeping real rates low or even negative. While I’m not that worried about a consumptive commodity bubble that would drive inflation up, and think the cyclical pressures right all point toward deflation (housing, labor, etc.), in practical terms there’s no point saving right now. As I’ve written about previously, with ultralow short rates savers become investors pretty fast. Anyway I don’t really think this is a critical question but I’m answering for form’s sake.

6. Will inflation fall further? See my answer above. Yes, both in CPI terms and in actual inflation.

7. Does the dollar pose an inflation risk? Yes, and this is one of the big mitigant of #6. I think the dollar will just keep falling all year, in a big way (big enough to matter even given the GS analysis of how much the dollar matters to imported goods.) That said I don’t think the inflation will actually rise that much, since our trade partners I suspect will just have to lower prices since US consumption is such a big part of their business. The commodity story is probably the big reason the dollar story is tied to inflation.

8. Will Congress pass more fiscal stimulus? Yes. GS nails this one.

9. How will the Fed “sequence the exit”? As I wrote about the other day, this is a bad question. Stop worrying about it.

10. Will the end to the asset purchases tighten financial conditions? First, the end may not be the end. If things are sucking in June, guess what they’re going to do–buy more bonds. Second, yes, I think it will. There’s just a staggering amount of issuance upcoming this year and it seems likely that the long end will sell off and the curve will keep steepening. The Fed will try to fight this by buying more I suspect, but the first impact will be a rate rise.

For one thing, the tremendous excess of printed money out there isn’t so tremendous–as Kohn points out, most of the money the Fed’s printed is still sitting in banks’ reserves rather than actually being lent into the economy. And so ironically, a lot of the Fed action hasn’t really reached into the economy as actual money. They’ve succeeded in lowering rates, and in keeping mortgage rates down in particular through dominating that market with QE, but they haven’t actually enabled a money transmission through to households. So there’s not even that much to unwind. For another thing, the market will anticipate their unwind so far ahead of it actually happening that it seems unlikely to me there will be a problem. The bond yield is already allegedly pricing in a possible Fed unwind, and you’ve seen the short rate futures move pretty dramatically whenever there’s a new sentiment for tightening. Unlike the Japan situation where the BoJ has a degree of unpredictability, and has a track record of screwing up with random mini-tightenings, the Fed is going above and beyond to be transparent and signal the markets of its intentions. Finally, as Kohn also mentions, the Fed has a ton of tactics available to them, most importantly their new ability to pay interest on reserves and set a true base rate directly. So this meme of the Fed struggling to exit–one that has really seen a ton of interest, including a long section in this piece from the IMF on lessons Japan’s lost decade (worth a quick glance, btw)–feels to me like something not really worth much more comment. I’d like to think it will die out in the press, but I’m sure it won’t.

On to the substance of Kohn’s speech.

The first key sentence: “…[to] support the flow of credit to households and businesses, we then needed to extend liquidity support…”  It’s not often that folks recognize enough the real essence of what the Fed has been trying to do for the past 18 months–to push credit out to households and businesses. Even though the bubble was created by an excess of credit, the Fed has essentially been trying to reflate the economy by (a) sustaining a stable level of credit in the world and (b) pushing money, in lieu of credit, directly out (akin to how we would normally think about a fiscal stimulus). This simple fact is often missed. The entire creation of liquidity that the Fed worked on was designed to stabilize the credit transmission channel. Kohn owns this reasonably explicitly. Kohn generally walks through the Fed’s actions to date in a clear way, and largely I agree with his descriptions.

But it’s in “Monetary Policy Present” that Kohn hits a good stride. It’s telling to me that Kohn starts off noting that financial markets are doing well. The Fed is paying attention to securities markets in a big way in part because they have stepped in to run swathes of them via some of their liquidity provision facilities. At the same time, it’s quite clear that the Fed is also paying attention because a healthy securities market matters to them independently. This makes sense to me, though it’s risky. Liquid capital markets are broadly indicative of a relatively healthy credit system, and create a wealth effect that helps anchor consumption. On the other hand, over-focusing on the capital markets can lead to mistakes, since the Fed’s job isn’t to please investors but rather to manage unemployment and inflation. That said, Kohn notes approvingly (and I agree) that “many securitization markets appear to be functioning more normally”, which really is the essence of what the Fed has wrought since the crisis. While not everything is back to what it once was, and many things likely won’t ever return, most of the basic pipes of the financial system seem to be functioning again. This is a non-trivial accomplishment for Bernanke and friends.

