We are writing this column on Friday morning, right smack in the middle of a speech by Fed Chair Jay Powell about the future of everything, apparently, but since we have a publishing deadline there is no opportunity to sit back and carefully consider whatever insights our chief central banker has to communicate about the world economy and what remedies his institution might consider appropriate. We will note, however, that the stock market is bouncing up and down like a ping pong ball, so apparently there are differences of opinion among the trader-bots at play as well and no obvious directional trends.

Banks Buy the Bars

Chair Powell is out in Jackson Hole, Wyoming today with his monetary policymaker-friends from around the globe, this being the annual central bank confab hosted by the Kansas City Fed. One bright and shiny thing that has grabbed the interest of many of these bankers over the past twelve months is…an actual bright and shiny thing – gold. Central banks have purchased $15.7 billion in gold over the first six months of this year, a record amount which comes on the heels of a year – 2018 – in which these institutions bought more gold than at any time since 1971. If that year rings a bell then you know your monetary history – 1971 was the year then-president Richard Nixon took the US off the gold exchange standard, thus ending seemingly forever the two century-plus reign of the gold standard.

Unsurprisingly, gold prices have been inching up over this period, but they went into turbo mode back in June. The chart below shows that this sudden spike in gold roughly coincided with bond yields flipping on their own hyperdrive switches.

An Asset For Our Day and Age

Why all the interest in gold? Readers who have been with us for a while know that our traditional view on this asset class has been fairly skeptical, to say the least. Gold is a commodity like any other physical thing that gets extracted from a topological location, be that oil or tin or coffee beans. Like these other commodities it goes up and down in price according to supply and demand, and offers little in the way of predictability as to the timing and magnitude of cash flows. As a haven asset, in other words, it doesn’t seem to offer much in the way of a safe harbor.

But those views may be better suited to the world we lived in a few years ago – namely one in which there was still a fairly mainstream expectation among economists and other market observers that interest rates would eventually wind up back somewhere close to historical norms. Those days are gone. We now live in a world where $16 trillion, or about 25 percent, of the total amount of government and corporate debt outstanding trades at negative interest rates. As things stand now that negative-rate volume is much more likely to increase than to decrease.

The Lesser Fool Theory

Negative interest rates only make sense in the context of the “greater fool theory” of investing: the idea that no matter how ridiculously priced an asset seems to be, there’s always a sucker out there (i.e. the greater fool) willing to take it off your hands for a profit. The greater fool theory has been a staple of financial markets since the days of tulipmania in seventeenth century Holland. It is literally the only explanation for 10-year German Bunds fetching yields of minus 0.7 percent.

Now it makes more sense why gold, long the preserve of paranoid “gold bugs” holed up in remote bunkers in rural Idaho or wherever and touted by dubious snake oil salespersons on late night cable TV, is gaining favor as a reserve asset by the monetary mandarins of global central banks. Call it the “lesser fool theory.” Nothing has changed about the fact of gold as a simple physical commodity with no inherent value outside the regular market forces of supply and demand. But hey – it sounds a lot more attractive than paying interest to the sovereign entity which is borrowing from you to fund all its (rational or otherwise) spending plans. Money has to go somewhere, after all.

Arian Vojdani was featured on a segment of BNN Bloomberg’s “The Close.” Arian discussed recent market volatility and MV Financial’s market outlook.

In late November of every year, our team convenes for a series of discussions about how to position the portfolios under our management for the year ahead. Since we manage our clients’ assets around long term financial goals, the changes we make from year to year tend to be incremental rather than radical. That being said, we do take into account potential likely economic and capital market scenarios for the year ahead, assessing the balance of upside and downside factors, to determine whether a somewhat more defensive or somewhat more growth-seeking approach makes sense.

In this week’s post we want to help you understand the thinking behind the portfolio management decisions we have made since the beginning of the year and how they stack up in the context of the current environment. A major influencing factor leading to those decisions was the expectation that we would be managing through a period of heightened uncertainty.

