• "Kee" Points with Jim Kee, Ph.D.

    • Forecasting Interest Rates  
    • On Negative Rates  

    Forecasting Interest Rates

    I have had a lot of questions from clients regarding negative interest rate policies, so in this week’s Kee Points I thought I would take a stab at explaining them. As a preliminary remark, I would be wary of those portending to be able to predict interest rates; they are set globally by trillions of dollars, and few people are smarter than the global bond market! When I worked for a macroeconomic forecasting firm, and this was over 20 years ago, we were perplexed that interest rates were so high. Our model, which used a lot of historical and forward-looking data to forecast interest rates, always said rates should be lower. That is, given expectations for real economic growth, inflation, etc., we consistently found rates to be higher than a quantitative model would predict. Our conclusion at the time was that there must be a “fiat currency premium” built into interest rates. Although inflation was in check, since currencies weren’t backed by anything like they were under the Bretton-Woods system (early 1970s), the market was probably baking into interest rates an expectation of inflation. In other words, there was more risk to paper money than the gold-backed money we (loosely) had under Bretton Woods. Well, fast-forward to today and we still have a paper or fiat currency (made legal by government decree only, not backed or convertible into something else). Interest rates are (and have been) below what most historical data would predict, given assumptions for growth, inflation, and perhaps even global capital flows. So much for the fiat currency premium thesis! I guess my point is that interest rates are just as perplexing as always (!), and I wouldn’t put a lot of money into strategies predicated on predicting them.


    On Negative Rates 

    On negative rates, I have been influenced by comments and writings of former Fed Chair Ben Bernanke, who has argued that anxiety about negative rates in the media is overdone. Economists tend to be less bothered by negative rate policies because our models tend to focus on “real interest rates” (nominal interest rates minus inflation), and real rates – at least short term rates like the federal funds rate – are often negative. Bernanke points out that there is no real disconnect or discontinuity in going from, say, +.2% interest rates to 0% and down to -.2%. It is just a move down, like going from +.4% to +.2%. In other words, to economists it’s the real rate that matters, and the media just hypes the negative rate narrative.

    The point of most interest rate targeting schemes is to push down longer-term rates, like mortgage rates, that are most important to consumers and businesses. The hope is that they will then borrow and spend more, stimulating the economy. One way to do this is for the Federal Reserve to buy short-term securities, pushing up their prices and pushing down their yields. The sellers of those securities (mostly banks) then use the proceeds to buy longer-term, higher yielding securities. This pushes up their prices, and pushes down their yields. In that way, it is hoped that lower interest rates permeate the term-structure (i.e. from short to long term), lowering those longer rates that are important to businesses and consumers. Another way for the Fed to achieve the same goal is by buying longer-term securities directly, which increases the prices of (and lowers the yields of) those longer-term securities directly. This has been a more recent tool used by the Fed and other central banks and has come to be known as quantitative easing.


    Negative interest rates are yet another (a third) means to achieve this end of lowering longer-term rates and stimulating the economy. This has been tried in Switzerland, Sweden, Japan, and the euro area. The idea here is that the central banks actually charge banks for the reserves that they hold for them (private banks hold reserves, i.e. a percentage of their deposits, at central banks). That means it costs banks to hold reserves at the central bank, so instead of making loans and earning interest, they are paying it! The expectation is that, in order to avoid the fees, banks will start making loans, i.e. shifting those funds to other short-term assets (I’m citing Bernanke here), driving their yields down and again hopefully transmitting lower rates throughout the system. If you think about it, if rates go too negative, then banks and people will just hold currency (“hoard currency”) rather than pay the central bank to hold it. That has costs too (storage, security, etc.), but the point is that there is some theoretical negative rate, below which currency hoarding will negate any stimulative impact on the economy.

    The negative rate policies enacted in various parts of the world haven’t really been effective at stimulating growth (mortgage rates and other business loan rates in those areas are still generally positive), but many argue that they haven’t been entirely ineffective either. That, too, doesn’t really surprise economists, who typically ascribe much less power to monetary policy for stimulating growth than layman or “media” economists do.

  • "Kee" Points with Jim Kee, Ph.D.

