Which Hat Are You Wearing?

hatsMost of us have multiple roles—as business owners, professionals, workers, consumers, citizens, students, parents and investors. So our views of the world can differ according to whatever hat we’re wearing at any one time.

This complexity of people and their range of motivations, depending on their circumstances, highlight the inadequacy of cookie-cutter or automated investment solutions.

For instance, if you work for a taxi booking firm, you’re naturally going to take greater-than-usual interest in technology that allows consumers to book cabs directly. That’s because these new disintermediated services might affect how you make your living.

On the other hand, as a consumer you may welcome any initiative that increases competition, widens your choice and lowers prices.

As a taxpayer, you may look kindly on efforts to encourage user-pays systems in universities. But as a parent, you may be concerned about your teenage children taking on excessive debt to fund their education.

As citizens, we might champion a laissez faire approach to economic policy. But as investors, we may feel uncomfortable about certain policies and seek to express our values by placing limits on how our money is invested.

The point is everyone has the right to their own opinions and intelligent people can legitimately and respectfully disagree on many issues, including about what might happen in the world economy and about how policymakers should act.

The trick is in being clear with ourselves about which hat we are wearing when we make investment decisions and the trade-offs involved in reconciling our personal opinions with our desired investment outcomes.

For example, you may have an opinion on what central banks should do in normalizing interest rates. But do you really want to hang your decision about your portfolio allocation to longer-term bonds on your view of the interest rate outlook?

As a worker in an industry undergoing digital disruption, you may have an aversion to the technology putting you out of a job. But as an investor, do you want to forsake earning a share of the wealth from the new forces created by this disruption?

As a resident of a suburb near the airport, you may oppose on noise grounds a government decision to build a new runway, but as an investor and a worker you might benefit from the increased productivity generated by the investment.

The point is we have many roles in life and there often can be conflicts between our personal beliefs and opinions in one area with our desires in another.

Our strong view on the economic outlook may lead us to think the market will come around to pricing assets based on that opinion. But the power of markets is such that they reflect the views of millions of people, many of whom may hold contrary views.

Keep in mind, also, that competitors in those markets include professional investors with multiple sources of information and state-of-the-art technology. And even they have trouble getting these forecasts right with any consistency.

This isn’t to say we can’t invest based on our personal principles. But we first have to start from the assumption that in liquid markets competition drives prices to fair value. Prices reveal information about expected returns. That leaves us to diversify around known risks according to our own preferences and goals.

In short, life is full of trade-offs. It is the same in investment. We may pursue higher expected returns, but we want to do so without sacrificing diversification or cost.

The over-riding principle is to understand what we can and can’t control. We can have an opinion on government policy and we can express it through our vote, but we can’t control the investment outcome. We can have an opinion on what should happen to interest rates, but we can’t control what happens. So we diversify.

The role of a financial advisor is to help you understand these trade-offs and to separate opinion from fact, to balance your risk preferences with your desired wealth outcomes, and to accommodate your personal values within a diversified portfolio.

People with many hats require many different investment solutions. And that’s a good thing.

OUTSIDE THE FLAGS
By Jim Parker
Vice President
DFA Australia Limited

Registered Representative, Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Lion’s Share U.S. Financial Services and Cambridge are not affiliated. Indices mentioned cannot be directly invested in. Past performance is no guarantee.  When you access other linked websites, you assume total responsibility and risk of the websites you are linking to caveat emptor. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. Article are provided for informational purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services in Alabama, Florida, Georgia, and Tennessee.

 

Considering Central Bank Influence on Yields

September 2015lion tamer

Fed watching is a favorite pastime for many market participants. Investors read statements from the Federal Reserve as if they were tea leaves, parsing new information and seeking to forecast future Fed activity. The presumption is that Fed actions lead to specific market outcomes. Recently, some market prognosticators believed that the Fed was going to begin raising the federal funds target rate. However, what actually happened reinforced how difficult it is to accurately forecast when a Fed tightening cycle will occur or what its effects may be.

The presumption of many is that longer-term interest rates will rise when a tightening policy does begin. However, history shows that short- and long-term rates do not move in lockstep. There have been periods when the Fed aggressively lifted the fed funds target rate—the short-term rate controlled by the central bank—while longer-term rates did not change or “stubbornly” declined.