Structural Volatility

During our deliberations in late 2018 financial markets were in a tailspin, with the S&P 500 coming very close to a technical bear market (the threshold for which is a 20 percent retreat from the previous high). Emotions can run high during pullbacks of this magnitude, and those emotions can lead to the wrong decisions. Rather than focusing on the immediate moment, therefore, we considered a broader picture of how markets had been behaving for much of the previous year. The fall 2018 pullback was the second significant correction of that year, the first having occurred in late January. After a very strong bull run in 2017 during which stock markets rose by more than 20 percent with very low underlying volatility, we believed the bull market had entered a new phase – one with less directional certainty (either up or down) and more dramatic variations around central trends.

We communicated this view to you in our annual outlook published on January 19 of this year. “We believe heightened volatility will be the principal characteristic of asset markets in 2019” was the key message of that report, noting that “volatility” is a two way street — both up and down. From a practical standpoint, that meant bringing our equity weightings down somewhat from where they were in our 2017 allocation models. Not dramatically – again, our portfolios are positioned around long-term financial objectives, not short-term market timing considerations. But we felt that a somewhat more defensive position for the risk asset classes in our portfolios was appropriate for an uncertain environment.

What About Bonds?

The volatility picture clarified in late April and May when markets pulled back by almost 7 percent, then rose sharply in June and July and have since fallen hard again in August (a bit more than 6 percent down from the late July high after this past Wednesday’s selloff). The S&P 500 is still up around 15 percent year to date, thanks to that sharp rally off last December’s low point, but it is below the pre-correction levels of January 2018. Sentiment is anything but complacent.

Meanwhile, the really big story in financial markets today is less about where the S&P 500 is on any given day, and more about what is going on in the bond market.

We manage the fixed income component of our portfolios with two objectives in mind: risk management, and predictable income aligned with the liquidity needs of each individual client. Our bond allocations are by and large conservative with a focus on high quality, low risk instruments. In a practical sense this implies a mix of short to intermediate term fixed and floating rate securities, and defined maturity ladders for more predictable cash flow management.

Back to that big story in bonds – the inverted yield curve has fixated financial market commentary for the past several weeks, particularly this week when 10-year yields fell below 2-year yields and the 30-year Treasury fell below 2 percent for the first time ever. The sheer force of the global bond rally – including by now more than $16 trillion worth of bonds trading at negative interest rates – has left seasoned market pros groping for reasoned explanations. When bond prices go up, interest rates go down – but there is something peculiar about how this relationship works that is worth understanding.

Bond Math Drama

Not all bond prices react the same way to a change in interest rates. To be specific, the price of a bond with a longer maturity will, all else being equal, go up or down by more than a bond with a shorter maturity for a given change in interest rates. You can see this effect (called the “duration effect” in bond parlance) in the chart below.

The left panel of this chart shows the interest rate trend for 2-year and 10-year Treasuries over the past year, which has been largely down after peaking late last year. On the right panel, you see the price effect of this interest rate trend on short term bonds (represented by a 1-3 year Treasury ETF shown in blue) and bonds with longer maturities (the 7-10 year Treasury ETF shown in green). The difference is dramatic – the price of longer term bonds has surged with the decline in rates. In fact, bonds in the 10-20 year range are outperforming the S&P 500 on a total return basis for the year to date.

But we don’t make bond allocation decisions with a view to outperforming the S&P 500. Again – this portion of our portfolio is for safety and for income. On a price appreciation basis our allocation will substantially lag those go-go long duration bonds – and we’re fine with that. What goes up that dramatically can also go down with equal amounts of drama – and that runs counter to our fundamental bond allocation philosophy.

Just as we described with regard to our equity allocation decisions, we believe that a conservative approach in the form of high quality bonds with low to intermediate maturities is the right decision for an environment of uncertainty. There are a great many questions about where bond yields go from here, how sustainable this phenomenon of negative interest rates will be, and how successful global central banks will be in fending off a potential economic downturn with their traditional monetary policy toolkits. We do not think this is an appropriate time to take aggressive positioning moves in fixed income.

This past week has in some ways been a microcosm of the volatility we wrote about at the beginning of this year. Monday, Tuesday and Wednesday all saw price moves in the S&P 500 greater than 1 percent – two down and one up (as we write this on Friday morning the index is perhaps poised for another 1 percent-plus day on the upside). In such an environment we need to keep our portfolios positioned so as to not miss out on growth opportunities while still maintaining a level of downside protection consistent with each client’s level of risk tolerance. It’s not an easy balancing act – but that’s our job and that’s what we will keep doing every day.

