By
The
Inflation Trader
:
Bonds, stocks, inflation-linked bonds, commodities, real estate,
MLPs, hedge funds, and cash. That is essentially the asset class
universe we face as investors. Now, before reading further, think
about what you would do with your investments if it were no longer
possible to invest in cash, or if some aspect of "cash" made it
inadvisable to hold. What would you do with your wealth that is
currently sitting in money market funds?
You would clearly invest in riskier assets, since (with the
exception of inflation-linked bonds held to your investing horizon)
there isn't a less-risky asset than cash in most cases. You may
choose to buy a short-duration bond fund, or you might trickle some
extra funds into stocks you feel are undervalued or into commodity
indices that I feel are undervalued.
The reason this is a relevant thought-experiment is that the New
York Fed, in a
little-covered report issued last week
, has recommended that investors in money market funds be
prohibited from withdrawing 100% of their funds without significant
advance notice. The staff of the New York Fed recommended that 5%
of an investor's balance in a money market fund be stuck for thirty
days, in order to "protect smaller investors" from the sort of runs
on money funds that caused investors in the Primary Reserve Fund to
lose the awesome sum of 1% of their money when Lehman obligations
went bust in the worst credit crisis in a century. Furthermore,
they "suggest a rule that would subordinate a portion of a
redeeming shareholders MBR [what the Fed calls the "minimum balance
at risk"], so that the redeemer's MBR absorbs losses before those
of non-redeemers." In other words, if you hear that your money fund
is 100% invested in Lehman 2.0 as it teeters on the edge of
bankruptcy, you get to choose between taking 95% of your money out
now and potentially losing the rest before anyone else loses money,
or leaving it all in the fund - in which case you'll get the second
loss, but
all
of your money is at risk.
Clearly, the New York Fed's suggestion is a solution in search
of a problem given the historical rarity of losses and of the
insignificance of those losses, but it is chilling for a couple of
reasons. Reason number one is that it pretty much eliminates the
main reason for holding a money market fund, which is ready access
to cash. People aren't holding assets earning 0.01%, with 2.2%
inflation eating away the real value every year, because they
like
the return. If you tell investors that they need to have 5% of
their principal at risk, and that they may have to choose a gamble
between a high-likelihood loss that would be capped at 5% and a
lower-likelihood loss that is capped at 100%, the rational
investors will simply leave. They may invest in short bond funds,
commodity funds, or equity funds where there is much more risk, but
at least their money is available with no advance notice. While
this development is in a sense bullish for all other assets since
it pushes potentially trillions of dollars out on to the risk
spectrum, it isn't clear to me that our biggest societal problem is
that investors aren't taking
enough
risk.
Reason number two that I hate this idea is that one destination
for money market fund cash will be bank deposits. However, savings
deposits are time deposits, and technically can be subject to
similar sequestration. Some of the money will go into checking
accounts, where it will doubtless burn a hole in many investors'
pockets. The biggest question about the inflation challenge that
has been rising over the last year or two is, "how fast will
velocity rise, when it rises?" If the Fed effectively forces money
into checking accounts, among other things, the velocity of money
will surely rise and the pace of the rebound in velocity will
become that much more difficult to predict than it already is.
Speaking of velocity, Friday's GDP figures allow us to make
preliminary estimates about what M2 velocity was in Q2. The
velocity of the transactional money supply last quarter fell
slightly, to 1.5766 (Bloomberg calculation that closely matches my
own). The pace of decline is slowing. The quarterly decline was
-0.5%.
It doesn't make a lot of sense to
focus
too much on quarterly wiggles, but since the big risk here is that
velocity abruptly begins to rise (contributing to, rather than
blunting, the rise in transactional money in terms of generating
inflation) it is worth keeping in the front of our minds. Of
course, velocity is a plug number so this doesn't tell us anything
we didn't already know: We deduce it from the M, the P, and the Q.
The trick is in knowing when V is turning and has turned, and as I
have said before (see
here
, for example) there are some reasons for concern on that
score.
Going back to the NY Fed study that I discussed above, here is
another thought to ponder. Remember that the biggest single
objection that the Fed has made against dropping the interest on
excess reserves ((IOER)) charge is that it might damage the money
market fund industry by making it impossible to preserve "the buck"
if there are no instruments with yields that exceed the cost of
operating the fund. And yet, this proposal puts those very same
money funds precisely in the crosshairs.
Personally, I think it would be just fine to have good-as-cash
funds that didn't guarantee a $1 price and indeed had a negative
yield over time, so I don't think dropping short yields would kill
good-as-cash funds even if they weren't
technically
money market funds because they traded on price. But changing the
contract so that investors can't get their money back immediately -
that's much worse, in my view. Moreover, I don't know why the
reasoning couldn't be extended to bond funds which are, after all,
just as vulnerable to runs. That slippery slope makes me
nervous.
Price action on Thursday and Friday in bonds and stocks was
surely frustrating to observers of the macroeconomy. Weak economic
data on Thursday and uninspiring data on Friday didn't prevent
10-year nominal bond yields from rising 15bps (to 1.55%), real
10-year note yields yields from rising 7bps (to -0.61%), and equity
prices rising 3.6% (basis the S&P). ECB President Draghi's
apparent determination to support the euro with every tool at his
disposal is mainly to credit for the mid-week about-face. The
question that the markets have to consider, and Mr. Draghi as well,
is the question of what that toolkit actually contains. There is
some evidence
that the Bundesbank doesn't believe Mr. Draghi has quite the
authority he thinks he does, and this weekend Draghi and the
Bundesbank President are
meeting to discuss their differences
.
I think that equity markets are overvalued and are
over-anticipating QE3 (although I agree that it is coming soon).
There isn't much going for stocks
other
than QE3, although if the Fed starts taking potshots at low-risk
investing alternatives it will help them. I can come up with
arguments for extending this rally further, but they all depend on
a bunch of faith and a little luck. I am trimming what small equity
investments I have, and raising cash allocations. Since the VIX is
also quite low considering the kaleidoscope of large risks, I may
also buy puts on the S&P.
See also
Thoughts From The Frontline: Time To Row Or
Sail?
on seekingalpha.com