A good example is the Fed’s last campaign of policy tightening through the use of the fed funds target rate (see Exhibit 1). From 2004 to 2006, the Fed increased the rate by 4.25%, yet longer-term rates experienced a period of decline. Alan Greenspan, Fed chairman at the time, referred to this phenomenon as a “conundrum.”

jpeg 1

jpeg 2

Other periods of short- and longer-term rates moving independently include the 1980s, when the fed funds target rate was increased by more than 3% while longer-term rates remained largely unchanged. In fact, the late 1980s was a period marked by an inverted yield curve; long‑term rates yielded less than short-term rates. This can be seen in Exhibit 2: The green line representing the fed funds target rate yielded more than 5- and 10-Year US Treasury notes. There have been a number of instances of inverted yield curves throughout history in the US (and other developed markets).

Another period when market participants attempted to forecast specific outcomes based on Fed actions occurred in 2013. In a statement to Congress on May 22, 2013, Ben Bernanke, then chairman of the Fed, asserted that the Federal Open Market Committee (FOMC) was prepared to scale back its bond purchasing program. At the time, the FOMC was purchasing approximately $85 billion a month in mortgage-backed and US Treasury securities.1 The news of the FOMC’s scaling back of purchases in the open market resulted in what became known as the “taper tantrum.”

Market forecasters speculated that the scaling back of bond purchases by the FOMC would inevitably result in higher interest rates. But interest rates actually declined when the FOMC eliminated its purchases from January 2014 to October 2014.

Exhibit 3 illustrates yields on intermediate- and long‑term US Treasury bonds from the time Bernanke made his statement to Congress until the end of the FOMC’s purchases in open market operations.

As mentioned earlier, history shows that investors who attempt to forecast interest rates have not demonstrated any ability to consistently and reliably predict the future path of those rates. Changes in fed funds target rate, as well as short- and long-term rates,

jpeg 3

 

are not perfectly correlated—and are often driven by market forces.

When analyzing the Fed’s impact on short-term rates, we must also consider the unprecedented action taken by the Fed since 2008—its massive issuance of reserves paying rates of interest.

As Eugene Fama has noted in his research,2 the Fed paid no interest to banks on excess reserves prior to 2008; thus, there was an opportunity cost for banks depositing excess reserves at the Fed. This opportunity cost naturally encouraged banks to make loans and purchase securities; the availability of loans and the money supply created by banks purchasing securities creates downward pressure on interest rates.

The Fed’s recent policy of paying interest rates on excess reserves removed the previous opportunity cost, assuming available rates in the market are not higher than what the Fed is paying. Due to a lack of attractive spreads on loans in the current market, holding excess reserves at the Fed is now the more attractive option. Conventional wisdom has been turned on its head.

By paying interest on excess reserves, the Fed has, in essence, created new “short-term securities.” The issuance of these reserves, or “short-term securities,” pulls monetary supply out of the economy, which by definition should raise interest rates. The question then becomes: Has the Fed really been trying to keep interest rates low? It does not seem that way. Perhaps, in an effort to fight deflation, the Fed has actually been trying to push interest rates higher, yet the lack of attractive lending opportunities in the market has flooded banks with deposits, pushing interest rates lower and limiting the power of the Fed.

In his academic blog, Professor John Cochrane3 also analyzes the effect of the Fed on interest rates. He poses an interesting rhetorical question: “Is the Fed in fact ‘holding down’ interest rates?” To answer this question, he points out that the Fed, to keep interest rates low, will lend money to banks at low interest rates so banks can then lend that money to the rest of the economy, making a spread. But, instead of going out to the market to find “higher” interest rate opportunities, banks have deposited $3 trillion worth of reserves at the central bank despite the “low” rates being paid. If the banks find the Fed rates attractive, is the Fed really keeping interest rates low—or high?

 

  1. Fama, Eugene F., “Does the Fed Control Interest Rates?” working paper, University of Chicago Booth School of Business, 2013.
  2. johnhcochrane.blogspot.com/2015/09/is-fed-pulling-or-pushing.html.
    Exhibits  by Dimensional Funds Advisers

 

 

Registered Representative, Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Lion’s Share U.S. Financial Services and Cambridge are not affiliated. Indices mentioned cannot be directly invested in. Past performance is no guarantee. When you access other linked websites, you assume total responsibility and risk of the websites you are linking to caveat emptor. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. Article are provided for informational purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services in Alabama, Florida, Georgia, and Tennessee. No offers may be made or accepted from any resident outside the specific state(s) referenced.