Friday, November 5, 2010

Earning "real' returns

   In the aftermath of the elections and Fed decision, the dollar broke through support to the downside overnight, sending stocks, commodities and bonds in a race to the top. When word broke during the morning that president Obama was open to extending the Bush tax cuts for all income levels, the gains grew even larger. Despite an unexpected rise in weekly unemployment claims back above 450,000 coupled with Goldman Sachs cutting expectations for tomorrow's jobs number, the Dow roared higher by more than 200 points.
   Several new milestones were hit today in the markets, as the Dow, S&P 500 and Nasdaq traded to their highest levels in over 2 years. On the bond side, 2, 3, 5, and 7-year treasuries all touched record prices, offering new low yields of .31%, .43%, 1.01% and 1.69% respectively. Given the Fed's presence in the Treasury market and commitment to purchase issues with an average maturity of 5 to 6 years, these yields are both sensible and confounding at the same time.
   To understand this dichotomy it is important to consider the investment merits from various points of view including the Fed, Foreign nations, Banks, Mutual/Hedge funds, pension funds and basic investors/savers. Before diving into the multitude of investment reasons, a quick review of the difference between nominal and real gains appears necessary. For anyone unfamiliar with these terms as investment references, nominal means an unadjusted rate, value or change in value. On the other hand, a real rate of return refers to the annual percentage return realized on an investment, which is adjusted for changes in prices due to inflation or other external effects. (Definitions from Investopedia) So why are these terms so important at this time?

   The true difference between nominal and real returns over time is the effect on an individual or corporations purchasing power. As an example, let's assume that an individual earns 5% a year on their investments. During that same year, due to inflation, their cost of living rises 3%. On a nominal basis the individual is 5% richer at the end of the year. However, in terms of the extra percentage of goods this individual can purchase at the end of the year, their real return is only 2%. Recognition of real returns is critical at this time because it appears many investors in the market are accepting negative real returns. 

  Based on the most recent reports of inflation watched by the Fed, core-CPI (Consumer Price Index) and core-PCE (Personal Consumption Expenditures), inflation is rising about 1% year over year. Although these measures exclude food and energy prices due to volatility, I'll hold off on that discussion for a future date. The Fed's recent actions clearly show their intent to not only prevent further disinflation or push it back to their previous goal of 2%, but increase inflation for a time above 2%. It's obviously too much to expect the Fed's actions to have an immediate effect, but based on recent TIPS auctions, it appears many investors are expecting inflation to pick up over the next several years. Now let's look back at the prevailing yields on Treasury securities today. If inflation merely holds at 1%, those holding 2 and 3-year issues will face real losses. Were inflation to pick up in the next few years and reach the Fed's targets, investors in 5 and 7-year issues will also see real losses. The question then becomes, why are investors so eager to own these securities?

   Let's start with the Fed itself, which has a mandate to maintain full employment and stable prices. To achieve these goals with interest rates at 0%, the Fed is attempting to create negative real rates and push investors further out on the risk spectrum. Although the Fed continues to buy these securities, the Fed is allowed and willing to accept real losses in the interest of the economy as a whole. Foreign nations also remain a significant investor in U.S. Treasuries. Many of these nations use these purchases as a function of controlling their exchange rate with the U.S. and maintaining their respective export advantages. 

   Banks often use Treasuries for storing excess reserves, which are currently larger than they've been in a long time, but also trade the securities on their proprietary desks. In this way, banks buy and sell Treasuries for much of the same reasons as mutual funds, hedge funds and pension funds. This group is generally forced to invest capital somewhere and Treasuries offer the most liquid market available. For these investors the investment premises become more troublesome. Although Treasuries offer a safe investment and balance out risk, many within this group are likely investing in Treasuries with the intent to sell the securities at higher prices (lower yields) before they mature. These reasons are likely the same as many individuals, however without the requirement to invest. Though this all sounds simplistic the game is far more complex and risky than it seems.

   These scenarios may be highly unlikely and could play out of several years, but one has to question the effects of so many investors holding Treasuries at negative real rates. Are the investors aware that they are losing purchasing power of time? Do these investors believe the U.S. is destined for a Japanese style destiny with consistent deflation? How long will foreign nations continue to accept such low returns? Will pension funds be forced to renege on their commitments failing to reach their target gains of 8% a year?

   An interesting side note announced by the Federal Reserve yesterday was the decision to waive a 35% per issue limit on portfolio holdings. Despite announcing that increases beyond this level would be done moderately, what will happen if a future auction shows weak demand? What are the consequences of the Fed holding more than 35% of an outstanding issue? If the Fed were ever to attempt reducing their balance sheet, where would the demand come from? Would it be there?

   From my perch, buying any object at an all-time high is a risky business, even when the securities are theoretically the safest in the world. While the trend is certainly higher in the short term, only a few years out lie numerous risks to the investment thesis. As for investors solely desiring to protect their money, make sure to understand the risk of lost purchasing power if inflation begins to trend higher. Guaranteed nominal returns may sound appealing, but its those individuals with the best real returns who get ahead in the long run.

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