In our annual investment outlook, which we published way back in January, we talked a great deal about volatility. Specifically, the following was a summation of our central thesis in assessing the year ahead: “We believe heightened volatility will be the principal characteristic of asset markets in 2019. Volatility cuts both ways – up and down – meaning that predictions about market directional trends will be subject to high amounts of variability.”

We’ve been having a very volatile week in equity markets during this first full week of August. True to our observation in the annual outlook, the volatility has cut both ways, up and down. After two dramatic days on Monday and Tuesday – one sharply lower and one higher – markets seesawed in a wide intraday range on Wednesday before settling close to flat. There has been little in the way of rhyme or reason to explain the sudden lurches to and fro. It seems like a good time for a review of what we mean when we talk about volatility – or, to use the more popular term, risk.

Risk Up, Risk Down

The following chart encapsulates two different ways of looking at risk (when used in the investment definition, the words “risk” and “volatility” are essentially interchangeable). The dotted green line shows the price trend of the CBOE VIX, a widely used proxy for market risk. The solid blue line shows the trajectory of the S&P 500 equity index over the past two years.

So what does this chart show us? The VIX is popularly known as the market’s “fear gauge.” When it spikes up above a price level of 20 or so it generally signifies a sudden pullback in equity prices. The best way to understand the VIX is through a topological analogy of peaks, valleys and mesas. In the chart above you can see a “valley” over on the far left extending through the latter part of 2017 and into the first month of 2018. Those were some of the lowest (i.e. least risk-on) levels ever recorded since the VIX contract launched back in 1990. Then, in between the sharp peaks of early 2018 and the latter three months of the same year, you see a mesa formation – a floor that is still at a noticeably higher altitude than that of the previous year. In 2019 we drive up to an even higher mesa, punctuated by this week’s risk spike.

Just from this part of the picture we see a slow, steady elevation in baseline risk levels. What this is actually saying – the raw material underlying the VIX being S&P 500 stock options – is that traders have been gradually increasing their hedge positions in the market from the low levels of 2017.

An Eight-Lane Sideways Corridor

We fill out the risk picture by analyzing the second element in that chart – the price trend for the S&P 500 itself. If you tune into the financial news on any given day you will usually learn little more than the fact of the market being up or down on that given day. If there has been a decisive directional move for, say, a couple weeks or so then you might hear some chatter about the bulls or the bears running hard. But rarely do the financial media chatterboxes stand back to look at the bigger picture. Here is where the two year view of stocks shown above provides a broader context for volatility.

From the market peak in late January 2018 to the current time, the basic directional trend of the market has been sideways. It peaked at 2872 on January 26, 2018 and closed at 2881 on August 6, 2019 – flat as can be. But the width of this sideways corridor has been wide enough to drive a handful of oversized semi-trailer convoys through. This is thanks to the plethora of pullbacks (the largest of which was the 19.8 percent peak-to-trough event of last fall) that have served to keep directional upside in check.

So what will break the corridor, either to the upside or the downside – and when? Those are questions for which every equity investor would love to have the answer, and none do. However, it is perfectly reasonable to imagine plausible catalysts that could enable the breakout. On the upside, it may be clear evidence of organic growth drivers that would give a renewed tailwind to corporate sales and earnings potential. On the downside, it could be a visible loss of credibility by central banks in their efforts to shore up asset prices with aggressive monetary policy.

As long as neither of these outcomes materializes, it would be reasonable to imagine staying in this wide risk corridor for some time to come, and putting up with the periodic pullbacks that follow a run-up in price appreciation. Meanwhile, it would be nice to see a healthy productivity reading when that figure comes out next week – though we’re not holding our breath.

MV Financial provided a webinar covering how nonprofit plan sponsors can fix their retirement plans with individual annuity contracts. The webinar recording can be found here.

This webinar covered IACs within sponsors’ current plan, their value and limitations, and solutions that are available to upgrade these plans.

