Presumably, this refers to Topic 8 of the Strategy Design seminar involving timing and hedging. I’m not good at integrating images with forum text, so instead of reproducing it here, I provide a link to the pdf.
And actually, it wasn’t condemnation. It was an effort to lay out the various probabilities. Feel free to address them, if you wish.
Sorry I missed it, but here goes:
Yes, TLT is a contrarian position. But that doesn’t mean it’s a good contrarian idea or a bad one. Further analysis is required for that.
Yeah Jack, you got me. Ooops, you’re not Jack. You’re Steve. Sorry about that. For a moment, I thought I was replying to the husband of my wife’s friend, the guy who sneered and wagged his finger at me because real estate continued to rise even after I argued it was a bubble and urged him not to go into that partnership for a development project in Flushing Queens. (A year later, at the end of 2008, he had lost $1 million on it.)
D’ya think!
WHOA THERE Jack . . . sorry, Steve. Actually, Jack had a better chance of being right than you do.
Yes, there is a floor and it’s a HUGE problem for the bond market. It’s called zero.
And yes, I’m aware that there is some negative-interest-rate rhetoric being bandied about. So let’s really dig into this.
Actually, I first encountered it about 10 years ago when a Federal Reserve researcher responding to an article I wrote when I was at Reuters corresponded with me and shared a white paper that resulted from a study of the topic commissioned by the Fed. As would be expected of any serious thought on the topic, it had to cover implementation. That paper postulated an “excess liquidity tax.”
Seems like a feasible answer. How else might one put through negative interest rates? Are savers/investors to purchase zero yielding Treasuries and send a fee to the Fed that allows them to hold them? How might this work in the secondary market? The Fed is still paying interest on the original face. So is there a formula that would impose a higher holding fee to more than offset the cash payments the fed makes? What are the tax rules? The current forms can’t comprehend interest as a negative; the tax software will crash the way everybody expected the rest of the world to crash at Y2K. Will we need new regs to allow the holding fee to be booked as a transaction cost? Will a new line item need to be created? What happens to corporate debt? If treasuries go low enough to give Jack/Steve the kinds of returns realized historically on TLT, as shown in sims, it’s unrealistic to think the spread will widen so far as to keep corporate rates in the black. Market forces will drive them down as people switch out of treasuries. If the corporate rate goes negative, that means banks and bondholders pay corporations a semi-annual fee for the privilege of holding zero interest-rate IRAs. This would wipe out the equity market, during all stocks to zero. Is there any corporation that won’t look to retire 100% of its equity in order to finance entirely with debt? If rates go negative enough, the holding fees can more than offset the risk of principal default, meaning even the least credit-worthy borrowers get all the capital they want.
The white paper didn’t go that far into details and the Fed tossed it onto the good-for-shits-and-giggles pile because they figured it was a political non-starter due to the clear-cut career suicide it would mean for anybody who supported it. Although the paper pre-dated the modern era, fast forwarding to today, this is one issue on which I can easily see Ted Cruz and Elizabeth Warren as enthusiastic allies. Lizze: how dare anybody try to rip-off the people by making them subsidize banks and the Fed in order to maintain their life savings? Teddy: We already have way too much in the way of taxes and complex regulations, no way we do this.
So, Jack/Steve, that’s my vision of negative interest rates. It makes for cute contrarian rhetoric. But in my opinion, this is probably the silliest view since the shmuck who paid the peak price for tulip bulbs and whose heirs are still waiting for prices to recover.
Finally, a worthy discussion .
I would agree that there is a ceiling on interest rates but would argue that we don’t really know where the ceiling is.
Current conventional economic wisdom is that as we raise rates, we depress investment. That’s pretty much what I learned in school back in the ‘70s and what I saw in the real world for a while. But what I also learned from observation is that this is not a linear function. The elasticity of the demand for capital viz. price is generally elastic but not universally so. At a certain point, the elasticity vanishes and we’ve been at that point for a long time.
I constantly dig into individual companies, both for my writings and because it’s something I do. Frankly, I have not heard one CFO cite cost of capital as a reason for not investing in more than 20 years. What I have heard, and still hear, is discouragement over revenue prospects. That’s what inhibits investment nowadays. This is why recent Fed efforts to prime the economy by pushing rates down have failed. Businesses don’t care. They want customers with money in their pockets and have long ago stopped caring about cost of capital. Those who feel they can sell continue to invest aggressively. Those that don’t have been and still are scaling back and shutting down. At some point, if/when rates rise, this will change. But given all the rhetoric and action around the obviously-wrong belief that recent efforts to slash rates would pump the economy, I suspect that economists today are flustered and scrambling, and have absolutely no idea where that ceiling really is.
At the time I was in school, the monetarists were making hay with their MV=PT model, which influenced the Regan administration in its early years but fell by the wayside as it got more entrenched, more pragmatic and less purely ideological, as so many wind up doing.
M = money supply
V = velocity of money; i.e. the pace at which money circulates
P = prices (think CPI etc.)
T = transactions; think GDP; etc.
We can measure M, P and T. The Fed can control M.
V is tricky. Early on, it was thought to be pretty-much constant. Thus you control the nominal economy by moving the money supply up and down, and watch as you go along so that P doesn’t crazily outrun T.
As it turned out, V is not constant at all. It’s been plummeting for decades and accelerating its decline recently. That’s why nothing the Fed has been doing has influenced the economy. They pump M, but V falls.
V is not controlled by any government body. It’s something that occurs naturally based on the emotions and beliefs and opinions of economic actors, mainly consumers and businesses. My belief is that decades of cost cutting, layoffs, outsourcing, etc. have walloped consumer sentiment and played a big role in driving V lower (this is part of the phenomenon that’s propelling Trump).
My opinion, I can’t prove this, it’s just a hunch, is that an increase in inflation to a non-excessive degree, say 4%-5%, would do wonders to arrest the declines in V and possibly even improve it. Objectively, consumers earn more and pay more, but I don’t see that as a problem as long as it’s more or less in balance. If consumers feel better at having more, they feel empowered over what they can control, how much and how often to buy higher priced goods and services. Emotion is important. Inflation is demoralizing only when it runs away and for that, we may have to wait a decade or more, or take a trip overseas, to Venezuela perhaps.
So again, I agree that there is a ceiling on interest rates. But in terms of how much concern we should have about it, I see us as being analogous to vertigo sufferer who is told: “Stop worrying so much about what it feels like to be on the roof deck of this high rise: You’re still holed up in the fu**ing basement!”
So if I figure out how to make a video for YouTube and post it and don’t come off as too much a dork, do promise to link to it? 
Don’t have a firm opinion yet on contrarianism re: healthcare.
Topic 8.pdf (900 KB)
