Risky Business

Yesterday CNBC reporter, Steve Liesman, interviewed the Dallas Federal Reserve President Robert Kaplan to discuss monetary policy amid our current economic recovery. There were two big take aways:

1. He stated the Federal Reserve (Fed) needs to keep interest rates at zero for the next 2.5 to 3 years.
2. He is worried that near zero interest rates will push investors out on the risk curve.

The first takeaway is understandable. The Fed wants to keep interest rates low to spur economic growth. Lower financing costs can encourage borrowing and investing. But what exactly does he mean by pushing investors out on the risk curve?

Typically when a crisis happens it is customary for the Fed to intervene, the first tool they often pull out of the toolbox is lowering the discount rate (lowering interest rates). When the Great Financial Crisis (GFC) occurred in 2008 they did exactly that – lower the discount rate. But when they felt they needed to do more they began Quantitative Easing (QE) where central bank purchases fixed-income securities from the open market to increase the money supply and encourage even more lending and investment. By using the QE tool this has artificially lowered interest rates which handicaps savers. Exactly how does that penalize savers?

Imagine your lovely grandma who worked hard her whole life and accumulated a savings of $400,000. Back in the 1990s, she used to be able to go open up a checking account, get her free toaster oven, and purchase a 5 year Certificate Deposit (CD) paying her 6-8% annually! She worked hard, paid her dues, and was able to see solid returns in a safe manner.

Fast forward to today and that same 5 year CD yields 1.25% (if you’re lucky). See the below chart to see how big of a change in income Granny had in her retirement years. (historical CD rates)

Now do you see how QE has penalized savers? Okay let’s get back to answering the original question posed in the beginning. How do near zero rates push investors out on the risk curve? Let’s start off by taking a look at expected annualized returns across different assets. For the chart below I used either broad based ETFs or average recent returns as sources.

Now that you can visualize the “risk curve” we can pick up where we left off with Grandma. In order for Grandma to get the same income/returns on her $400,000 of savings back in 1990’s she would have to shift her current day asset holdings to High Yield Bonds, Structured Credit or Stocks! She went from sleeping easy at night knowing her Certificate Deposits were safe and carried little risk to now having to take on risk to see any chance at those previous returns she became accustomed to.

Does this mean Stocks are now inherently less risky as investors, Grandma included, now pour into these “higher risk assets”? I think so, and as each individual, family office and pension plan chases yield stocks will continue to be an asset you want to own. This is a subject I am constantly thinking about and something I will continue to watch and monitor. Let me know what you think in the comments below.

If you want to soak up some additional great content from our Founder and CIO, he gives his recent thoughts on the market and believes there is still a tremendous amount of liquidity, alongside cash, to push stocks higher as sentiment improves about stimulus and growth.