    • Expect This Kind of Volatility  
    • Bonds as a Separate Asset Class  

    Expect This Kind of Volatility

    Financial economists tend to look at stocks through the lens of discounted cash flows, which means they start by estimating the future cash flows (profits) that a company is likely to generate. But a dollar received today is worth more than a dollar to be received ten years from now. That is because a lot can happen in ten years, from tax rate changes, to changes in inflation, to the company going out of business (to name a few). So future cash flows are “discounted,” meaning analysts estimate a discount rate in order to value future cash flows less than current cash flows. Hence the term “discounted cash flow models.” While people tend to look at big short-term swings in market prices or valuations as irrational, economists like Nobel Laureate Merton Miller would often point out that it only takes a small change in the future cash flow estimates and/or the discount rate to lead to huge swings in prices. And since events happen all of the time that could influence both cash flows and discount rates, market swings or stock price volatility should be expected. With that as background, I had worked with what is perhaps the best data set for estimating cash flows and discount rates while I was at the Credit Suisse Holt group. My take away was that nobody has a model good enough to peg what the theoretical value of the market should be within, say, plus or minus ten percent. So I would expect movements within that range to be pretty common. With a DOW level of 26,000-27,000, a ten percent movement is 2,500 points or more. Looked at this way, movements within 1,000 should be viewed by investors as normal, unpredictable, and meaningless in the long-run. Looking at this past week, the ups and downs in the trade talks have clearly lead to ups and downs in the markets. The media, which is often a distraction to investors, has been focusing on everything from Middle East strife, to Presidential Impeachment talks, to Hong Kong protests. But keep in mind that the media watches market movements and looks for stories to explain them, so they follow the market, they don’t lead it. As I mentioned in a prior Kee Points, that means you cannot extrapolate media stories to anticipate the markets. As for turmoil in Hong Kong, I have also mentioned in a prior Kee Points that it has been a long-time coming. My guess is that China will back off a bit, as they seem to have too many fires going at the moment.

    Bonds as a Separate Asset Class

    One sign that I and most of the economists I know aren’t comfortable with is low long-term interest rates. As I write, 10-Year US Treasury yields are just below 2 percent, which I believe reflects their global safe-haven status, i.e. when turmoil occurs anywhere in the world money flows into US Treasuries, bidding up prices and lowering yields. It remains to be seen whether yields will fall to the 1.4 percent levels we saw during the summer of 2016. But of most concern to investors should be whether or not they or their advisors are buying the right kind of bonds. You want to make sure that you are actually investing in an asset class that is driven by factors distinct or different than those that drive stocks. Stocks should be the risky portion of your portfolio, while bonds should be the safe portion. Often there are factors that affect stocks more than bonds, like changes in corporate tax rates. Likewise there are also factors that affect (in general) bonds more than stocks, like inflation. Certain types of bonds, however, are driven mostly by the factors that drive stocks, so they do not provide downside protection to your portfolio. High-yield corporate (i.e. junk) bonds are a good example. Environments that tend to be hard on corporate profits, like economic downturns, also make it harder for companies to make their bond coupon commitments, particularly companies in the high-yield space that were already on the edge (that’s why they have to borrow at higher interest rates). Instead, you want bonds like US Treasuries, which have the taxing power of the federal government to help keep their promise to pay; or general obligation municipal bonds which have similar authorities backing them. Those bonds are least likely to behave like stocks during a period when stocks are selling off. As for corporate bonds, only those issued by companies with healthy balance sheets and cash flows should be considered, and they tend to be able to borrow at lower rates (so they have lower yields), not junk rates. And sure, junk bonds tend to do well when stocks do well, but in those cases you’re much better off just owning stocks. 


  • "Kee" Points with Jim Kee, Ph.D.

    • Outlook
    • And Speaking of Monetary Policy Actions


    The International Monetary Fund’s July Global Economic Outlook sees 3.2% global growth this year followed by 3.5% in 2020. This outlook is somewhat precariously (their words) based upon expected stabilization in some emerging and developing countries, and also upon continued accommodative monetary policies around the developed world. I agree with the outlook, but less because of monetary policy and more because of fiscal policies like the substantial business tax cuts and deregulation passed in the US at the end of 2017. There seems to be a widespread view that the tax cuts offer a one-time “shot in the arm,” which I think is a misperception or misunderstanding of the way tax cuts work. Right now the tax cuts seem to have impacted the US economy very little (Tax Foundation). Think about tax cuts as changing the rates of return to productive or business activities, and, over time, tax cuts encourage resources to flow into the now higher return sectors of the economy. Output expands until rates of return are competed back toward a new equilibrium at a higher rate of output. This is a multiyear process, as it takes time to update plans and for resources to get recommitted. Working against this has been the trade war. Tax cuts spur production but trade concerns thwart exchange. And wealth is created by production and exchange; it is a symbiotic relationship where both encouraging production and widening exchange or trade are required. That’s why I refer to the President’s policy agenda as being somewhat at war with itself: it encourages production, and discourages exchange. A little progress on the trade front (less uncertainty, more permanence) would go a long way towards encouraging continued US and global expansion. That to me is what we need to see, not so much monetary policy actions. Monetary policies can help facilitate production and exchange, but they are the lesser tool for encouraging economic growth. I think that’s been plain to see with all of the monetary innovations of the past 10 years and the sluggish growth that has accompanied them.

