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Where to Find Yield

The Fed Has Made it Tough

Written by Geoffrey Pike
Posted January 30, 2015

The Federal Open Market Committee (FOMC) wrapped up its latest meeting on Wednesday and released its latest statement on monetary policy. Since it ended its latest round of quantitative easing (monetary inflation) in October, much of the focus has been on interest rates.

Most analysts are expecting the Fed to raise interest rates sometime later this year. The big questions seem to be when and by how much, as well as when and where it will stop and what it would take for the Fed to reverse its position of raising rates.

When we talk about the Fed raising rates, we are really talking about the federal funds rate — the overnight borrowing rate for banks. This is the rate the Fed directly controls (although not as much as in the past).

The Fed has multiplied the monetary base approximately five-fold over the last six years. But much of this new money went into bank reserves. The Fed has been paying an interest rate of 0.25% to the banks for their reserves.

Since the commercial banks have plenty of excess reserves, they have little need for overnight borrowing. So there is a big question that isn’t being addressed in the media: How is the Fed going to raise rates?

There is no way the Fed is going to sell off assets to such a degree that it will force rates up. That would require so much selling (monetary deflation) that it would crash the economy. The only way the Fed can raise the federal funds rate right now is by increasing the interest rate paid on bank reserves.

How much is the Fed really going to raise this rate? Will it tolerate paying banks 2% interest at some point in the future? It won’t be remitting money back to the Treasury each year (as it currently does) with a significantly higher rate.

Of course, the FOMC statement really left the door open for interest rate hikes, saying they could happen sooner or later than expected depending on unemployment and inflation numbers.

We should not be surprised at all if the Fed changes its position on raising rates with a change in the economic outlook. This could include lower-than-expected price inflation numbers, a stock market crash, a negative GDP, or higher unemployment numbers.

The Euro and the Yen

Despite the last six years of easy money and low interest rates, the U.S. dollar has been strong lately (or perhaps it would be more accurate to say other major currencies have been weak).

The Japanese central bank is in the middle of a massive money creation spree, actually making the Federal Reserve look tame by comparison.

Meanwhile, the European Central Bank (ECB) is about to start its own round of massive monetary inflation.

The really big problem for Japan and Western Europe is that the economies there are already weak and getting weaker. Even with Japan’s massive stimulus, the country is still in recession. You would think we would see some kind of an artificial boom with all of the money printing.

The whole future of the European Union is in question right now as well. Greece just elected a left-wing government, and it would not be surprising to see Greece exit the EU. The welfare state is not working for them, but the Greek politicians will break away if they lose their subsidies from the richer European countries. They would choose to have their own central bank so they can make their own attempts at inflating away their problems.

So if you are an American investor, you are going to want to avoid European and Japanese investments. The economies are weak, and the currencies are a bad bet.

Looking for Yield

In the United States, the 10-year yield is now well below the 2% mark. Either investors aren’t buying the Fed’s promise to raise rates or they don’t think it will matter.

The decreasing long-term rates and flattening of the yield curve are indicating a possible recession, or at least a slowdown, for the American economy.

It is hard to imagine an investor buying a 10-year bond that will pay less than 2% per year, locked in for 10 years. If inflation runs at 2% (which happens to be the Fed’s target), then you will be losing money. Not only is your real interest rate negative, but you also have to pay taxes on the nominal gains, which are really non-existent gains.

The reason investors would lock in such a low rate today is because they don’t see any better alternatives.

This is a real problem. It seems we hear about all of the good things associated with low interest rates: It is cheaper to get a mortgage on a new house or to refinance your existing mortgage, and other loans, such as car loans, may be cheaper.

But there are major downsides to low interest rates. The low rates are sending false signals that more savings exist than is actually the case. This misallocates resources and encourages less saving and investment.

Of course, low rates are a major problem for investors looking for yield. Think about retirees. You could have a million dollars in the bank and if you buy a 10-year bond, it is going to pay you less than $20,000 per year before taxes. That seems like a pretty lousy income for a millionaire.

You could put the money into stocks, but that obviously presents its own risk, especially now. It is not hard to believe that much of the stock market boom coincides with the Fed’s easy money policies.

Now that the Fed is no longer inflating (for now), the stock market is a bit scarier than it was in previous years with the Fed’s support.

Finding Yield

Unconventional times call for unconventional investments. We have to believe the Fed is not going to sit back and do nothing for years to come. There will be more monetary inflation. We should also not expect price inflation to stay below 2% forever.

You can wait for interest rates to go up before investing in bonds, but you probably won’t do better than break even at that point. And how long are you going to wait?

While real estate has been a scary investment over the last decade, it still offers a lot of opportunity. Everyone needs a place to live, and there is only so much prime land.

You can invest in REITs, which may do well in the coming years. But I still believe that actually buying and owning real estate is the more profitable venture.

The guy with a million dollars in the bank could buy five houses at $200,000 apiece instead of buying bonds and earning less than $20,000 per year. In a cheaper area, he could by 10 houses at $100,000 a piece. It would be reasonable for him to expect a 7% to 10% gain ($70,000 to $100,000) or more per year if done wisely.

I’m not suggesting you put all of your eggs in one basket, but the above example illustrates that you can still find decent yield if you are willing to do some extra work.

Most hard assets are likely to do well over the next several years. If you can’t even get a 2% yield by locking in your money for 10 years, then it almost seems pointless to lock it up.

Investors will figure out that if they aren’t going to get a high-paying yield, then they might as well put it in something such as gold, where at least it can’t be devalued on a computer screen.

Gold, silver, and even oil are likely to do well over the coming years. If you can’t find yield, then at least protect your money from central bank inflation.

Until next time,

Geoffrey Pike for Wealth Daily

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