COVID-10 Diary Number 7 (July  8, 2020)


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Would negative interest rates help the economy recover from anti-virus strictures and propel the stock market rally?  President Donald Trump seems to think so.  He has publicly pressured Federal Reserve Board (Fed) Chairman Jay Powell to pursue just such a policy, saying that the country deserves the “gift” of below-zero interest rates.  Though the Fed has readily brought short-term rates down to nearly zero, it has thus far resisted moving them still lower. Powell has said that the monetary actions already in place will do a better job of fostering a strong economic recovery.  In this dispute, the weight of economic good sense would seem to lie with the Fed, but the struggle will turn more on political than on economic matters, especially on the political optics of an economic re-opening.

Before examining prospects for negative interest rates or the reasoning on each side of this debate, let’s review exactly what negative interest rates are.  They do not demand, as some have suggested, that banks or other lenders actually pay borrowers for the privilege of extending them credit.  They are instead a result of movements in bond markets.  Here is how they work:  A government or a large and secure corporation issues a bond at a very low coupon –– that is, stated –– interest or with no interest attached to it at all.  Effectively, the issuer promises the bond buyer to return only the initial amount borrowed when the bond matures.  When bond buyers are flush with cash and also have concerns about defaults on anything but the most secure credits, they could so increase the demand for such quality bonds that they bid their price above the amount that the borrower promises to repay at maturity.  These bond buyers then, if they hold the bond to maturity, will get less back than the premium price they paid for the bond.  That constitutes a negative interest rate.

Trump’s motivations for making his demands are clear.  He wants to get re-elected and thus wants as much immediate economic stimulus as possible, regardless of all other considerations.  In this respect Trump differs not at all from all presidents before him.  He may feel even more such pressure than past presidents because he will have to carry the lingering economic effects of the pandemic into his re-election campaign.

But the Fed is not running for office and so it takes a broader, longer-term approach to policy, as its charter demands.  Thus it views negative interest rates through the prism of at least four considerations:

  1. It can see a need for stimulus to bring the economy back after re-opening, and it recognizes the immediate stimulatory potential of negative interest rates.
  2. It can also see –– from the experience of other countries –– that negative interest rates have more often than not failed to generate much economic response.
  3. The Fed also worries that negative interest rates will distort financial decision-making, because their unusual nature can undermine the rules of thumb and formal algorithms commonly used by traders and investors.
  4. An additional concern is that negative rates now will strain bank finances, especially because the anti-virus quarantines and lockdowns have raised the risks of corporate defaults and bankruptcies.  It is not that the Fed wants to protect bank profits, but rather that it wants to avoid the kinds of financial failures that plagued the Great Recession economy in 2008-09.

Although neither Powell nor other Fed governors have mentioned it, there is also concern about the harm that negative interest rates might visit on business confidence.  Because the returns offered in financial markets naturally reflect returns available in the larger economy, a policy that pursues negative rates effectively announces that economic prospects are limited.  The relationship stands to reason.  When returns to economic endeavor are high, businesspeople will happily borrow in order to pursue those returns and that borrowing in turn will push up lending rates in financial markets.  When returns to economic endeavor are low, business has no appetite for expansion or for borrowing, no matter how low interest rates are. Low and especially negative returns hint at this sad economic condition.  When countries such as Japan and Germany pursue negative interest rates, they suggest some deeper economic malaise, perhaps the need for regulatory reform or a change in trade policy or in labor law to raise returns available to economic endeavor.  Monetary policy, even if it forces negative interest rates, cannot answer such needs. To be sure, very low interest rates say something similar, but negative rates are a thing apart.

With all these considerations in mind, Chairman Powell has countered the president’s pressure by pointing to the lower risks and greater efficacy of monetary policies already in place.  After all, the Fed has brought short-term interest rates down to nearly zero, so that it is effectively costless or very inexpensive for businesses to borrow.  Under the broad heading of “quantitative easing,” the Fed has also entered financial markets through a number of programs to provide copious liquidity for individual and business borrowers, as well as municipalities and states.  All these measures should help protect the stability of financial markets, Powell contends, and promote a robust recovery as anti-virus strictures lift.  They will do so, he implies, without the distorting risks introduced by negative interest rates.

Whatever the economic fundamentals or the experience abroad, the dispute between the president and the Fed will play out in the political, and not the economic, arena.  If the economy responds smartly to the re-opening efforts, a gratified Donald Trump may look at the coming election with greater optimism.  Needing less help from monetary policy, he may likely ease the pressure on the Fed.  But if the economy fails to respond adequately to the re-opening and unemployment remain high, Trump, in his increasing desperation, may redouble the pressure on the Fed, making negative interest rates a greater likelihood, regardless of the reasonable reservations of Chairman Powell and the other Fed governors.