Kohn next mentions the “tapering” down of QE in agencies, MBS & Treasuries. All I can say here is “we’ll see.” For now it does indeed seem like the Fed was able to successfully transition a lot of these bonds out of foreign holdings and onto its balance sheet without a disruptive spike in borrowing rates for home buyers during the crisis. The next real test though will be to see if mortgage rates can stay low over the next year without another big dose of QE, and hopefully kickstart the housing market a bit, since it still seems to be in freefall.

It’s in the next paragraph though that Kohn hits the heart of the matter. It’s worth quoting verbatim:

But the cost of credit remains relatively high and its availability relatively limited for many borrowers. Although many long-term interest rates are fairly low, spreads in bond markets are somewhat elevated–not surprising, perhaps, as many borrowers are still under stress with the unemployment rate quite high and utilization of the capital stock still very low.

This is it–the big question. Kohn’s right–borrowing is still far from normal, and so the big Fed reflation effort hasn’t created an economy functioning anywhere close to previous levels. Unemployment is the big bear in the room that doesn’t seem to be getting any better (despite recent numbers that show some very marginal improvement), and until you can gain confidence that employment really is recovering the US economy is still in the critical care room, the Fed standing by with liquidity shock paddles to revive the heart just in case we get back to October 08 again. Because as Kohn notes, banks are still reluctant to lend despite all the provision of liquidity from the government. In other words, the deleveraging cycle continues, and so new credit just isn’t happening, dragging down growth. Kohn sounds optimistic that as the fiscal and financial stimuli end in 2010 private sector demand will kick in to push the economy forward; I’m not as sanguine as he.

Kohn’s entire section on monetary policy present really just nails the current picture. I think he highlights precisely the questions that will resolve over the next six months, and even paints a reasonable picture of how things might play out. There are of course a wide range of possible outcomes, and in future posts I’ll try to highlight a couple of those scenarios and what they might mean.

Interesting quick piece from GS reporting off IMF data that EM central banks have let their share of $ reserves slip below 60% in 09Q3, to 57.5%. This down from 64.5% Y/Y. Now, that’s actually not that big of a flow in the period–when you consider that developing reserves went up ~5% to $4.8T, meaning that flows into EM reserves were in the neighborhood of $24B. And so a slide of 7% is like $2B. This is a trifle. But it might be the beginnings of a big move, and if that happens, look out. Because so much of the dollar’s support has largely been through foreign CBs intervening to keep their currencies depressed. And while the China story is the (by far) dominant force in this dynamic, the other CBs are playing the same game.

The big risk the US is gambling with is a loss of faith in its fiat money. If collectively the dollar stops being considered a stable storehold of wealth, we’re back in 1973 and the breakdown of a dollar system. In that period the peg to gold broke down and the world just had to live with accepting that dollars meant nothing more than the US military might could enforce. If today’s effective global peg to dollars broke, then we might very well see a period of sudden, sharp reversal in ease of trade flows, as FX risk dominates considerations of international trade and investment. Without the dollar as an anchor for the global monetary system, many small countries would be suddenly destabilized (ie, all the ones pegged to USD), and investors everywhere would suddenly face an array of portfolio construction issues (including a ton of liquidity problems) that most of them haven’t ever had to really deal with. Even assuming the chaos is managed well, it’s still an unpleasant place to be.

I’d bet on Euro & Yen benefiting from this effect, if it happens, probably with more boost for Yen than Euro (since I think Euroland banks are still hiding some nukes in their closets.) And the real winners would be Brazil and China, whose economies are universally believed to be on golden paths for the next couple decades.

But this is, frankly, still a far-fetched event. A dollar collapse would be fought by every DM central bank. Despite the political rhetoric, none of the world’s monetary authorities want a dollar shakeout. And if the Lehman crisis showed us anything, it’s that there’s still a lot of dollar-safe-haven panic instinct out there anyway. A far more likely scenario I think is a continued, gradual decline in the dollar’s value, paired with a continued faith in the greenback as a source of international stability. Through some combination of competitiveness and rate changes, foreign holders of dollar assets would remain incentivized to bid and the world will muddle through. Real assets will inflate versus cash globally, and EM assets will inflate versus dollars.

