Friday, September 14, 2012

The Era of Finanical Repression Continues

Writing in the Financial Times last May, columnist Gillian Tett wrote an excellent column discussing our current era of "financial repression".

Coined originally by economists Carmen Reinhart and Belen Sbrancia, the term describes the negative effects that low interests are having on the world's capital markets.

Interest rates have been moved to historically low levels in most of the developed world's economies in an attempt to rekindle economic growth and restore the banking system to health.

Whether this has been successful or not is an open question.  It would appear, for example, that the health of the U.S. banking system has been greatly improved by the actions of the Fed and Treasury, while the recovery in the European banking system has been delayed by partisan bickering.

Economic growth, however, remains anemic, and yesterday's announcement of a third round of quantitative easing by the Fed is targeted at reducing our stubbornly high unemployment rate is a recognition that government economic policies have more work ahead.

What is clear, however, is that the bulk of the "pain" of the uber-low interest policies is being felt by savers and investors.

Ms. Tett's column last May marveled the apparent indifference that bond investors had to buying bonds with yields below the current rate of inflation. 

With the Fed's announcement that short term interest rates will stay at essentially zero through the middle of 2015 - three more years! - bonds are either a sucker bet or an incredibly expensive way to make sure that you'll at least have some cash a few years from now.

Here's what she wrote:

Anybody buying Treasuries, in other words, is essentially agreeing to subsidize the US government in coming years - unless you believe that deep deflation looms. Call it, if you like, a form of voluntary repression; either way, it will almost certainly end up helping the US state, to the detriment of investors.

This subsidy, by the way, is not insignificant.  Here's an excerpt from a piece that appeared in the New York Times earlier this week (I added the emphasis):

In the nearly four years that the Fed set its benchmark interest rate at zero, the government has saved trillions of dollars in interest payments. If interest rates today were what they were in 2007, the Treasury would be paying about twice as much to service its debt.

The bond market finally seems to be sensing that it is picking up the tab for government profligacy.

While interest rates on shorter maturities are unchanged - which seems perfectly rational in light of yesterday's announcement -  longer maturity bond yields are soaring.  Ten year Treasury bond yields now stand at 1.86%, or more than 40 basis points higher than just two months ago.

My thinking:  the bond market is finally waking up to the idea that the Fed is going to whatever it takes to get the economy going, inflation be damned.

And they probably will succeed, meaning growth will be stronger a few years from now but inflation will also be higher.

If this is right, stocks should also work, although they feel a little frothy right now.