Locking in a Smaller Loss

Why are TIPS yields negative out to 20+ years?  People are willing to lock in a loss versus CPI inflation in order to avoid a possibly larger loss.

Why do some people continue to invest in money market funds, bank deposits, savings accounts, when inflation is running at 2%+/year?  They are willing to lock in a loss versus inflation in order to avoid a possibly larger loss.

When the Fed adopts aggressive strategies, people will have two responses:

  1. “Yields on safe investments are too low.  I need more income.  I guess I have to take more risk.”
  2. “Policy is abnormal, and I am scared.  I know I am going to lose here, but I want to lose as little as possible.  TIPS, bank deposits, and money market funds make sense here.  Maybe some gold as well.”

The Fed is counting on response #1, but response #2 is much more common than they would like.  Now, response #1 is nothing all that great — the Fed is trying to extract value out of economic actors by making them undervalue risks, whether those risks are duration, convexity, credit, etc.  When they encourage more risk, they are trying to extract economic wherewithal out of those that invest there.  Who is the one that buys when things are hot, before they are not?  That is the target.

So be wary amid the efforts to “stimulate” the economy.  When an economy is heavily indebted, stimulus does not work.  Far better to invest your money in areas where stimulus does not play a role.  Look for healthy places in the economy that do not rely closely on the government.

Finally, don’t take minor changes by the Fed too seriously.  They are utterly convinced of their “super powers,” and do not appreciate how little control they have.  Every action of the Fed in their “stimulus” has produced progressively less response.

The Fed does not control the US economy.  They are codependent with it, and they do not act, they react.  The FOMC is hopelessly lost, with a cast of C+ students running the show — people who can’t think more broadly than the failed ideas of neoclassical economics.  As I have said before, the FOMC needs more historians, and no neoclassical economists.  Bring in the Austrians, they might solve things.  You might get a depression in the short-run, but afterwards, things would be normal.

That’s why some would rather lock in a smaller loss; this situation is volatile enough that many will want to do so.  As for me, I will try to buy undervalued companies, and make money there.


  • Conscience of a Conservative says:

    At yields close to zero the incremental bps to take on risks becomes a meaningless exercise. At some point the rational person says, why take on all this risk if in the end I’m just getting my suit-case full of cash back. I suspect more and more people will opt for choice #2. Abnormally low yields discourage both investment and lending.

  • Greg says:

    This seems too obvious for academics to grasp, but the sorts of people with personality type #1 (yields are too low, I think I will buy overpriced risky assets instead) are the very people who went bankrupt in the housing bubble.

    Except for the insolvent bankers who got immoral bailouts — people with personality type 1 are now bankrupt. They don’t need to worry about where to invest money they don’t have.

    Personality type #2 (cautious, “scared”, distrusting of current economic management) are the only private sector actors with actual money. They have money because they don’t play rigged games.

    I would argue that the politicians picked Ben Bernanke because they know he is an arrogant fool. The root cause of the stalemate in Washington DC is that the government is insolvent. It has been insolvent for a long time (before Obama, before Bush, before…).

    Even if we assume higher taxes, end the wars in Iraq/Afghanistan, get the economy (GDP) growing at historical rates (~4-4.5%) … the government cannot afford to make good on all the empty promises they have made.

    That is why they put money printing buffoons in at the Federal Reserve. That is why they insist on all this partisan bickering. That is why they don’t just take their lumps, fix the problems, and move on.

    The US government is bankrupt, and the politicians don’t want to admit it. Not to the voters, and not to themselves.

  • David,

    Absolutely BRILLIANT post. The root cause of the problem (and the reason QE hasn’t worked in Japan, either), is that mispricing risk through policy does not create value. It does the opposite by encouraging unsafe leverage levels.

    The goosing of consumption via leverage was fun while it lasted, but no one ever asked what the cost of lower rates would be. The apparent answer to what happens when your central bank is determined to shorten recessions through credit expansion, is eventually leverage ratios become the limiting factor.

    These appear to be largely beyond the power of the central bank to change, however.

    I like your suggestion about how to address some of this – get a few historians who are practiced at weighing evidence rather than just creating models.

    As you say, the smart money looks at this and says, all of these prices seem artificial, better not to buy anything.

    The good news is, abnormal policy is likely to cause lots of mispricings (though sadly many of them will go the wrong way).

    But where does most of the money that sit while waiting for these mispricings? In low yielding highly liquid positions – money markets and cash.