There’s a lot still to happen though, frankly. If the US economy really does hit a big rebound in 2010 as consensus seems to be pointing, then all bets are off and we might just get back to the 2002-8 “Bretton Woods II” dynamic again. I’ll be surprised by this, but it’s a possible outcome. Of course for that dynamic to recur, it simply requires EM CBs to recycle their cash back into the US via bond purchases. So regardless, the EM CB holdings might prove a useful indicator of what’s going to happen. Because there certainly aren’t enough real money players to buy all the debt the Treasury’s going to have to issue if the US economy falls out of bed again. (Unlike Japanese investors, my hunch is that US real money is smart enough to not just buy domestic sovereigns out of patriotism.) So it might be that the real play from watching the EM CBs isn’t the dollar, but the ten year…

Of course, 2008 put the lie to the strategy, as basically the only folks who made money were the macro guys. What the crisis revealed was that equity-dominated strategies almost always included vast amounts of beta in their return streams, and so when equities collapsed very few people generated true alpha. (Some of the true market-neutral equity folks did well, as you’d expect, but basically long-short & PE were disasters in 2008.) And yet in 2009, despite the huge equity rally, a lot of these same folks have lagged again.  Why?

Simply put, it’s been the macro story driving returns for about 18 months now, and not the micro. The Morgan piece captures the environment well with it’s 2×2:



Liquidity premiums are of course just one aspect of the shift. Most investors have gotten themselves used to an environment of low volatility, low risk premia, low inflation, low cross-border capital friction and low political risk. All of these have now changed. And, on top of this, the fundamental decoupling between DM & EM economies only exacerbates the importance of macro. Where previously investors could get away with looking at the minor differences between the US & Euroland (Japan being a pariah), if you’re looking at emerging markets you can’t really lump China with Brazil with India with Turkey with Korea. There’s just too much difference between them, since all these economies are much more specialized and smaller. And, the various asset classes involved in trading EM–especially FX–simply require more attention to macro variables.

In short, while micro security selection was arguably the key to quality excess returns for the past decade or so, going forward it’s the macro drivers that I think will matter more. Market timing rather than security selection will be the key, especially since there’s so much more uncertainty in the global trends right now. You can see this currently in the way markets are reacting to news; the marginal vol is extremely high relative to the impact of any given piece of macro news. And of course the news flow is totally dominated by macro news more than by sector or specific company news. The macro is going to matter more than ever.

Along those lines, I read a nice little piece about EM bond ETFs  and how retail investors can access them: Definitive Guide To Emerging Market Bond ETF Investing | ETF Database. A solidly diversified bond portfolio will provide exposure to sovereign rates outside the US at a minimum, and ideally also outside the developed markets. Part of the reason for this exposure is that it’s a good way to get FX diversification cheaply, as part of a bond portfolio. But the better reason is that even with the relatively high synchronization of DM & EM inflation and growth cycles, you still get valuable diversification within the bond asset class from foreign rates. For a US investor, when US bonds are selling off due to, say, inflation expectations rising, Brazilian inflation expectations might very well be moving in the opposite direction, leading to a rally in Brazil bonds. Similarly, there’s embedded sector diversification in using EM bonds versus DM bonds, since EM economies are going to be driven by different sector strengths than the DM world. This diversification allows an investor to capture the risk premia of bonds more frequently. As part of a strategic, passive portfolio EM diversification is essential. And, because it’s so underweight in most portfolios, there’s a great opportunity set available for extraordinary returns, since fewer investors are true buyers of these risks, making the rewards likely quite attractive.

Both of the ETFs mentioned are pretty decent, with expense ratios of 0.60 and 0.50 for EMB & PCY. Unfortunately, neither of them give you any true EM FX exposure, as both only trade the dollar-denominated (aka “Brady”) bonds. The two track different indices, and it would probably make sense to blend a position between the two as the indices appear to differ materially. EMB tracks the MSCI EMBI Global Core, while PCY tracks some sort of proprietary index from DB. Neither is particularly liquid, with $1.1B and $455m for EMB & PCY respectively of outstanding cap. But it’s enough for any retail investor to buy and not feel like there’s risk of squeeze. PCY has slightly more average duration (7.48 vs 6.84 effective for EMB), but it also holds slightly higher rated credits, so they are likely about the same risk. EMB is yielding around 5.6% while PCY yields about 6.5%, so it’s a solid way to generate income for investors in addition to the prospect of capital gain. Right now I suspect EM credit spreads are elevated relative to the outperformance vs. DM markets that I expect over the next several years, though I’ve not yet done a lot of fundamental work on the question. I’m biased to be long both of these ETFs right now tactically, and certainly as a strategic play I would highly recommend including them in a portfolio, somewhere around the 5% of risk neighborhood.

