Offending the gods

The Dow dropped 137 yesterday. Gold was flat.

Stocks have a historic up-trend; not for 40 years have there been so few counter-trend down days. That’s what zero interest rates can do for you! Never before have financial markets had so much wind at their backs. It’s enough to blow their shirts off.

In a normal world, savers have the choice of staying in cash or quasi-cash and receiving a fair rate of interest. No more. The interest they receive on a ten-year Treasury note is barely over 2.5%. But the real rate of consumer price inflation – according to the most exhaustive survey, done by the Billion Prices Project – is 3.91%.

What kind of world is it where an honest householder loses nearly 1.5% per year on his savings? It is an odd, rigged-up and dangerously windy one.

The Wall Street Journal reports that investors are stretching out their sails in order to get higher yields. As a result, bond prices have gone up, reducing yields on bonds rated CCC – below investment grade – to the lowest levels ever recorded:

“Large investors are rushing into the riskiest corporate bonds, frustrated by low interest rates on safer investments and convinced that even companies with shaky finances are in little danger of default.

That buying is driving up prices on those bonds and pushing down their yields, which this month fell to 8.187% on a closely watched Bank of America Merrill Lynch index — the lowest level on record. Yields fall when prices rise.

Demand for those and other bonds rated below investment grade — so-called junk bonds — is helping fuel corporate merger-and-acquisition activity.

The low-rate environment, says Ford O’Neil, manager of the $14.5 billion Fidelity Total Bond fund, ‘is forcing folks into riskier strategies in which they feel they will be more richly compensated.”

The Fed’s low rates lure investors to do reckless things. But why worry? If the seas get too rough, investors tell themselves, the government will send a helicopter loaded with money.

FREE daily investment email from MoneyWeek
Receive our thought-provoking investment email Money Morning every weekday morning, plus occasional promotions, & become a smarter investor.

Please enter a valid email address

To sign up, enter your email address:

Yes, dear reader, here you see the difference between a properly functioning economy and one that has been propped up by central banks and politicians. In a normal economy, businesses borrow money when they need it. And lenders lend money when they think they can make a buck on it. Otherwise, they stay in cash… or equities.

Money lenders look for solid borrowers, with good business plans. And they demand a rate of interest to protect themselves from risk. Lenders know that even the best plans fail from time to time; a failure will cost them their hard-earned savings.

But in today’s economy even weak borrowers are able to get cheap financing. And why not? No one ever earned it, or saved it. If it is lost, who really gives a damn? Who takes the loss when the money came from the Fed’s QE or the banks’ unbacked loan portfolio?

Then, too, who takes a loss at all, when the Fed keeps a watchful eye over the whole system, like a nervous new parent with a baby monitor?

In the crisis of 2008, all eyes turned to Washington. There, the sage authorities knew just what to do. And so it was that the TARP programme was born in the heat of crisis, the fruit of an unfortunate union between cupidity and panic.

TARP was a bailout scheme. It offered $700bn in direct giveaways, and an incredible $23trn in guarantees and other credit inducements. That kind of money is bound to have some unintended consequences.

In the event, we see them today in the aforementioned junk bond market and in the banks’ assets. A study by professors Duchin and Sosyura published in the Journal of Financial Economics tells us that the banks are bolder now:

“This paper has investigated the effect of government assistance on bank risk taking. While we do not find a significant effect of government assistance on the aggregate credit supply, our results suggest a considerable effect on the risk of originated loans. After being approved for federal funds… participants issue riskier loans and increase capital allocations to riskier, higher- yield securities, as compared to banks that were denied federal funds. … the net effect is a significant increase in systematic risk and the probability of distress at approved banks. Overall, our evidence is broadly consistent with the theories that predict an increase in risk taking incentives as a result of government protection.”

In a properly working economy, borrowers fail one by one. But in a jived-up financial system, investors big and small unfurl their sails and put on speed. This is practically an affront to King Neptune and all the gods. Sailors must show some respect for the weather, and the dark, stormy waves. Otherwise, the seas rise up, and the little banks go down all together.

FREE daily investment email from MoneyWeek
Receive our thought-provoking investment email Money Morning every weekday morning, plus occasional promotions, & become a smarter investor.

Please enter a valid email address

To sign up, enter your email address:

• Stay up to date with MoneyWeek: Follow us on TwitterFacebook and Google+

MoneyWeek magazine

Latest issue:

Magazine cover
Cleaning up

Profiting from the fight against pollution

The UK's best-selling financial magazine. Take a FREE trial today.
Claim 4 FREE Issues

Which investment platform?

When it comes to buying shares and funds, there are several investment platforms and brokers to choose from. They all offer various fee structures to suit individual investing habits.
Find out which one is best for you.

29 May 1660: Charles II restored to the throne  

While Charles II was formally proclaimed King by parliament in April, he only reached London on this day in 1660.

The Kids' Portfolio: the four best funds to buy for your children

Investing for your children's long-term future is an excellent idea. But what should you buy? The Kids' Portfolio is a simple collection of four funds intended to be tucked away for 20 to 40 years.