What’s the problem with low yields? They encourage more borrowing, lower the costs of business expansion, and in theory, create inflation – as the increase in debt (a.k.a. the amount of spending that income does not fully cover) produces upward pressure on pricing because natural demand has been inflated by the amount of new debt. So in a low growth low inflation economy, one where deflation poses some modicum of threat, low interest rates are warranted to ensure deflation doesn’t take root – right?
That’s where central bankers have it all wrong.
Indeed, monetary governors around the world are deathly afraid of deflation, the general decrease in prices. As a result, institutions like the Federal Reserve have long employed monetary tricks like QE to thwart deflation. But their efforts haven’t worked. Inflation is still well below normal levels and economic growth is dismal. Job participation persists at historic lows, consumer spending is sluggish at best, and central government debt is running rampant.
In other words, QE has failed on almost every front. It hasn’t spurred lending or expanded the economic base, and it hasn’t facilitated anything but runaway government spending. There’s absolutely no viable economic reason to continue keeping yields so low.
For instance, with rates being so low for such a long period of time, companies with access to leverage have already borrowed what they need to invest into their businesses. Persistently low rates can’t attract them to leverage more. It’s just not happening.
That’s the major problem with QE is that the new money never reached small to mid-sized businesses – those who truly drive the economic engine. That’s why job growth and consumer activity has been so lethargic. And it’s also why the recovery has been so weak.
The reason banks aren’t lending to small and medium-sized businesses is because there isn’t enough incentive to compensate them for the higher costs, and higher risks, associated with smaller enterprises – and that includes smaller banks.
Market consolidation in the banking sector continues to be a major problem. Bank costs have risen dramatically under the legislative action known as Dodd-Frank, which was passed in the wake of the ’08 crash. This legislation levies regulatory burdens on all banks in the same exact manner – in other words, Dodd-Frank treats a local ten-branch bank group the same way it assesses mega banks like Wells Fargo, which have thousands of locations. This costly burden makes it impossible for local and regional banks to lend profitably to small businesses – let alone to survive. As a consequence, smaller bank groups are getting gobbled up by big bank chains (who use QE money to make the acquisition), which ultimately makes financial institutions that were already too big to fail even bigger.
Yet again, Congressional action made matters worse and produced contrary results from their intention.
As mentioned before, the easiest way to get money moving is to raise interest rates. Banks will lend more money and make more profit, and the economy will expand. The higher cost of borrowing will raise prices and produce more income to bondholders – all of which will deal a blow to deflation. But no, central bankers want lower yields and more QE – which is why the international bond market is so screwed up.
Consider the yields of two European pariahs, Italy and Spain, which have recently experienced a pleasant reversal in fortunes. It was just two years ago when yields for Italy and Spain were up around 7.5% – and Greece couldn’t borrow two nickels to rub together. Yet today Greece sold $28 billion of new five year bonds at 4.95%, and Italy and Spain are paying 3.2% – just a few fractions higher than the U.S. ten year bonds (now 2.7%) – while Germany is currently borrowing at 1.56%.
What the heck is going on? Germany is safer than the U.S. and Greece is just a couple of points behind. Really?
Debt for Greece needs be expensive and difficult to get, otherwise that country will continue spending more than it could reasonably pay back. Artificially low yields (driven by the U.S. and QE programs) encourage irresponsible lending and borrowing practices – just as they did during the subprime mortgage boom. And that’s the larger problem.
The world is turning into one big subprime mortgage, where irresponsible borrowers (now sovereign States) are biting off more than they can chew. And just like what happened to subprime borrowers in 2008, Greece will someday run out of money and borrowing power to service their debt.
What many mutual fund owners don’t know is that they’re footing the international bill. In fact, 49% of Greece’s recent debt issue was purchased by asset managers (a.k.a. mutual funds) and another 33% by hedge fund managers (a.k.a. mutual funds for rich people.)
That’s why I advocate independent investment – so Greece doesn’t directly affect your portfolio unless you put it there. But make no mistake, a collapse or significant devaluation of sovereign state debt will indirectly affect your stock and bond portfolios. That’s why a multiple asset class portfolio is essential to mitigating that risk.
Stay tuned…
