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In July 2014, the dollar, having trended gently down for a year, began a steady ascent as measured by the DXY index made up of large trading currencies. Today, the index is at 98 compared with 80 last July, an increase of 22.5%.
This extraordinary rise is wreaking havoc on the US economy, as well as China’s, whose currency is linked. I wonder what a Cadillac dealer in Peoria, Illinois, who was barely competing with Audi and Mercedes last July, is thinking now that German cars are another 20% cheaper?
This rise in the dollar reflects the expectation that the US Federal Reserve will be in a club of one by raising rates in 2015. The consequences of the Fed’s intentions are already apparent and unacceptable. This reality has become obvious even to Fed governors.
As Chair Janet Yellen said a month ago: “Just because we removed the word ‘patient’ from the statement doesn’t mean we are going to be impatient.” So having removed the word ‘patient,’ they will remain ‘not impatient’, or, in other words, ‘patient’.
The incongruity between the Fed’s stated intention to raise rates and the cutting going on beyond US borders prompted me to begin counting rate cuts from January 1, 2015. On March 13 I reached the 25th cut when Russia reduced rates (this was the unkindest cut of all, perhaps), preceded by Serbia, Poland, South Korea, India, China, Turkey, Israel, Sweden, Honduras and Australia, to name a few, after which I stopped counting. It is worth noting that no one raised rates during this period. By then, although we had not yet reached the 1,000 cuts of the gruesome Chinese ideal, we were already witnessing the agonizing death of the Fed’s rate increase plan.
A discordant horn sounds
Like the bull-leapers of Minoan Crete, the overly confident members of the Fed Board have somersaulted themselves onto the horns of a dilemma, and it hurts. One sharp horn is the damaging strength of the dollar. The other sharp horn is the slow but inexorable corrosion of the financial system being wrought by the zero interest rate policy (Zirp).
This corrosion is evident in many parts of the financial system. By suppressing returns in the fixed income market, the Fed has also suppressed the discount rate that pension funds apply to future liabilities. Pension funding depends on two factors. Firstly, the discount rate applied to future liabilities. (This rate is a formula based on average interest rates over time. As rates are now low, the discount rate, an average of 4.05% for large US private plans, is declining and liabilities are consequently rising). The second factor is the assumed rate of return on assets, now 7.51%, which has also been declining.
Because of these two factors, the average funding ratio for these plans dropped to 85.8% in 2014 from 93.5% in 2013 even though plans earned 9.2%. Since plan sponsors are motivated to offset funding pressures by shifting to riskier assets, US pension plans have increased exposure to alternative investments, up to 29% in 2014 compared with 16% in 2004. Zirp makes pensions riskier.
Excessive currency appreciation, economic contraction |
Zirp is making banks and insurance companies sick. US banks now average a return of 1% on assets compared to 1.25% before the crash. In the first quarter Wells Fargo’s net interest margin dropped to the lowest level in decades.
Zirp gives poor-quality borrowers the rosy glow of health. Few indeed are the marginally viable businesses that cannot afford to borrow long-term if the rate is only a few percent. But what would happen if the Fed were to achieve its goal of higher inflation and rates spiked to 10%?
Zirp is transforming endowments and foundations. A recent study of university endowments shows that stocks and bonds, which had constituted close to 100% of assets of three large endowments in 1980, have now been reduced to about 30%, the other 70% being real estate and other alternatives.
For retirees, the mathematics of Zirp is particularly cruel. The rule of 100, which states that an investor’s exposure to equities should equal the number 100 minus his age (e.g. 35% for a 65 year old) is out the window as retirees needing income replace bonds with higher dividend stocks. The 4% rule, which states that a retiree may safely spend 4% of his capital annually without fear of depleting his resources, has now been replaced by the 3% rule. Zirp means higher risk and lower income for retirees.
Higher-risk asset allocations, reduced exposure to cash, weaker banks and insurance companies, lower credit quality, declining competitiveness, impoverished retirees, incentives for households to borrow more and save less – these are the pestilences that pullulate in the miasmal swamp of Zirp. Excessive currency appreciation, economic contraction and a credit crisis – these would be the consequences of draining the swamp by ending Zirp. The consequences of the Fed’s policies over the past few years have been both unintended and dangerous.
Monetary normalization sounds, well, normal, but do not think it will necessarily be pleasant. Cash anyone?