The webinar discussed how to achieve:

• A more current, competitive and compliant plan
• Greater fiduciary control
• A substantially wider range of investment options
• Cost-efficiency
• Improved service
• Enhanced plan education, including individual investment guidance for plan participants

Listen to the webinar here.

It’s a strange economy, this one. All of the following happened this week: several data releases confirmed that manufacturing activity is hovering barely above the threshold for contraction; US consumers appear to be more confident about the economy than at any time in the last three decades apart from the very peak of the giddy late-1990s growth cycle; the Core Personal Consumption Expenditure (PCE) indicator, the Fed’s favorite measure of inflation, registered an anemic 1.6 percent year-on-year expansion; and today’s jobs report showed basically more of the same with a healthy clip in payroll additions and wages growing at a brisker rate than inflation.

Oh, and the Fed cut its target Fed funds rate range by 0.25 percent, which came as a surprise to zero people but a disappointment to many for whom 25 basis points just doesn’t deliver the intravenous jolt they have come to need. And the trade war is back on, apparently, just one day after Fed Chair Powell noted an apparent recent subsiding in trade tensions. Conspiracy theorists, discuss amongst yourselves.

Insure This

That hotchpotch of mixed economic data points described above points to the likely thinking behind the Fed’s move this week. There is evidence of a slowing pace of growth (hence the manufacturing production data, which tend to serve as a leading indicator) even while consumers are as happy as pigs in mud and job creation keeps up its record-breaking pace. Corporate earnings season is winding down and a second straight quarter of EPS declines (albeit modest) is the likely outcome. Inflation seems permanently stuck in second gear. An insurance cut – which is how Powell characterized it at the post-FOMC press conference – would seem to make sense. At the very least, it is hard to see how it could do much harm in the absence of any plausible argument for an overheated economy.

The Longest, Least Productive Growth Cycle

Overheated, to be clear, is a word with entirely no relevance to what is by now the longest economic growth cycle on record. In previous growth cycles the Fed had to engineer interest rates back up above at least five percent to cool off late-cycle consumer binges and capacity build-outs. Previous cycles also had more of something this one has pretty much gone entirely without: organic, productivity-driven growth.

The chart below illustrates the US productivity trend since the earliest postwar economic cycles, along with the labor force participation rate. These two indicators tend to be largely ignored in the quarter-to-quarter analysis that dominates mainstream economic reporting, but they are central to the long term growth equation. As the chart shows, they have both been subdued throughout this entire growth cycle.

This chart illustrates the dilemma that economic policymakers face in trying to anticipate what happens after the effects of short term monetary and/or fiscal stimulus wear off. This economy has survived on eleven years of aggressive monetary stimulus and intermittent doses of fiscal largesse. The effects of the most recent fiscal injection – the tax cuts that went into effect in 2018 – are pretty much over. Corporations bought back massive amounts of their own stock and some even increased their capital spending on productive assets, but by this year’s second quarter private sector nonresidential investment had already waned as a contributor to gross national product.

Demographic Doldrums

Demographics also work against the economy. The labor force participation rate is likely to stay stagnant as the population skews older and towards retirement. The segment of the population below age 18 is in decline. Overall population growth, at 0.62 percent according to the Census Bureau’s most recent reading, is the lowest growth rate since the Depression-scarred environment of 1937. None of this is going to help growth. That leaves productivity, of which there has not been much. The productivity report for the second quarter comes out on August 15, and is expected to reflect another below-trend reading.

In the meantime, though, a slowing economy does not necessarily mean one in near-term danger of falling into recession. Perhaps the silver lining in the anemic growth formulation is less volatility on the downside. Lower growth, lower risk – just like a boring, stable utility versus a high growth start-up tech company, perhaps. Maybe that will work out in the long run – but in the short run it is unlikely to be either helped much or hurt much by however many “insurance” cuts the Fed has planned.

Before the iPhone, there was i-mode. Seven years before Steve Jobs turned the world on its head with the iconic Apple product, a much stodgier company produced the world’s first smartphone. In 1999 NTT, the incumbent Japanese telecom provider and a byword for “lumbering bureaucracy,” launched a mobile phone service with Internet access through a subsidiary called DoCoMo. I-mode, as the new service was called, went viral. Barely two years after the service was launched, i-mode had gained an 80 percent penetration rate and had considerably brightened the multi-hour commutes of Japan’s legions of office workers. Mind you, this was all happening right at the turn of the 21^st century, before even the iPod, let alone the iPhone, had entered the lexicon of modern technology.