Bill Gates Embarrasses Himself, But Offers an Investment Lesson Nonetheless

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Bill Gates of Microsoft fame and fortune gave an interview recently, and though he embarrassed himself, the exchange offers investors an important lesson:

No one has secret knowledge. Someone may perhaps have special knowledge, but nothing that amounts to magic. The Gates interview teaches this important point in two different ways:

He spoke on the inadequacies of economists and the economics profession in general.  “Too bad,” he told the interviewer, that “economists don’t actually understand macroeconomics.” By macroeconomics he meant those aspects of economics concerned with large-scale or general economic factors, such as interest rates and national productivity.

On this point he is correct.  They do not.   Economists and economic thought cannot grasp all the intricacies of the macro economy, much as historians cannot grasp all the intricacies and motivations involved in past events, and much as medical doctors admit to the ongoing mysteries of human health.

Everyone knows – or should know – that, unlike mechanical engineering for instance, economics deals with people, their perceptions and their irrationalities. What seemed to work one way yesterday can lurch in a different direction tomorrow. Why?  Because, for example, the public mood is now different from what it was yesterday, or because popular ideas have changed, or because businesses, having observed yesterday’s results, have now repositioned themselves.  No one pretends, or should pretend, that economics can predict accurately in the way that physics can be sure of the speed of Newton’s famous apple falling from that tree.

Most economists know this and readily admit it. Economists make the effort to predict, not because they are arrogant (though some are), or because they have deluded themselves (though some have), but rather because their subject matter is so immediately important to so many people. If economics were astronomy, this state of affairs would hardly merit comment or criticism. No one faults astronomers because they cannot fully explain the existence of black holes, or even characterize them adequately. People do not readily accept the limitations of economic thought because its subject matter is jobs and income, prosperity and wealth, things that matter deeply to individuals and businesses, as well as to governments. When Washington and businesses try to improve the fortunes of citizens or workers or shareholders, they want a roadmap to tell them where the turns are and where the pitfalls lie. When told that economic thought and its practitioners cannot provide such guidance, these decision-makers ask for a best guess, rough guidance on at least what is not likely to happen. Because a guess that is made within disciplined thought — no matter how inadequate to the task — is better than simply a guess, these decision-makers accept what they can get from the economists.

My posts have repeatedly focused on this lesson – that no one can know, because no one can see the future.  Every forecast, whether about the market or an individual security, is a guess, an educated guess perhaps, but a guess nonetheless.  There is no magic, which is why my posts advise against trying to time markets but emphasize instead diversification so as to avoid having too much riding on one or two insights.

Gates’s interview teaches this lesson again, from a different vantage point, though no doubt he did so inadvertently.  In his criticism, he implied that his insight about the inadequacies of economics was somehow new or shared by only a select group.  As I have said, most economists admit their knowledge is limited, that the subject matter is too complex and too variable for any straightforward treatment.

If Gates had wanted to convey what most everyone knows, he might have explained why economics cannot do what politicians and others sometimes expect of it. As if to buttress my point about his claim to special knowledge, he called in this interview on the wisdom of another billionaire, Warren Buffett.  Mr. Buffett, it seems, has pointed out the existence of negative interest rates and faulted the discipline of economics because no textbook mentions the phenomenon. Somehow, this is supposed to explain how the field does not understand its own subject matter. It would be strange to fill textbooks with anomalies, but that aside, negative interest rates are neither hard to understand nor are they a particularly economic development. They occur less because of economic forces (though those forces have some role), than because institutional arrangements in day-to-day financial business –– the need for collateral, for instance –– force people and institutions to buy and hold instruments that pay a negative rate of interest. They do not buy to invest in a financial instrument that lose them money. It was hardly magical knowledge that informed the more thorough discussion of negative rates I offered in a previous post.  But such explanations matter little when billionaires opine smugly on the inadequacies of others.

Whether the speaker or writer is a billionaire, a spokesperson for a respected investment house, or someone you just met at the bar, they may have experience and insight worth listening to and considering, but nobody knows.  The advice offered in my posts will never lose sight of that fact.

The Bond Part of Your Portfolio

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The last post explained general decisions in creating a portfolio, what financial professionals call asset allocation.  This post focuses on the bonds in the portfolio.

Bond decisions focus on two main considerations, maturity risk and credit risk.

Maturity Risk

 This is the tradeoff between yield and the term to maturity of the bonds. Long-maturity bonds tend to pay higher yields than short-maturity bonds, but their prices are also more sensitive to movements in interest rates, falling as they go up and rising as rates fall. (See the box in this post for a more complete discussion.)  Unless you have strong convictions on the future direction of interest rates (always a problematic prospect) you should aim to balance the higher current yield of longer-maturity bonds against the risk of a price decline should rates rise.

