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Archive for April, 2016

Rates too heavy ?

Every heady bull run has excesses. From stocks being valued on eyeballs, junk bonds being rated AAA or NINJA ( no income no job no assets) loans being distributed by banks, these parties have seen them all. A notable common factor towards the latter phase of all these bull-run periods have been Fed interest rate hikes.

 

In fact a simplistic view of the situation could make a case that the Federal Reserve prompted the subsequent crashes through the interest rate hikes. Eventually, borrowers could not pay higher interest rates and defaulted or money stopped flowing into stock markets attracted by higher bond yields. It appears that this simplistic view is being taken seriously by none other than the Fed itself. This cannot be dismissed as mistakenly assuming correlation for causation.

The debt levels of today’s world are incomparable to those of earlier eras. Money is literally cheap today. Frighteningly, making it so does not bring inflation and growth. The interest rate hike announcements had been necessary for the Fed to signify that the economic situation was benign as dilly-dallying in the wake of supposedly strong employment and wage data would have been suspicious. Yet, it is impossible for it to deliver on its rate hike promises without precipitating a crash.

Earlier long-term bull-run phases had real earnings pick-ups which allowed the Federal Reserve to raise rates and rein in inflation. The markets did crash but only after years of growth. In any event, stock markets are cyclical. Now we are in an era of tepid growth and tepid inflation in much of the world. Corporate bond defaults are at multi-year highs as are student loan defaults. Yet, the S&P 500 has risen more than 200% since its ‘09 lows and is still rising. It’s a rally whose lifeblood is liquidity, something interest rate hikes are supposed to suck out. This is possible to achieve without immediate negative fallout during strong economic growth periods; this is certainly not the case today.

Regrettably, the Federal Reserve is in a situation where it cannot raise interest rates by more than a percent or thereabouts as it is painfully obvious that the heavily indebted businesses of today would not be able to afford much higher interest rates and neither can it hold firm forever as it would be giving live to its claim of a booming economy and a robust economic environment.

 

Imagine Janet Yellen trying to lift a big zero shaped boulder towards the sky. You get the picture. She is no Hercules.

P.S: Gordon Gekko said,” Greed is good.” Janet Yellen says, “Debt is good. ” We know how the movie ended.

 

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How zero and negative interest policies are playing with the cost of equity

A lot of things are very different today in the world of finance. However, what has prompted me to write today is the imminent demise in the developed world of something which was at the very foundation of the course on ‘Financial Management’ I studied during my Masters- the concept of the risk free interest rate.

The risk free interest rate is basic opportunity cost. It is traditionally taken as the yield of a long term sovereign bond or some other such asset which is guaranteed by the government. The concept is somewhat ideal as sovereign defaults do happen but it is definitely true that sovereign bonds of first world countries have a good credit history.

The developed world is now a place of either Zero Interest Rate Policy (ZIRP) or Negative Interest Rate Policy (NIRP). In a world having inflation, both policies mean that a person buying a risk free asset would lose money over time. While ZIRP makes its way felt through creeping inflation, NIRP is more direct as a direct debit on your bank account. Effectively though the message is clear, there is no risk free asset that delivers a return. No FD in a sovereign bank or long term sovereign bond that preserves your capital. Even to preserve capital, investors would need to take risk.

The removal of risk free interest rate has far reaching implications, especially on cost of equity. Taking an example, let’s assume that the 10 year Government bond is the risk free interest rate in India. Currently, its yield is approximately 7.5% and an investor’s equity risk premium is also 8%. This means that the cost of equity is 15.5%.

However, in ZIRP, the cost of equity would just be the risk of investing in equity, the equity risk premium i.e 8%. Thus theoretically, it also means a lower expected return from equity.

It is a terrible situation to be in; the inflation indicators are benign in most of the world but the truth is that food, housing, medical bills and education are getting more expensive year on year almost everywhere. If one has to spend in the future on any of these things, one has to save and this means that getting a return is important. However, with no risk free asset, one is literally forced to dabble in the markets. Thus with more demand, equity asset prices go up.

That is theory. In real life too, the US markets have enjoyed a speculative rally fuelled by debt. However, something is seriously wrong when the Dow and S&P 500 reach lifetime highs without any meaningful increase in economic indicators and investors have to bet our life’s savings on the hope that this continues because they simply have nowhere else to go. This is bad because if there are no savings, one can only borrow. Borrowing is based on the premise that one would earn more in the future. Is that really guaranteed when wages have been stagnating in the developed world for decades? Don’t take my word for it, read Michael Lewis’ ‘Liar’s Poker’ that mentions starting 1980s salaries in the USA in Wall Street and it is difficult to believe how little the salaries have changed even in nominal terms. Yet, cars, houses and tuition are phenomenally more expensive now than then.

How do central banks tackle the crisis? They try to remove the ‘risk’ from the equity risk premium by playing to the market. Witness the efforts of the central banks of China, Japan, the Euro zone and of course the US. It is working so far: basic concepts of Financial Management be damned.

I sincerely hope that the rate easing cycle in India never reaches ZIRP in my lifetime but I am afraid the odds are against me.

My PreciousZIRP

The ring is too precious to let go