Tuesday, February 07, 2012

Good Commentary on Bill Gross' FT Article

Foriegn Policy has a discussion about Bill Gross's article in the FT that discusses what is happening with the ZIRP and how it can trap people in cash.

The comments are more insightful than the blog post, actually, and I think this goes a long way to understanding the Japanese malaise, which I have always believed was caused by low interest rates.  In theory, lower interest rates should favorably improve the risk/reward ratio of risk assets and always encourage additional borrowing.  However, at some point, low, low interest rates can actually CREATE risk, because the price of credit becomes so unattractive that the risk/reward ratio actually skews in favor of holding cash, even though it earns nothing.

This is the flaw in the "Greenspan put".  It works, so long as there is room to reduce interest rates and steepen the yield curve sufficiently to enable financial intermediaries (banks) to borrow short and lend long.  But when short term rates hit the lower bound of zero, further reduction in long term rates (as in Japan) flattens the yield curve, reducing the value of the carry trade (and discouraging further purchase of long bonds).  Moreover, with interest rates very low, the probability of both price, inflation and interest rate risk increases significantly.  Few people want to lend large sums of money over an extended period to a deeply indebted government, running massive deficits for as far as the eye can see.  The probability of inflation producing negative real returns is too great.  Speculators and traders might be willing to buy bonds if they believe that there is room for significant price appreciation (yet lower rates), but again, the risk/reward profile of low rates is that there is limited upside (as the curve flattens, fewer buyers will materialize for the reasons mentioned above) while the the downside risk (higher rates due to inflation or default concerns) is massive.

In short, investors are truly concerned about ensuring that they can get their capital back - and bonds do not look like a relatively safe place to preserve one's capital, let alone a place to earn a modest return in the form of coupons.

Having made bonds unattractive, however, has not made equities or risk assets attractive, really, as they are also subject to significant risks.  Instead, people park their money in demand accounts earning nothing, and low rates actually reduce incomes, resulting in lower spending, resulting in lower final demand, resulting in less economic activity, which increases investors risk aversion and the availability of attractive risk assets.

If you couple that with massive missmatches between generations in terms of assets - with older generations, benefitting from massive expropriation in the form of transfers to themselves from younger, more risk-seeking savers - you receive a double whammy in which retirees and near retirees hold all the financial assets and are petrified of capital loss.

Pretty soon, you wind up with decades of slow growth.

All of which suggests deflation in our future, in which case, the smart money is on nominal assets.  In other words, buy Treasuries.  I am not sold, as I believe most governments are out to increase inflation and if they really want to, they can succeed, but I would be cautious about companies that rely too much on debt financing.

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