One thing the article mentions early on is the conceptual risk premium associated with the inflation component of a nominal bond. This article, and most academic treatises on inflation-linked bonds (ILs), tend to just assume the existence of this premium. Yet it’s not obvious that prices actually show this risk premium, ever. Either that, or the market systematically understates inflation–it seems like the market doesn’t really change it’s expectations at all. Was it really the case that 10y BEI was sensibly 2.5% or so for the past 5 years? It seems to me that surely at some point during that time–say, when oil was at $130–BEI should have risen a bit above this? Looking further back (see the chart in the middle) you can see breakevens basically staying in the same range. Yet if there is a risk premium in the breakeven rate, it would imply that breakeven is overstating the actual expected inflation. And given the historical rate of breakeven this implies a regular rate of inflation expectations around 2%, which would be lower than even the recent historical average of CPI (say from 1990 forward), and materially lower than the longer-term historical record. What kind of risk premium can there really be if BEI is always 2.5% when CPI averages way higher?

Of course, one thing the article does note correctly is that regardless of whether you think there’s a risk premium or not, if you think the premium (or lack thereof) is at least stable, then analysis of changes to breakeven will definitely give you a good sense of changes in market sentiment, if not level. And this would be true for both the liquidity premium and the inflation risk premium. Unfortunately, it seems almost certain that the liquidity premium isn’t stable in any way–the enormous spike in real yields in the height of the crisis is without question partially attributable to a tremendous spike in liquidity premia across the board as well as a specific spike in the TIPs liquidity premium. During the crisis apex you basically couldn’t find buyers of TIPs in size, and repo desks for TIPs were effectively shut. So the marginal change in price wasn’t useful at all as an indicator.

Now I’m not saying that in October 08 the real yield was entirely a function of liquidity. But with deflation a genuine possibility, you have to wonder why you’d be seeing high real yields priced in. Instead I suspect most of the pricing fell out of the tremendous rally in nominal yields, combined with a slowup of liquidity in TIPs.

This is in line with most of the paper’s observations about TIPs breakevens tracking survey expectations. Yet the author seems to expect the liquidity premium to decline over time, as he suggests it has to date. I wonder if this is likely, and certainly hasn’t been the case YTD. I would expect instead that the liquidity distortion increases for TIPs as nominal treasury supply increases relative to TIPs, sucking up US sovereign rate demand. Moreover, even with inflation protection, the downward pressure on the dollar should mitigate demand for US rates. There’s also the scenario painted on page 48 of the paper, where excess supply boosts nominal rates, creating an appearance of higher breakevens purely as a liquidity effect.

In any case, regardless of the liquidity problem, today many sources cite breakevens as a good indicator of inflation expectations. Of course, it’s really just one of many, and the best way to assess the market’s expectations would be to survey all of them. Inflation swaps and other inflation derivatives are increasing in popularity, and every year economists predict inflation, as do surveys of households and other groups. Even with the liquidity distortions, however, it’s likely that current pricing isn’t too far off reality. It seems pretty reasonable to me that 2.3% is a fair guess as to what the market is actually pricing over the next ten years for inflation (though I’d be a buyer…), especially when 10y swaps are pricing 2.85. If anything it’s probably a bit low, as TIPs liquidity continues to suffer, probably distorting real yields upwards in price right now. The Fed seems to agree–they still haven’t started re-posting their liquidity-adjusted TIPS breakevens.

Another great example of Bloomberg news getting things jumbled but also having a lot of interesting nuggets. Let’s see if we can parse out what’s actually going on.

First, the article notes breakevens having risen this year and indicates this is Bernanke having beaten deflation.  I quickly clock current RYs at 1.31, and current NY at 3.55, so breakeven inflaiton (BEI) is about 2.4. That is considerably higher than the beginning of the year, when reals were 2.43 and nominals 2.46. It’s been a heck of a year for inflation-linked bonds, as 112 bps at something around 10 years of duration is going to generate a nice little return for a low-vol asset class. I’ve not calc’d the ratio of ILs this year but I’d expect it’s pretty great.

