"Kee" Points with Jim Kee, Ph.D.

This will be a short week for investing as equity markets are closed this Thursday for Thanksgiving and close early on Friday. Last week the US stock market (S&P 500) closed at an all-time high amidst news of more monetary easing coming out of China and the European Central Bank (ECB).

 

In China, the central bank cut lending rates in order to spur recovery (Nasdaq), and in Europe the ECB’s President Mario Draghi hinted at purchasing government debt, following the rest of the developed world’s central banks in what has become known as “quantitative easing” (despite former Fed Chairman Ben Bernanke’s attempts to more accurately define it as “credit easing”). I wish monetary policy could create growth – it can only facilitate growth, which happens at the enterprise level – but monetary accommodation can perhaps provide a backstop to the downside or, in China’s case, ease the slowing. I think that is why risky assets have responded positively to monetary stimulus. In fact, US stocks (S&P 500) are up almost 14% year-to-date, which is well above the long-term average annual rate of return of 9%-10%. By the way, China’s main banks (they have a big 4) don’t operate too freely, but instead have strict government controls over lending rates, deposit rates, and reserve requirements. By alternating these somewhat, it is the government’s goal to approximate a more market-determined (and hence efficient) allocation of capital.

 

As for bonds, interest rates remain low, with 10-year Treasury yields around 2.33%. Some of this is due to the unprecedented central bank purchases of fixed income securities (again, “quantitative easing”), and this dominates the business headlines, but there are other forces at work as well. First, the global demand for fixed income instruments has been outstripping the supply – thus driving up their prices and lowering yields – since before the financial crisis that began in 2007. That is the “global liquidity glut” as Bernanke described it back then (2006), and it is still with us (also dubbed the “global thirst for yield”). There is more cash being generated globally than being reinvested, and the surplus (in addition to central bank purchases) is going into fixed income instruments. This is one of the forces keeping yields or interest rates low. But potentially moving interest rates in the opposite direction (up) would be a big increase in inflation expectations as the world’s central banks engage in unprecedented monetary actions. However, the concerns right now are still more with disinflation turning into deflation, not inflation. That’s the second force keeping yields down. While moderately higher rates would be expected based upon both historical data and the Fed’s completion of its monthly bond purchases, I think it is these other two factors that explain low rates now and that will ultimately determine interest rates going forward. As for fixed income or bond performance, in the U.S. municipal bonds have outperformed government bonds, corporate bonds, and even high-yield bonds year-to-date (Bloomberg, Barclays).