Leading Where We Don’t Want to Follow

What point are we making with that little history lesson about the birth of the smartphone? Only that while we tend not to think of Japan as much of a leader when it comes to economic trends, there are times when the world’s third largest economy paves the way. In the case of the smartphone, that was probably a good thing. But when it comes to monetary policy – another area where Japan has been a world-beating, ahead-of-the-curve pioneer – the rest of the world may be ruing the day we all had to follow the leader.

Japan rode the crest of an asset bubble in real estate and stock prices for about five years before the bubble burst in 1990. As the chart below shows, it has been an unhappy 30 years for anyone who put money into Japanese equities at the peak of that bubble.

Today the Nikkei 225, the broad market benchmark for Japanese equities, stands at a little more than half of its value, in nominal terms, at the market peak of December 1989. For much of the time since then, the country’s economy has been mired in a mix of slow growth, recession, deflation and population decline. To try and combat these chronic, structural problems the Bank of Japan started throwing stimulus money at the economy throughout the 1990s. In 1999 – the same year as the DoCoMo i-mode launch – the BoJ became the first central bank in the developed world to establish a zero-bound interest rate policy. Two years later it launched another innovation – quantitative easing. These unconventional policy approaches lurked silently in the background as world markets fell down the rabbit hole in the 2008 market crash.

Bonds Today, Stocks Tomorrow

The Bank of Japan didn’t take its foot off the innovation pedal while the US Fed and the ECB made their own first forays into unconventional QE policies in the wake of the recession. In 2010 the BoJ put on another hat – equity investor. It now has a policy of investing around $55 billion annually in equity ETFs with the stated goal of providing volatility reduction in risk asset markets and encouraging investor psychology. This activity makes the central bank the owner of about 5 percent of the total market capitalization of the Japanese stock market. It is a top ten shareholder in some 40 percent of all Japanese companies with listed common shares. And despite the fact that nearly ten years of equity purchases don’t seem to have had much of a positive effect on the economy at large – Japan’s macro headlines remain largely underwhelming – the program shows no signs of slowing down.

Japan led the world to zero interest rates, to QE and, more recently, to negative interest rates. Will the ECB, the Fed and the Bank of England follow down the yellow brick road yet again and start actively buying stocks? The idea is certainly in the mainstream discourse, if not yet actual policy. This week featured several articles in the Financial Times, a redoubt of establishment economics, weighing the various aspects of this approach for the ECB. For their part, investors appear to be fixated on central bank policy actions to the exclusion of just about everything else that happens in the world. It is not hard to imagine that the market’s abject dependence on the monetary stimulus drug reaches a point where only direct investment in risk assets like commons stocks will be strong enough to have a palliative effect. We’re not there today. But call us absolutely unsurprised if, come 2022, the Fed is buying S&P 500 ETFs and the ECB is siphoning up shares on the DAX and the CAC-40. We all live in Wonderland now.

An emergency fund is something that I, as an investment adviser and financial planner, always stress is the first bucket of savings anyone should establish. However, I am constantly surprised when talking to others to learn that they either have not shored up enough in funds for a proper emergency fund, or don’t have one at all.

So, what is an emergency fund? An emergency fund is just as the name implies: savings you have in an accessible and liquid position (savings account, money market account, or short term CDs) set aside for an emergency – think an injury which prevents you from working, unexpected medical bills, or any type of unexpected expense (like I had last year when my faithful refrigerator died and needed to be replaced). The point of an emergency fund is to give you a cushion so that you don’t have to either stop accumulating your savings or go into debt due to said emergency/unexpected expense.

How much should you put into an emergency fund? Typically, we suggest holding 3 – 6 months of monthly expenses in savings. Deciding on how many months of expenses you should set aside will come down to each person’s judgement call. However, there are some factors that can help us decide how much to put aside. For example, if you are married in a dual income household of roughly similar incomes – 3 months is probably fine. (If one person gets injured and can’t work, the other’s income is still being maintained for expenses.) If you are married with only one income – it probably makes sense to set aside 6 months. If you are single, how much you set aside will be a judgement call based on your level of comfort, expenses, lifestyle and other factors.

