What you're looking for

This is a new feature I’m thinking about including on the blog.  Blogspot sometimes shows search keywords that are used to find my blog, and I figured that maybe some of my readers might like it if I were to post some more commentary on those subjects.  Of course, if readers are finding my blog using those keywords, then I must have posted something about those subjects in the past, but it may be that the subject could use some updating or in some cases it may be that I merely mentioned a subject and never really delved into it before.  At any rate, I hope you find this new feature informative as well as entertaining.

Most of the searches involved a couple of items: interest rates and QE.  Then there was also a search for “why war doesn’t help the economy.”  I think that war search is particularly interesting, so I’ll talk about that first.

War

The main reason I find the war question so interesting is that I rarely, if ever, make any kind of statements that are so deterministic.  In other words, in this case, I don’t believe I have ever said that war doesn’t help the economy; in fact, I think it sometimes does.  I just don’t think it always does.  And sometimes, it does more damage than good.  But then again, it depends on how one defines “help,” or “damage,” or “hurt,” or most any other term one might use to describe an effect on the economy.  And it also depends on whether we’re talking about the long run or the short run, and what our definition of those terms is.  Not to worry, though.  I’m not going to spend a lot of time defining those terms.

The way I see it, war, at least in the short run, is mostly negative.  It removes capital, both human and otherwise, from the economy.  The removal of capital from the economy lowers potential GDP, which of course means that the economy is actually capable of producing less.  In the case where the economy has a “recessionary gap,” this could actually be seen as a positive.  As potential GDP falls, unemployment declines.  Most people would agree, though, that war isn’t a really good solution to unemployment.  Then again, while I won’t go into it here, from an economic perspective it might actually be a great way to lower unemployment.  Economics rarely takes into account the extreme difficulties that might be put on a few to benefit the many.

Then again, in the short run, war could bring about some positive economic effects.  For example, it could lead to technological advances and greater efficiencies than would otherwise have occurred.  I think World War II is a good example of this, but other wars, not so much.  It depends on how much of a threat the entity that we’re at war with actually poses to our country.  And I don’t really think our economy would benefit so much from those things until after the war, perhaps making these benefits more of a long run consideration.  Regardless, in my opinion, most wars turn out to be a drag on our economy in the short run.

In the long run, if you’re on the winning team in a war, there can definitely be some economic benefits.  If the enemy is crushed, there will be less competition and industry should flourish.  Then again, if you’re on the losing team, war might bring about some positive changes that in the long run will give your team a competitive advantage.  Once the war is lost, and your economy is in shambles, the loser is forced to become better with less and that force can lead to increased competitiveness in the future.  The act of having to rebuild, of being forced into a situation where you have no choice but to do better can lead to tremendous advances.  I think that most of the time, people perform their absolute best when they aren’t given a choice; it’s do or die.

On a global basis, in my opinion, war is a net negative.  But economically speaking, it may be that war is net neutral.  For every gain that comes from war, there is also a loss.  Whether war does or doesn’t help the economy is really a subjective question and is simply a matter of opinion.  My opinion that it is a net negative comes from the idea that the suffering brought on by war is far worse than any economic benefit that may arise from war.

Risk free rate and QE

I’ve dealt with these subjects before and fairly recently, so I’m not going to go into a whole lot of detail here.

Some of the queries are just looking for what the risk free rate is in 2013.  For most applications, there is no single risk free rate.  Since this blog is mostly about individual investing, I’ll talk about the risk free rate from that perspective.  For this purpose, I don’t care about any theoretical rate.  The only rate that matters is the least risky rate of return I can actually achieve.  Here in the U.S., that rate is the rate on U.S. Treasuries.

For the purpose of valuing investments, I use the Treasury rate that matures at the same time as my holding period is, usually a year.  I use 1 year because I think investors should at least consider rebalancing their portfolios once a year.  If I were going to rebalance more frequently than that, I might use a shorter maturity, such as the 3 month T-bill.  These days, there isn’t much difference between the two anyway.  If I were dealing with corporate finance and looking at a 10 year project, I would use the 10 year Treasury rate.  While these rates may not be “correct” from a theoretical point of view, they represent reality and the best “least risky” return I can get for my money.

I’ve also had a couple of questions about what happens when QE ends.  The short answer is that nobody really knows.  But, considering that the Fed is committed to keeping short term rates down while decreasing their purchases of longer term treasuries and mortgages, the net effect should be a widening of the spread between short and long term bonds.  Strictly speaking, this should prove beneficial to banks, but the reality is it may be beneficial and it may not.  Long term assets held by banks, if they’re classified as “available for sale” or “trading” securities, will be devalued on the balance sheet.  Depending on the bank, this could lead to some capitalization problems, although I actually think that in general banks are much better capitalized than they have been in the past.  The widening spread, though, should lead to higher net interest margin for banks, which is a good thing.

At any rate, I hope that answers at least some of your questions.  If any of you have other questions or comments, please feel free to comment here, or email quasisaneATcomastDOTnet.

What really happens when QE ends?

Markets have apparently been speculating that the Fed will begin to taper quantitative easing (QE) sometime sooner than was previously anticipated. (See: Stocks plunge as Fed minutes hint at cutback for more detail.) What bothers me is that a lot of people don't really seem to understand what the result of Fed tapering will be. So, let's see if we can work this out.

