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


  • Risk and Return
  • Thinking About Fed Policy
  • Global Forces
  • What About Inflation? 

  

Risk and Return

If I were asked to describe modern finance in one sentence, it would be, “You don’t talk about returns without talking about risk in the same sentence.” That means investments that earn higher returns generally have higher risks. Global capital flows ensure this by increasing the price of assets with high returns relative to their risks, until a current buyer would earn just a normal rate of return. Historically that “normal” or average return would be about 10% for stocks and about 6%-7% for bonds, with the difference between the two often referred to as the “equity risk premium.” Stocks are riskier than bonds, if for no other reason than stockholders stand behind bondholders in the event that a company has financial problems and has to sell (liquidate) its assets. Stocks are also riskier than bonds because they are subject to recurring but unpredictable shocks that temporarily collapse earnings and stock prices. Because of these higher risks, stock prices tend to adjust until a current buyer would earn higher returns (a “premium”) than that available on bonds. Of course like just about everything in financial economics, these longer-term numbers are multi-decade averages that tend to be pretty period specific under shorter 5 or 10-year time frames.


When it comes to bonds, a lot of individuals tend to forget that you don’t talk about returns without talking about risks in the same sentence. Higher yields on bonds or other income earning instruments like real estate investment trusts (REITs) or master limited partnerships (MLPs) usually come with higher risks. Currently, short-term interest rates like the federal funds rate and the US 3-month Treasury bill rate are around 2%. Longer-term rates, like 10-year Treasury yields, are at 2.9%. Yields on riskier 10-year bonds, like high quality corporate bonds (AAA rated) are up around 3.93%, while yields on even riskier instruments like low quality corporate bonds (BAA) are around 4.8%. So higher interest rates only come with a higher level of one or both of the two types of bond risks, interest rate risk and credit or default risk.


Federal Reserve Policy

How does Fed policy relate to all of this? Well, post-financial crash the Federal Reserve was pretty successful at holding short-term interest rates down. If you think about it, that meant that most investors who would normally buy short-term instruments would have to buy longer-term instruments in order to earn the same yield as they could have earned on shorter-term instruments before the Fed intervened. More money “going into the longer end of the curve” bid prices up and yields down, for example on 10-year US Treasuries. That means investors who normally bought 10-year treasuries would have to take on more risk than before in order to earn the same yield as before, so they in-turn bid up the price of lower quality bonds and even longer 10-20 year bonds. The yields on these instruments declined as their prices were bid up, which led to what investors call "low quality spreads" and a flatter yield curve, particularly at the longer-end (I am borrowing heavily here from economist Victor Canto’s book, “Economic Disturbances and Equilibrium in an Integrated Global Economy”).


Global Forces

It seems reasonable to assume that as the Fed reverses its policies and “normalizes,” this process would move in reverse, with yields rising and spreads widening. But the world is integrated, so international forces also have to be taken into account. For example, much of the world’s growth is occurring in emerging economies like China and India. Many of these countries don’t have well-developed social safety nets like social security or Medicare/Medicaid here, so individuals there save a much higher proportion of their income to compensate. They also don’t have fully developed capital markets like the developed world, so growth doesn’t always translate into higher wealth, which means a lower “wealth effect” as again individuals consume less and save more than they would in fully developed capital and property markets. These savings end up bidding up the price and lowering the yields on fixed income instruments globally (i.e. the “global savings glut”). When added to the fact that central banks internationally are pursing lower interest rates than in the US, which also bids up the prices and lowers the yields on US fixed-income instruments (because they are relatively more attractive), it becomes very clear why interest rates are so hard to predict!


What About inflation?

So far we have not even discussed inflation, which used to be the main focus for interest rate forecasters. Bondholders are typically among the first hurt by inflation because as lenders they are paid back in a currency that is worth less. So interest rate forecasts also involve inflation forecasting, which you might have noticed has been pretty poor over the past decade. My point here is to just help you keep your red flag up when listening to analysts and media pundits. When somebody is telling you what interest rates are going to do, try to keep in mind that he or she is also telling you that they understand all of these forces and can anticipate how they are going to change in the future.