Finance 101: follow the interest rates, or carry is king

Interest rates are all the rage these days in the media: various countries are cutting base rates to below zero (an idea once thought impossible, called ‘the zero bound’).  The latest culprits are Scandinavian countries Sweden and Denmark – their economies are closely tied with the Euro-area, so the quantitative easing from the latter increases pressure on the Scandi countries’ exporters.  Enter negative base rates.  Longer-term interest rates have fallen as well, with multiple governments now able to borrow at near-zero for 10-year loans.

With all this in mind, let’s consider the big picture, and implications for individuals.

  • Definition: an interest rate is the cost to the borrower for getting money now, rather than later.  Seen from the other side, the interest rate is the return to the lender for giving up money now, rather than later.  The interest rate is an example of carry, or the return to an investor for holding an asset (in this case, a loan/bond).
  • Usage: we can use the interest rate to help judge one debt versus another.
    • Borrower’s perspective: suppose you have several loans outstanding, or need to borrow, and are considering different types of loans.  Some examples, with typical interest rates are below, in descending rate order:
      • Payday loansaround 400% interest per year.  No security needed, and very short term.
      • Credit cardsaround 15% interest.  No security needed, and short term (balances can be rolled forward, as long as credit card company allows).
      • Peer to peer loansaround 10-15% interest.  No security needed, and medium term (3-5 years).
      • Student loansaround 5-10% interest for Federal loans; 7-15% for private loans.  No security needed, though sort of the ultimate security: you can’t get rid of these loans through bankruptcy.  5-15 year term.
      • Home equity loansabout 6% interest.  They’re 2nd mortgages on your house. 5-15 year term.
      • Auto loansaround 4% interest.  Car title held as security; medium term (3-5 years).
      • Home mortgagearound 3-4% interest.  House title held as security; long term (15-30 years).  In the US, mortgage interest is tax-deductible at your highest marginal rate, so the effective interest rate may be much lower.
      • In sum: if I had several types of debt outstanding, I would probably pay them off in the order above.  If I needed to borrow, I’d probably borrow from the bottom up.
    • Saver’s perspective: suppose you have some cash to put to work, and are choosing between the options.  Rates help us here, as the interest rate is the maximum return you will receive on your investment.  There is a clear risk – return trade-off, though.  Anyway, in ascending order of interest rate/risk:
      • Savings accountabout 0-1% interest.  Instant access, and government-insured.
      • Certificate of deposit/fixed savings1-2% interest.  Government-insured.  1-5 year term.
      • Government bonds (Treasuries)0-2.5% interest.  Government-issued.  30 day-30 year term.
      • Corporate bonds1-6% interest.  ‘Proper’ credit risk – you may not get back what you put in.  Typical 5-year term.
      • Peer to peer lending5-15% interest.  Lending to ordinary folks, with no collateral.  3-5 year term.
      • In sum: pick your poison.  If you need the funds at any time (e.g. an emergency fund), better to stick with the earlier entries on the list.  If you’re looking for more risk, head on down the list.  Keep in mind rates are at all-time lows in most places, so maybe keeping with short duration (i.e. sticking with shorter-term stuff) is a safer play.

There you go.  Other types of carry (e.g. dividends, rental yield) we can pick up later.

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Friday rant: Charles Schwab…wtf?

The previous few posts have been a bit heavy, so let’s change topics.  Today I read an open letter from Charles Schwab asking the Fed to raise rates ASAP.  His opinion is that retirees have been fleeced by the low rates, and are hurting to the detriment of the economy overall.  Statistics are offered aplenty, as Chuck applauds the return of normal monetary policy.

Sigh.  I’ve written about this a bit before.  A summary:

  • The unconventional monetary policy wasn’t intended to redistribute from savers to borrowers, nor was it designed to hurt retirees.  The policy helped avoid catastrophic economic collapse, which would have hurt everyone.
  • Savers (including yours truly) are disappointed with low interest rates.  Borrowers (including all those people now buying houses, so that house prices are back to pre-crisis levels) are very happy.  Though Chuck wants to focus on retirees’ marginal propensity to consume (i.e. they spend more than they earn), I would argue we’re about as well off with borrowers (who, by definition, spend more than they earn) having lower interest rates.
  • Following the housing point: though it’s more common in the UK, there are probably a lot of US retirees relying on ‘trading down’ their housing to help fund retirement.  Thank the Fed’s low rates for high mortgage – and thus housing – affordability among younger homebuyers.  In this sense, the Fed saved retirees – not hurt them.
  • Beware partial equilibrium analysis.  Higher interest rates better for the economy?  Really?  Yes, higher rates mean more interest received, but also means more interest paid.  In an environment where we want to encourage business investment and employment, higher interest rates are a bad thing.