    And Speaking of Monetary Policy Actions

    Yesterday the Chinese allowed the yuan to depreciate against the dollar, the main currency in the basket of currencies to which the Chinese yuan is more or less pegged. That makes sense to me, although markets certainly didn’t like the tone or the timing of the move. China has pegged its currency to the US dollar since 1994. That smart act helped the Chinese gain credibility on the monetary policy front, which is necessary for countries to attract capital and grow. The peg or “reference” rate was 8.32 yuan per dollar (+2%) from 1995 mid-2005 (ten years). By that time China was growing at double digit rates. When you peg your currency to another country’s currency and you are growing dramatically, there is tremendous upward pressure on your currency, that is, pressure to appreciate. Many in the US were calling China a currency manipulator and demanding that China let its currency float, or appreciate dramatically. China’s better council at the time (e.g. Robert Mundell) cautioned against that, warning that a floating, fiat communist currency might just collapse amidst gut-wrenching capital flight. So China allowed the currency to slowly appreciate in a sequence of moves, and by 2014 it hit 6.04 yuan per dollar (so it only took 6 yuan to buy a dollar, rather than 8+). But China has experienced a pronounced slowdown since then, which has put downward pressure on the currency. The yuan has slowly ratcheted back down, trading at 6.8 yuan per dollar by the end of July (2019). The big story today is that China allowed its currency to fall further to around 7 yuan per dollar. It is still not back down to the original peg of 8.32 per dollar, but it seems to be getting there. Think of the yuan as completing a round-trip that began in the mid-2000s. So a yuan devaluation shouldn’t be a big surprise given how much China’s economy continues to slow. But yesterday’s move – occurring after the Fed cut rates and in the midst of Trump’s latest tweets with regards to China – is seen as China hitting back with belligerence of its own. That’s why markets were selling off Monday.

  • "Kee" Points with Jim Kee, Ph.D.

    • Things That Take Your Eye Off the Ball
    • How Many Stocks? 

    Things That Take Your Eye Off The Ball

    The most important thing for an investor to do this week is to avoid the media hype as (1) the US and China resume trade negotiations (Monday), (2) the Federal Reserve announces its interest rate decision (Wednesday), and (3) July payroll numbers get reported (Friday). Bloomberg, for example, had a piece over the weekend titled, “Get Ready for the World Economy’s Biggest Week of 2019,” citing these three events. Here’s my quick take: As for a China/US trade deal, both have a lot at stake, but the current buzz is that China might prefer to wait until the 2020 election (with the hopes of a Democratic win) than deal with Trump, while Trump wants a deal sooner in order to facilitate re-election. That would give China the upper hand, but I’m not so sure. Most world leaders have acknowledged at this point that China doesn’t play by the rules with respect to intellectual property, so China will need to acquiesce on that sooner rather than later. It makes China a less attractive trading partner for all of the countries that it trades with, not just the US, and China certainly needs trade (access to global markets). Time also allows companies to rework supply chains in countries other than China, which would not be in China’s interest. So I’m neutral as to who can wait on a trade deal and who cannot between China and the US. As for the Fed, in a nutshell I think that the Federal Reserve sees the “neutral” rate closer to 2% than 3% these days (3% was the number cited a year ago), but I feel that Trump had made it awkward for the Fed not to raise its target rate last December (2018) to 2.25%-2.5%. It wouldn’t surprise me to see the Fed take that hike back this week, but that’s about all I expect from the Fed. As for Friday’s payroll numbers, this, too, in my opinion has become way overhyped. Unemployment is low, participation rates have flat lined, and GDP growth last week at 2.1% came in a bit above expectations. My advice, from an investment perspective, is to think about this week less in terms of “World Economy’s Biggest Week in 2019,” and more terms of, “things that take your eye off the ball.”

    How Many Stocks?

    Mutual funds and hedge funds are experiencing a record overlap of holdings in the top 50 stocks (Wall Street Journal), leading many investors to experience more company-specific risk. A general result of modern finance is that higher returns usually don’t come without taking higher risk, although higher risks don’t assure higher returns. In my years as a portfolio consultant, I often saw portfolio managers taking on extra risk by making bigger bets on fewer companies. That begs the question, “just how many stocks should a well-diversified investor own?” If you own too few stocks, then the risk of a single-stock blow up (happens all the time!) contributes more to the risk of your portfolio than it adds in potential return. If you own too many stocks, then the reduction of risk from owning more individual stocks is not worth the foregone potential returns that the portfolio suffers by being too diluted, i.e. it doesn’t really matter if a stock triples if it is only 1 of 5,000 in a portfolio. Of course, financial economics has a lot of statistical metrics and terms used to describe and measure risks and returns and the trade-offs between the two, but that’s the gist of it. So what’s the right number of stocks to hold in a portfolio? When I was in graduate school, I saw numbers cited as low as 12. But the optimal number of stocks in a portfolio seems to be increasing, at least that is my reading of the peer-reviewed research. According to Princeton professor Burton Malkiel, increased volatility means that investors might need to hold as many as 200 stocks to get the same level of diversification that they got with 20 stocks in the 1960s. The bottom line? I see very little research advocating fewer than 50 stocks. To quote Malkiel, “If you think that you can do an adequate job of minimizing portfolio risk with 15 or 30 stocks, then you are imperiling your financial future and the future of those who depend on you” (The Irish Times).

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