Welcome to eighth edition of Allison’s Ode to the Second Moment, a newsletter that remains cheerful even as it fixates on downside risk.
Let’s talk about interest rates
Last week 10-year treasury yields reached record lows, 1.3%. And US nominal yields are relatively high. By one estimate, one third of global government debt offers a negative nominal yield. Even long-term rates are low. A 50-year Swiss bond yield is negative!
It’s hard to know what to make of this. It seems like everything we thought we knew about the yield curve is no longer true. Here’s what we used to think about interest rates:
Rates mean-revert to their long-term average.
Low rates spur economic growth by boosting investment.
A flat or inverted yield curves means a recession is coming.
Fixed income models normally assume low (high) rates eventually go back up (down) to their long-term average. But for the last twenty years, bond prices kept going up with no end in sight. It’s left people wondering if the equilibrium interest rate (a short-term rate) is permanently lower. Long term rates normally reflect people's expectations; their expectations of what future rates will be, what inflation will be, and their feelings toward risk.
Larry Summers seems convinced low rates are here to stay. He thinks they signal deficient demand, too much saving, and low inflation. These forces will keep rates low for the foreseeable future. (I am not sure who is saving so much, it’s not American households or the US government…). Or low rates may be temporary. They may indicate heightened risk aversion in an economy facing many potential headwinds (What’s the future of Europe post-Brexit? Will the Chinese economy collapse? Will our governments descend into fascism?).
To be honest, I am less concerned about what’s causing low rates than what their effect will be. Mohamed El-Erian says this time is different. Low rates probably won't boost growth and the flat curve doesn't signal an impending recession.
One thing is for sure. It is near impossible to move money into the future without risking you’ll lose some of it. That’s a big deal.
Retail investors must save more or take on more risk in order to retire one day. Retiring baby boomers face a tough choice. They are at an age when it makes sense to de-risk and possibly annuitize. Many can’t afford to do so at these risk-free prices. They must remain in risky assets, which leaves them vulnerable to a bad day shattering their retirement plans. Low rates may have profound implications on consumption and households’ sense of security. If so, monetary policy may be less effective and there will be lower growth.
There are also consequences for institutional investors who have long term liabilities like pension benefits and insurance contracts. Low rates increase the size of their liabilities because it means a smaller discount rate. Asset management is harder too. Hedging risk with bonds costs a fortune. At least anecdotally, that’s pushing investors into riskier assets. They need high returns from somewhere to meet their obligations.
Pushing retail and institutional investors into riskier assets would seem to make the whole economy riskier. And we aren't even getting the growth we normally associate with more risk-taking. Safety (insurance and a certain income) either costs a fortune or it isn’t a realistic promise to make anymore.
I also worry low rates have changed our view toward risk. It seems once we become complacent about risk it blows up. We might be tempted to change regulations in ways we'll regret later. Once the IMF publishes research arguing it's fine to run deficits indefinitely because you can ‘abstract from’ from the risk interest rates will rise….it might be time to worry.
Call me crazy, but I still believe in interest rate mean-reversion. I don’t know when rates will rise, probably not next year or even the next five. But some day they will. And the increase may be volatile, sharp, and fast and destabilize an economy/financial system built on the promise of low rates forever.
Crisis, what crisis?
Retirement crisis is a strong word. I’d say there is a significant retirement quandary. I am more worried than Andrew Biggs. He thinks Americans are in better shape than people in other countries and don’t need so much money anyhow. And I am less worried than others who think the problem is so grave we need massive government intervention—even for the upper middle class. They’d like future tax-payers absorb all our risk and have the government pay everyone a large pension.
I think there’s a problem, but it’s not insurmountable. We can make the current structure (Social Security combined with defined contribution accounts) work. The problem is we’re groping in the dark about what the problem is and how to address it. Most people are unsure of who gets what, how much money they need to retire, and who bears what risk. If we just clarified these issues, solving the problem needn’t be so hard. We just need to:
Shore up the long-term finances of Social Security and Medicare and better educate people on what they provide.
Expand access to 401(k)-type plans.
Expand auto enrollment and offer sensible, low cost default options.
Offer more education and income options in retirement.
True these are not trivial tasks, but not impossible.
It’s hard out there for quasi-independent nation states
I am not sure if it’s good or bad news, post-Brexit, it looks like the United Kingdom may stay together after all. When you look at their finances, it could be that Scotland can’t afford to leave the UK and join the EU
Now I said a cheerful take on downside risk, so some happy news. Help is on the way to Puerto Rico. A control board now has the authority to deal with the island's debt problem. We can start thinking about how to revive growth there.
Until next time, Pension Geeks!