In sum: this is the second letter written by Chuck that I have a serious issue with (the other one is this, which shows an absolute lack of information and analysis about high-frequency trading).  Why does the man insist on putting his name to such insanity??  I guess he’s getting some free press, even if it’s discouraging.

Happy weekend, everyone.

End the Fed? Not too hasty…

I’m a big fan of Vonetta Logan and her Nailed It! segment on tastytrade.  In a somewhat similar vein to the Daily Show or Last Week Tonight, Vonetta doses her segments with enough humour to be able to hold attention for a fairly boring topic.

Last week’s Nailed It was about the Fed, including ways to improve oversight of their regulatory responsibilities and open market operations.  Yes, generally a boring topic.  The segment points out some generally known (though not universally agreed-upon) areas of Fed policy:

  • No Congressional oversight of open market ops: the Fed can buy and sell Treasuries and such as it pleases.  The bank’s leverage ratio (about 77 to 1, according to Vonetta, quoting Fed docs) is WAY above that required of too big to fail banks.
  • Regulatory capture: Fed regulators are generally considered too lacking in knowledge and courage to stand up to those banks they are meant to govern.
  • Punishment of savers/retirees/’pure market’ folks: the continuing unconventional policies of QE and forward guidance are keeping interest rates too low (hurting savers and pensioners) and volatility artificially deflated (hurting ‘pure market’ folks).

Vonetta has a few, rather uncontroversial, remedies for the situation.  I encourage anyone to watch the segment to get the full scoop.

In the meantime, I’ve heard a lot of folks grumbling about the Fed, for similar reasons to the above.  This got me thinking…has the Fed been acting outside its mandate?  Has the group made markets worse for us?  I can immediately think of a few reasons why the Fed is doing a good job, all things considered:

  • Small interest > capital loss: yes, the unconventional policies mean 30-year Treasuries yield less than 3%.  But, having worked in the financial services industry during 2008, I’m very familiar with stories such as the failing banks of several nations (Ireland, Iceland, Spain, Portugal, Greece, Cyprus,………) and the bailed out banks of several other nations (England, France, Germany, US, …….).  The downward economic spiral of that time meant real rates needed to be very negative, to adjust for sticky wages and the like.  The Fed has done what it can to make real rates as negative as possible, which (in theory, though I like Paul Krugman’s use of IS-LM liquidity trap framework) is as much as it can do.
  • Regulatory capture is not a Fed issue.  It’s a general issue:  suppose you made $x million per year creating RMBS and related derivatives, or came up with the credit modelling to value said derivatives.  It’s now 2008, and everything has blown up; what will you do now?  In one corner is the regulators, who need to understand what the hell just happened; provided they don’t want to arrest you, they want you to help them figure out the mess.  You can earn a government salary for that – maybe $100k or 200k.  OR you could go work for the same bank, or a hedge fund, and pick up the gems from the crap; you’d probably still earn $x millions.  Which do you choose?  There should be no question that bank regulators, who could never be paid as much as the people they are regulating, would much rather ‘play nice’ and increase their (very small) chance of getting hired by the banks they regulate.  It’s simple economics, and it goes on in probably every regulated industry there is (e.g. see all the examples of Congressmen/regulatory heads becoming industry lobbyists).  This isn’t the Fed’s fault; it’s general greed.
  • Low interest rates?  Choose equities!  so the Fed is to blame both for returns being too low (interest rates too low for savers/pensioners) and for returns being too high (equity market gains of 100%+ since 2009).  Macro hedge funds can’t make money due to weird markets.  Options volatility has been too low.  Hmmm.  There seems to be a solution in all of this, which the Fed has telegraphed for a long time: take on more risk; particularly equity risk.  The Fed has helped ensure the stock markets have fully recovered the losses from 2008, so patient investors haven’t been harmed in the process.  Now that we’re back to black…maybe the Fed should step away?

OK, enough soap box.  I’m more sanguine about the Fed’s policies in the past several years, if only because I very clearly remember the utter fear and uncertainty whether the Fed could do enough to save the economy in 2008.  It did; it has.  The more relevant question going forward is: how dependent have we all become on unconventional policies to stabilise confidence in financial markets?  Will the end of QE, and the beginning of ‘normal markets’, mean even fewer individual investors?  If so, I’m even more fearful of the pension situation.