To put it simply, an emergency fund is a must. Before you start saving for a home, upping your 401(k) contributions or adding more to your non-qualified investment account, make sure you have your bases covered and that you have an emergency fund for a rainy day. Hopefully, you will never have to use any of the money in your emergency fund, but if that rainy day ever comes (which you will be surprised, they do pop up – like the day my refrigerator decided it was clocking out) you will be happy you did.

It would appear that the Twitter-dominated world in which we live is incapable of existing anywhere below the level of five-alarm panic for any meaningful period of time. In actual fact, global economic growth has not been laid waste by the ravages of the trade war now well into its second year, but that minor bit of empirical evidence has not stopped the daily churn of angst-filled headlines. But the Twitterverse also sustains itself through the constant ingestion of the shiny and new. Cue up the newest discussion morsel for the uproar and consternation of the financial chattering class – the prospect of an imminent currency war led by the US dollar. Is this a real threat, as a growing number of industry pros are telling us? Is it even possible to wage a currency war on behalf of the world’s reserve currency? Let’s consider the evidence.

Strong Dollar Blues

The US dollar is in a position of strength – that much is indisputable. The chart below shows the long-term trend (going back to 1995) for the US trade weighted dollar index. This shows the performance of the greenback versus a basket of 26 foreign currencies with whom the US engages in bilateral trade. As the chart shows, the dollar is currently close to its quarter-century high point reached in the early 2000s.

For most of the time shown in this chart, there has been very little in the way of coordinated currency intervention involving the US dollar. The big trend movements you see in the chart derive mostly from organic economic trends, including the ballooning trade deficits of the mid-2000s that significantly weakened the dollar, and then the embrace of hyper-aggressive monetary stimulus by the European Central Bank and Bank of Japan earlier this decade, pushing interest rates below zero in those markets and making dollar-denominated assets a more attractive alternative. In terms of short-term trading movements, the dollar has tended to be viewed as a safe haven currency during periods of heightened economic uncertainty, while losing value against the likes of the euro or the Chinese renminbi during more robust spurts of global growth.

In simplistic terms, economic policymakers tend to see a strong national currency as an impediment to growth as it negatively affects the competitiveness of exports. This is the argument you hear from those in the current US administration pushing for intervention. This rhetoric goes hand in glove with the persistent attempts of this administration to jawbone the Fed into lowering interest rates. Indeed, a number of professional observers worry that an aggressive Fed move on rates later this month (the odds of which have gone up yet again after some super-dovish comments by Fed members yesterday) will be seen by the market as the Fed acceding to a push by the Treasury Department to formally intervene in currency markets (Treasury maintains that such a formal program “for the time being” is not on the table).

Be Careful What You Wish For

The relationship between a national currency and domestic economic growth is simple enough in the textbooks, but the real world is a more complex Petri dish of unanticipated consequences. The US certainly does have formal mechanisms in place to launch a currency intervention should it choose. The Exchange Stabilization Fund has been around since 1934, and it is through this mechanism that the Treasury Department could undertake direct market intervention.

But currency intervention is not a one-sided thing. Consider, for example, one of the most prominent historical examples in the post-Bretton Woods era of concerted currency manipulation: the Plaza Accords of 1985. The US and its major economic partners agreed at that time that the US dollar’s strength was an impediment to global growth (the greenback had appreciated against the Deutsche mark by some 90 percent in the five years leading to the Plaza Accords). As a result, the action taken by the Reagan Treasury Department to bring down the value of the dollar was supported by the monetary authorities of Japan, West Germany and elsewhere to support their own currencies).

It is very unlikely that today’s policymakers in Brussels or Tokyo or Beijing would line up on the same side of the argument as Trump and Mnuchin to carry out some modern reprise of the Plaza Accords. More likely, a US-driven currency war would lead to a destructive race to the bottom as all players sought to shore up their own domestic competitiveness.

