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Free Money August 13, 2011

Posted by The Synaptic Gap in Uncategorized.
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On August 9, 2011 the United States Federal Reserve announced that its key funds interest rate would be held at an historic low of 0% – .25% until at least mid-2013. This unprecedented move is both an indicator of the slow pace of growth the Fed now believes will define the US economy over the next two years as well as an attempt to calm market jitters by adding a drop of certainty into an otherwise stormy sea. This is welcome news to anyone who holds debt, such as a variable rate mortgage, or who holds investments or is looking to invest. One obvious way to benefit from this news is to pick up shares of Real Estate Investment Trusts (REITs) who are currently making outsized returns by borrowing in the short-term at very low rates and lending those funds out to longer-term high-yielding mortgage securities, such as American Capital Agency (NYSE: AGNC), Annaly Capital (NYSE: NLY), Chimera (NYSE: CIM) or Hatteras Financial (NYSE: HTS). Some investors have been holding out on these REITs given the likelihood of lowered profits with rising interest rates. Now that the Fed has guaranteed low rates for at least two more years, the 15% – 20% dividends of these companies will continue for some time.

But what should investors with a medium and long-term horizon do? Are western nations experiencing a short-term bump in the economic road, or is a fundamental economic shift underway? After decades of borrowing to maintain extraordinarily high standards of living, will the US eventually return to a high-growth, high interest rate environment, or should we expect low interest rates for the next 5-10 years and beyond? These diverging paths will have a significant impact on investment choices. In a prolonged period of low interest de-leveraging, a contrarian investor will want to borrow and leverage to take advantage of what is, essentially, free money. However, if rates rebound in an inflationary environment, being highly leveraged could be devastating. What to do?

The key factor is whether one believes the growth rate of the US economy will rebound anytime soon. Currently, a number of economists believe that the US is heading into a second recession. This is because after decades of borrowing too much, and crashing in 2008, the US government (and the Federal Reserve) tried to kick-start the economy by feeding it the same poison that led to the crash in the first place: debt. When the private sector tried to de-leverage, the public sector rang up massive spending and deficits to prevent the inevitable. But the American people wouldn’t have it. In the end, the deficit spending failed to achieve the objective of kick-starting the economy and caused recent financial panic when the US federal debt ceiling needed to be raised…again. Now, the government and the Fed are stepping back and letting the US economy correct itself, and that is going to take time – years – at a minimum.

In the meantime, all of that government debt accumulated in the west must be paid off, which is going to be difficult to do in a slow-growing economic environment. The US is not alone on this front: The Greek government is eventually going to default on its debt – possibly Ireland and Portugal as well. Investors are driving up the returns these governments must pay on their bonds to compensate for the risk of default (see chart reproduced below from Agora Financial). This leads to a vicious cycle as debt payments eat up a larger percentage of tax revenues. Once debt-to-GDP ratios surpass 100%, it is usually just a matter of time before governments default. Currently, the USA, Portugal, Ireland, Belgium, Singapore, Italy, Iceland, Jamaica, Greece, Zimbabwe, and Lebanon have debt-to-GDP ratios of more than 100%. But Japan is the hands-down winner when it comes to debt as a percent of GDP, at over 225%.

As the ratio of debt-to-GDP grows, confidence in a government’s ability to pay back the debt falls, raising the rate of interest it must pay on that debt. Or, maybe not? Take a look at the chart again – notice anything odd? The country with the largest debt-to-GDP ratio in the world, Japan, also pays the lowest interest rates on its government bonds – approximately 1%. Investors are happy to accept a near zero return from the Japanese government even though it has the greatest debt burden of any nation on earth. What gives here?

Japan is, after Monaco, the oldest nation on earth, with a median age of 44.6. For comparison purposes, the median age of all the world’s population is 28.4. As a general rule, the older one gets, the more likely one is to retire. To retire, one must have some sort of savings or pension to live off. And the elderly who are living off of savings tend to put those savings in very low-risk investments. Could the extraordinary confluence of Japan’s very high debt-to-GDP ratio and its very low government bond yield be the result of the classic economic law of supply and demand? Are there so many elderly and retired individuals in Japan seeking a low-risk stable investment that the government finds itself in the enviable position of being cash-flush? It is not unusual for any nationality to buy into its own government bonds as a source of “pride” even though better returns may be found elsewhere. For example, according to http://www.economicshelp.org/blog/economics/list-of-national-debt-by-country/ 90% of Japanese debt is owned by Japanese individuals. Could the Japanese be supporting their government despite the extraordinarily low returns? If this hypothesis is true, what should we expect from other nations that are aging? And what of the baby-boomers in North America? How will the aging and retirement of this massive cohort influence demand for “safe” government and corporate bonds? And what will this mean for interest rates long-term?

Is it possible that North America, driven by aging baby-boomers, is entering a long-term low interest rate environment where excess cash seeks low-risk, stable investments?  If that is true, younger investors may wish to position themselves to leverage as much of this “free money” as possible. This can be done by allocating capital into stable, dividend-paying opportunities in faster growing economies or new technologies. Historically low mortgage rates offer one opportunity. I know of people in Canada who have been able to secure a variable rate mortgage at Prime – .85%, which, at one point, translated into an effective interest rate of 1.4%. That is about as close to free money as you will ever get.

Full disclosure: The author owns shares of Annaly Capital