When the Fed sets the Fed Funds Rate, it typically uses open market operations to manipulate short-term interest rates. Basically, when the Fed wants to lower interest rates, it buys treasury bills to lower the yield on short-term government borrowings. Because banks are limited in what they can do with excess cash, a lower yield on T-bills makes overnight loaning to other banks more attractive, and banks will be more willing to loan to other banks when the alternative (T-bills) offer a lower yield. In this case, the T-bill rate is the driver behind the Fed Funds Rate.

In theory, all other things equal, if the Fed lowers the yield on T-bills, the yield on longer-term government borrowings will follow, so the Fed doesn't normally get involved with those. But in the wake of the last recession, the Fed, for multiple reasons, decided that long-term rates (especially mortgage rates) weren't falling enough to spur growth. So, they decided to take a more direct approach, purchasing long-term treasury bonds, which have a more direct effect on mortgage rates. As near as I can tell, this isn't the official explanation for QE, but it's the one that I think explains the reason for QE best, and certainly does actually address the effect of QE. Forget about money supply; it's about interest rates.

Generally speaking, then, the effect of QE is to flatten the yield curve. Has it worked? You tell me. Here is a chart of showing the Treasury Yield Curve currently, as well as in November of 2008, before QE1. (Source)

Yes it has, because the green line isn't as steep as the blue line. And one effect is that we've seen historically low mortgage rates, rates that we'll likely not see again in any of our lifetimes. Low mortgage rates help to pave the way to stabilizing the real estate market, and, in my opinion, the latest QE has done that a little too well.

But the point of this post is not so much what's happening in the markets now, but what to expect when the inevitable end of QE comes. The recent market reaction to rumors about the Fed maybe tapering earlier than expected shows a high level of uncertainty. Pretty much, every asset class dropped, indicating there must have been a substantial move into cash. Why cash? Because the value of cash is not dependent on interest rates at all, but nearly every other investment in the world is. Even gold.

Now, I know there are some people thinking that what I just said about the value of cash not being dependent on interest rates is just plain wrong, and that the end of QE will make cash more valuable. All other things equal, it will, but not because of the interest rates; it will be because of the difference in the supply of money. Other countries have turned on their printing presses as well, and if one stops, it will likely see an increase in the value of its currency as the supply of other currencies relative to that one currency grows. At least in the short-run. Longer term, there are other factors that will affect the value of the currency, but interest rates just isn't one of them. As usual, that's my opinion, based on the current workings of the global monetary system. Things change, though, and I could change that opinion at any time.

Okay, back to the topic at hand: the effect of ending QE. The first thing we should see is a steepening of the yield curve, and we can check that out using the same graphing utility on the Treasury's web site.

This time, I figured the beginning of the year as being as good a starting point as any, and as we can see, this time the blue line (January) is less steep than the green line (Current). Why? Because of speculation that the end is nearer than investors thought it was in January. (Almost) Nobody wants to be holding those long bonds when the Fed stops buying. This chart also shows something which is vital to a discussion of the effect of ending QE: rates under 2 years hardly budged. So, here we've found evidence that when people say interest rates are going to sky rocket with the end of QE are misstating what will actually happen. Some interest rates will likely increase, but not all interest rates. In other words, the yield curve will get steeper.

So what. Right? It is a kind of big deal depending on what investments you have in your portfolio. If you are invested in companies with little or no debt, then the impact should be minimal. However, there will be some slight decline as the risk premium rises (and perhaps whatever proxy for the risk-free rate investors are using). But for most companies with little debt, there should be no major impact on that company's results. For companies with a lot of debt on their balance sheet, it could be another story though. It really depends on how each company's debt is structured. If a company has a lot of long-term fixed rate debt, then it shouldn't be impacted as much because it has a low rate locked in. Maybe. Sometimes companies issue "putable" bonds to get a lower rate. These, of course, are not safe against interest rate increases.

One of the things that makes me believe that people in general don't understand QE is the volume of articles, blog posts, and comments that QE is somehow a way of bailing banks out, or making life easier for banks. There may be ways for banks to "game" QE that I'm unaware of, but generally speaking, QE is actually makes life harder for banks. The reason is clear when you consider that banks generally borrow short-term funds and loan long term, pocketing the difference in rates. A steep yield curve benefits banks because the spread is bigger, similar to a store that can raise prices while their cost remains the same can increase gross margin.

But, and there's always a but isn't there, the end of QE might not be that great for all banks (or other financial institutions that make money in similar ways). It's possible that the loans (or investments) made by the bank will lose value, making their collateral worth less and forcing the bank to pay higher interest, or perhaps issue more stock, or... well, lots of bad stuff can happen. If the loans a bank makes are fixed rate, then the value of those loans will fall; but if the loans are variable, then the value should stay the same because the borrower will have to pay a higher interest rate. However, this may not be true; if the variable rate loan has a floor (minimum) rate, and the borrower is currently paying the "floor" rate, then even if rates go up, the borrower may not be required to make higher payments, and so, the value of that loan will still decline.

Hopefully, this gives you some kind of idea of the complexity surrounding QE and its end. Because of this complexity, I've decided to start writing a series of articles that I'll publish on Seeking Alpha covering a variety of types of financial institutions. In case anyone was wondering, this is what I've been working on lately and the reason I'm posting less frequently.