The result of which, very plausibly, would be an ever-greater level of economic uncertainty and a higher likelihood of falling growth or global recession. In other words, an environment that would be seen by the market as decidedly “risk-off,” raising the attractiveness of traditional risk-off assets. Like, oh, just to name one, the US dollar. Yes, a currency war could wind up delivering the opposite of what its backers wanted.

Now, we don’t think a currency war is going to happen – if the trade war is any example, then this would likely be 90 parts Twitter braggadocio and 10 parts substance. But the risk is not zero, so sadly, as always, attention must be paid.

According to the teachings of traditional financial theory, investors make rational choices when deciding which assets to include in their portfolios, based on their particular return objectives and tolerance for risk. “Choice” implies evaluating the relative merits of the cash flow prospects for Company ABC versus Company XYZ, or the stability of securities backed by the full faith and credit of the United States government versus those issued by sovereign entities in volatile frontier markets, and assigning valuations accordingly. The safer the asset, the less return an investor should demand for holding it. Which is why it might have raised a few eyebrows earlier this week when the yield on 10-year government bonds issued by Greece – yes, that Greece – briefly fell below the yield on comparable US Treasury securities.

The Lagarde Put

If you have been following the goings-on in the capital marketplace for some years now, you may remember that back in 2012 Greece was on the verge of failing out of the single-currency Eurozone, and its government bonds were fetching yields of nearly 35 percent. But 2012 was also the year of the three most famous words pronounced on the European continent since “veni, vidi, vici” – “whatever it takes” per European Central Bank chief Mario Draghi. Draghi’s term will end this coming October, and the ECB torch will most likely pass to Christine Lagarde, current head of the International Monetary Fund. Lagarde will ascend to the commanding heights of a world where those dog-eared pages of traditional finance textbooks are as good as worthless. Euro-denominated bonds issued by the Czech Republic trade at negative yields, while Japanese insurance companies, thirsting for positive yields, scour the likes of Kazakhstan and even Turkey for inclusions to their portfolios. “How low is too low?” will likely be one of the persistent questions to be faced by the new ECB chief. The first 10-year benchmark to come with a coupon of minus one percent may not be too far down the road.

It’s the Fed’s World, We Just Live In It

Back on this side of the Atlantic, “Fed funds cut in July” appears to have joined death and taxes as the only certainties in life. Equity markets were briefly unsettled earlier in the week by the better than expected jobs numbers that came out last Friday. Good news (e.g. jobs, wages, consumer confidence), after all, might throw a wrench into those rate cut expectations. Not to worry, though, as Fed Chair Powell made it perfectly clear that, come what may, the rate cut is in the post.

Now, from the standpoint of prolonging the economic growth cycle it may be entirely reasonable to produce a couple “insurance” rate cuts – a topic we discussed here a couple weeks back. The problem is that in the current market environment, these are not just one-off measures but rather part and parcel of a seemingly endless program of easy money all around the world. What this accomplishes in economic terms is up for debate; what is not debatable is that it has a distorting effect on asset prices. Not just in the form of negative interest rates and Greek bonds trading at par with Treasuries, but in the valuation of equities as well.

Back in the days when those old finance textbooks were relevant, there was a methodology for calculating the value of a company’s equity by computing the net present value of a future stream of cash flows. The net present value figure was arrived at by assuming an appropriate cost of capital and then discounting future cash flows back to the present at that cost of capital. All else being equal, a decline in interest rates will increase the value of those cash flows being discounted to the present (that’s one big reason why stock prices reflexively rise on the news of interest rate cuts). When rates go to zero or turn negative, though, it can render meaningless that discount rate calculation. Market prices are distorted accordingly, and the ability of investors to make rational choices between assets of varying creditworthiness is likewise impaired.

The current bull market is in its eleventh year, the second-longest on record since the end of the Second World War. This longevity is almost entirely due to the presence of easy money. The market’s inability to live without the Fed, ECB et al was made perfectly clear last fall, when fears about monetary tightening took equities just nanometers away from a bear market. A willingness to trade rational price discovery for the security of government intervention is the bargain investors have accepted. It’s the TINA market – There Is No Alternative. What nobody wants to do is imagine what might come after TINA.