The interesting question is what does this mean? Bloomberg seems to think that 10y breakevens rallying from basically zero to 2.4 means we’re over the deflation worry. And there’s some truth to that–clearly markets were a whole lot more worried about deflation in January than they seem to be pricing in now. But it’s also the case that there’s been a pronounced move into risk assets over the year generally, from the flight to UST quality that was running in the early spring. And of course there’s been our buddies at the Fed buying every bond they can find, trying to keep the lid on the nominal rate. As it turns out they bought 3.5B of TIPS y/y. (Which doesn’t sound like a lot, but is actually a decent sized flow–TIPS only average about 1% of daily Treasury volume despite being 8% of total outstanding, and average as little as $500m a day in trading.) But the real news is of course that every single FOMC statement declares as clearly as possible that short rates are going be at zero for a while. So naturally, the real yield curve has to roll down. What may have actually happened here is that the real yields fell and nominals sold off on risk reasons, without markets “really” pricing in a big inflationary pop. In other words, the inflation pricing from BEI today may be less driven by a strong view of inflation than simply falling out from very sensible other pricing dynamics.

And this seems to be what’s eating Bloomberg in the BEI rise. Is it a real foreshadowing of inflation to come? Half the finance world is talking about how helicopter Ben’s printing (which really wasn’t even that big) is going to drive massive inflation down the road, but the other half is talking about how worrying about inflation with a 10%+ unemployment rate is roughly insane. I’ll save my detailed views on inflation for a future set of posts, but suffice it to say I’m certainly more inclined to believe that in the near term the risk is more disinflationary. The long run is a bit of a wildcard since so much depends on the next couple years of the macroeconomy. And that’s what I read in this inflation pricing. 2.4% is an awfully low inflation number versus history; it’s only in the 1990-2000s deflationary China dividend era that we got used to thinking inflation is always a manageable number like that. Most of history would indicate otherwise, and Mr. Pond from Barclays is right to note in the article that inflations becoming unmoored could really be a driver here. Of course the biggest driver is just going to be the currency decline, and ILs provide a poor protection against that.  The five year/five year discussed at the end of the piece indicates that this is exactly what it seems like the market is pricing. Some nearer term disinflation (though probably not outright deflation), followed by a sustained rise in actual inflation. Interesting that the BEI market seems to be thinking inflation rises way later than the Fed funds markets is pricing. More on that market in another post to come.

Financial assets are priced, in part, off of the future expectation of cash flows to the investor. Those cash flows exist in a context of opportunity cost, set by the price of money. Finance professors would likely call this price the risk free rate, and most of them would call the risk free rate the real government short rate. The higher real short rates are, the more expensive the opportunity cost of investing in an asset versus holding cash. And the opposite is true when real short rates are low–people have very little incentive to save, since savings earn such little return. And right now, that’s precisely the situation we find ourselves in. Assets are inflating versus cash, because cash earns next to nothing, and if the Fed is to be believed (as I think they are) then this situation will persist. Said differently, all return right now is excess return–returns over the risk free rate.

Unfortunately, when returns are all excess return, investors have to adjust their expectations. Over the past 50 years, cash rates have averaged something considerably higher than the zero rate they are at now. Most investors don’t have access to the Fed funds rate shown below, so short term cash is typically actually higher than this, but as you can see the average annual total return of asset classes has included something like 5% a year in return from cash. For the next several years this is simply not going to happen for US investors, short of an inflationary dollar collapse that forces the Fed into raising rates (and if such a thing happened, assets would get killed anyway.) So while assets are inflating against cash, the overall expected return going forward is lower. This year’s bonanza returns are a direct function of rates crashing down, and of pricing in the expected low rates in the future. It’s a one-time benefit that shouldn’t recur.

The situation is even more dire for investors when you take into account inflation. Currently inflation is likely running at slightly below recent historical normal (1.5-2.5% a year). With a zero nominal short rate, this makes the real short rate negative actually penalizing an investor for holding cash. This might seem to drive further flows into risk assets from cash, boosting asset prices. But it can also lead to selling USD cash in favor of alternate FX or commodities. While a true dollar collapse isn’t likely, an long, slow decline is, meaning that USD returns for asset classes will suffer. Over the next several years investors should expect lower real and USD total returns on assets as zero interest rates eliminate a powerful historical source of return.