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Stupid Things


I have written before about the effects and dangers of negative real interest rates (a Fed funds rate lower than the inflation rate). So has Stephen Roach of Morgan Stanley, and in his latest piece, Jim Grant of Grant's Interest Rate Observer (I highly recommend this newsletter as thoughtful and well researched).

Running such a policy for an extended period of time does one basic thing: it encourages people to do stupid things.

My Aunt wrote seeking my guidance. She and her husband are retired and are starving for income. They have always been conservative in a healthy way and currently have what I consider to be an appropriate part of their net worth in stocks (which is much smaller than what is recommended by the pundits on Wall Street).

But the low interest rate she is earning on her cash equivalents is now lower than her most conservative expectations when she retired. As time goes on this becomes more and more painful as inflation (expense) outpaces her interest income. She can make ends meet by shaving some expenses, but wondered if she should instead take more risk with her cash equivalents to try to "earn more income".

The pressure to do this is everywhere. Negative real rates are putting immense pressure on not only the retired, but almost all investors to move less risky assets into more risky assets. Treasury bond buyers are now buying corporate bonds for the higher yield (causing credit spreads to narrow), corporate bond buyers are shifting into equities, and equity investors are buying riskier stocks.

And not only that, but stock owners are selling options to try to "earn some income" against their positions. This means that more and more short gamma is being introduced into the equity markets as options become cheaper and cheaper. Short gamma acts like leverage.

If people looked at this objectively they would find that they are getting little marginal return for the marginal risk that they are taking. It may make them feel better now, that is until something happens.

When something happens they will quickly realize that they have taken too much risk and cannot afford to take the losses. This causes the biggest mistake in investing: forced selling. They will find that they have simply mis-estimated their time horizon and the volatility of their assets.

Negative real rates have caused lenders to do stupid things too. From 1995 to 2003 the volume of sub-prime mortgages has risen from $17 billion to $195 billion; no-money down loans have risen from $1 billion to $80 billion.

Home Depot, which owns 86% of its land and buildings, is considering a sale-lease back arrangement on 50% to "unlock" this value. This would normally be a zero-sum game, but because of negative real rates, the arrangement could add $1 to next year's earnings.

Of course nothing bad may happen, but that does not change the fact that bad trades, where the "risk for reward" is too high, are being conducted everywhere.

Risk is potential at first, but it is real nonetheless. We can "hope" that it stays that way.

If it doesn't, we will find out just how stupid we are being.

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