With the Lights Low, Everything Looks Great

It’s Thursday, and that means there’s only one more day to go.

Is it the end of the beginning or the beginning of the end?

There’s a lot of chatter out there about the Fed not taking enough action to quell the red hot markets.

Where were all these clowns in the run-up?  Too busy making money out of government policy, I’d wager.

And now, because they want to protect their stolen – yes, stolen – loot, they’re begging Big Daddy Powell to do something.

But when a central bank tries to engineer a “soft landing,” a crash is usually around the corner.

Singapore, 2009

I had just turned 34 when I arrived in Singapore in January 2009.  Not yet middle-aged and wizened, but old enough to travel, settle, and thrive in a new country.

After all, I had done that just before my 25th birthday in London.

My good friend, the Duke of Omata, calls Singapore “Asia’s On-Ramp.”  Others used to call it “Little America.”

It was as shiny and new as a Victorian trading port could be.

And my goodness, could they party there!

The booze was expensive compared to London, but the party scene was thriving.  And the women seemed to me as welcoming as they could be.

Though I was already bald and sported an over 40-inch waist by then, their, ahem, willingness to get to know me better was a welcome surprise.

I felt like Captain Kirk in Generations when he was stuck in the Nexus.  The Nexus was an extra-dimensional heaven-like realm in which one’s thoughts and desires shaped reality.

Kirk remarked to Picard that he used to be terrified whenever he jumped the ravine near his uncle’s house with his horse.

But not in the Nexus.

I understood the Captain completely.  I felt like I could jump anything in Singapore, too!

There was this famous nightclub in Singapore called Zouk.  I think it’s at a new location now, and certainly not the same as it was before.

Like the great nightclubs around Asia like Apocalypse Now in Ho Chi Minh City or Dragon Eye in Hong Kong, Zouk was where hot young things in very high heels and very short skirts danced the steamy night away.

Management always kept the lights low as the dance music thumped on.

You couldn’t see who you were dancing with much of the time.

And then… inevitably… the lights would slowly turn on.

Sometimes, you weren’t always happy when you saw who you were dancing with.

As I teach grads for banks, perhaps only a nerd like me can make the connection: that’s the same way interest rates work.  Like the lights in a dance club.

The Journal Goes Anarchocapitalist for a Moment

I’ve bitched, moaned, and complained about this in many editions of the Rude.

When management (The Fed) keeps the lights (interest rates) low, your dance partner (project or investment) looks great.

But when the interest rates rise, your projects or investments start to look like a horrible idea.

You can imagine my surprise when I read in The Wall Street Journal a howl in the opinion section about the Fed having to take action.

Here’s the link, but if you’ve been reading the Rude for the past six months, there’s nothing much new in this piece for you.

Mind you, I agree with everything the author wrote.

What is new is that the Journal deigned to print such a piece.

Let’s parse out a few nuggets from the article:

Since 1970, negative real Treasury bond yields typically have corresponded with a plunging stock market. Example: Yields reached a low of negative 4.9% in 1974. During that year, the S&P 500 fell 37%. Today, real yields of negative 4.7% are the second-lowest since 1970, yet the S&P 500 has risen nearly 30% over the past year.

The author, Lawrence Goodman, President of the Center for Financial Stability, lays out two reasons why this is (bolds are mine):

First, the U.S. Treasury bond market has been rigged and manipulated since the Federal Reserve’s second quantitative-easing program began in 2010. Since then, Fed purchases of Treasury debt have funded as much as 60% to 80% of the entire government borrowing requirement.

In other words, Fed actions have crowded out private-sector price discovery for more than 10 years, pushing yields to lows and stock prices to record highs. The consequence of this blurred line between Fed and Treasury responsibilities—“monetizing the debt”—is inflation.

Second, the infamous bond vigilantes, who sold bonds to protest inflationary policies, are relics of the past. They were driven by opportunity, not ideology. These investors voted on government budget deficits and debt management by buying or selling bonds every day. But active Fed intervention has silenced them. “Fighting the Fed” has always been fraught with risk, but fighting a Fed operating with such force will result only in big and consistent losses.

“Rigged and manipulated?”

“Crowded out private-sector price discovery?”

“Fed intervention silenced them?”

You’d be forgiven for thinking the Journal has gone full-blown anarchocapitalist.

Real Money is Starting to Get the Shivers

After reading Goodman’s opinion piece, I got on the horn with my good friend and mentor, Hunter Hastings, of the Economics for Business podcast.

Despite being a capitalist to the core, Hunter resides in the People’s Republic of California.  After I mentioned the Goodman piece, Hunter said something shocking, but not surprising.

Calpers, the California Public Employees Retirement System, has decided to add leverage to the fund.

I can’t convey my outrage at this insanity, so I’ll try to explain it calmly.

Tying it back to the Goodman piece: because the Fed has crowded out private investment in the bond markets, rates (yields) have fallen to the floor.

To remind you, there’s an inverse relationship between bond prices and yields.  Also, yields and rates are synonymous terms.

Because rates are on the floor, funds need to take bigger risks to earn the yield (return) they need to satisfy their investors.

From the article:

Without changes, Calpers said its current asset mix would produce 20-year returns of 6.2%, short of both the 7% target the fund started 2021 with and the 6.8% target implemented over the summer.

Say it again, Charlie… Show me the incentive, and I’ll show you the outcome.

But big funds like Calpers have pushed straight past equities into alternative investments like venture capital, private equity, and real assets like commodities.

I don’t think they should be anywhere near those types of investments.  The risk is simply too high.

Now, they want to add leverage to the mix.

Have a look at this chart:

Credit: PIMCO

This is a chart of the efficient frontier.  It represents the best return for a given level of risk within investing parameters.

For instance, we start with equities and bonds.  That’s the lowest curve.

To increase returns without increasing risk (too much), fund managers add alternative investments such as venture capital, private equity, and commodities to the asset mix.

Then they can add real estate to increase returns further.

Why does this work (most of the time, historically speaking)?

Because these assets are usually uncorrelated with each other.  This doesn’t work so well in the Everything Rally.

Now, look at the top curve.  This one adds lending (borrowing from the investor’s standpoint).  By borrowing, a fund can certainly increase its returns.

But at this point, it can only increase returns by increasing risk.  Everything added to the portfolio before this point is meant to increase returns while reducing – or at least increasing – risk.

Borrowing to increase your returns is therefore a dangerous thing to do.

Especially when you’re sitting on $500 billion in assets.

As when Sherlock Holmes washed Hugh Boone’s face to reveal Mr. Neville St. Clair in The Man With the Twisted Lip, leverage may be the very reason the makeup gets wiped off the face of Clown World.

Until tomorrow.

All the best,

Sean

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