Hint:  Be aware that some bonds have a call provision that permits the bond issuer to call the bond back before it runs its full term to maturity.  If interest rates fall below levels that prevailed when the bond was initially sold, the issuer may decide to borrow anew at a lower interest cost and use the money to call back your holding.  You would get your money back and the interest due you to the date of the call, but you would lose the benefit of having a long-maturity bond appreciating in a falling rate environment.

Credit Risk

 As we mentioned in an earlier post, there is always a chance that the bond issuer will go bankrupt and fail to meet its obligations.  The greater this risk, the higher yield the bond pays, but you must decide, based on your life cycle/life style needs, how much of this risk you are willing to assume. Even if there is no bankruptcy, the prices of bonds with a greater risk might suffer on bad economic news.  With this trade-off in mind, we can identify three basic types of bonds:

  1. Treasuries: These are the obligations of the federal government.  They are issued in different maturities and carry the same maturity risk as all bonds, but they never have call provisions.  Because they are considered entirely secure credits, they generally offer lower yields than other bonds.
  2. Investment grade corporate bonds: These are issued by companies with strong finances. All else being equal, they generally pay a higher yield than U.S. treasuries.  There is only a small chance that they might have problems meeting their obligations. Credit rating agencies (of which more in a later post) show this risk on a relative scale.  (See the box at the end of this post.)  Investment-grade bonds have little risk that they will fail to pay the holder all they owe.  But they do have maturity risk, and many have call provisions.
  3. Junk bonds: Despite their colorful name, such bonds can play an important role in a portfolio.  Because they either have low credit ratings or none at all, they are considered more vulnerable to failure than other bonds and accordingly pay higher yields than other bonds of comparable maturity.  As with all bonds, these also carry maturity risk and often have call provisions.

Municipal Bonds

 This is a fourth type of bond that doesn’t fit neatly into any of these categories.  “Municipals” or “munis” are issued by states, cities, and other municipalities.  Their appeal is largely because their interest earnings are exempt from federal income tax as well as from state tax for the state in which they were issued.  Because of that break, they generally pay lower yields than bonds on which interest earnings are subject to tax.

Hint: Except in rare circumstances, the only reason to buy municipal bonds is for the tax break.  If you have a combined tax rate of less than 25-30 percent, you shouldn’t consider them.  The tax break you would enjoy would not compensate you for accepting the lower yield munis pay.

If your tax situation warrants buying them, be aware that municipal bonds are otherwise much like other bonds.  They carry more maturity risk at longer maturities and accordingly pay higher yields at longer maturities.  Their credit ratings can vary from good down to junk status, depending on past behavior and the finances of the issuing municipality.  As with other bonds, the less credit-worthy bonds tend to pay higher yields.  Many munis carry call provisions.  Municipal bonds come in three types:

  1. General Obligation Bonds (GOs): These are the safest because the full taxing authority of the issuer backs them.  They finance roads, schools, and other government projects.  They remain exempt from tax as long as no more than 10 percent of the money raised by them goes to finance a private enterprise, not pay for its services.
  2. Revenue Bonds: These pay from the income earned by a specific project or government agency, for instance the tolls from a road or a publically financed operation such as a hospital, a stadium, or convention center.
  3. Industrial Development Bonds: These bonds finance the construction of facilities that are then leased to a private corporation.  Their tax-exempt status follows the same rules as GOs.

A Last Word

 Remembering the necessity of  diversification explained in the last post, the object here is not to settle on one bond or type of bond but to construct the bond portion of your portfolio with a variety of bonds that, when combined, both diversify your bond risk and meet your specific needs.










Bond Ratings


Moody’s   S&P
Aaa Best Possible AAA
Aa1 High Grade AA+
A1 Higher Medium Grade A+
Baa1 Lower Medium Grade BBB+
Ba1 Non-Investment Grade BB+
Ba2 Speculative BB
B1 Highly Speculative B+
Caa1 Significant Risk CCC+
buildingC Near Default CCC-
D In Default D





Which to Pay First

Which to Pay First

In response to my last post about what to do with surplus cash, an insightful reader asked whether it is best to pay off credit cards first or student loans.  Definitely, pay the cards first.  The most onerous student loan debt carries a lower interest rate than the least burdensome credit card.  Pay the cards off first, starting with those that charge the highest rates.  Only then should you turn to the student loans.

Student loans, burdensome as they are, often carry attractive terms.  In such cases you might consider investing the surplus cash and using the income from those investments to meet the regular student loan payments.  This way, the student loan payments cease to burden your everyday income, presumably from your job, and possibly even earn a little extra.  If you pay off the student debt, you do, of course, get relief, but no chance of that little extra from your investments.  With credit cards, the cost of borrowing is so high that there is no chance investing what would pay them off can earn more or even enough to cover the cost.  Best to use the surplus cash to pay off the cards as completely as you possibly can.

This was a good question, I look forward to others from other readers.