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Short Term Gain For Long Term Pain

By Greg Canavan

Well, March was a pretty wild month for the Aussie market. There was a whole lotta shakin’ for not much action. After the dust settled, the ASX200 had advanced just 0.4 per cent. The quarterly performance was not much better, with the index rising just 1 per cent.

But that’s OK. Investing in the stock market is all about the long term. Let’s have a look at returns over the past 12 months. What… minus 0.9 per cent…it went backwards?

How about two years, that’s long term, right?

35 per cent…that’s more like it.

Now, gimme 5 years…it’s all about holding and riding the ups and downs.  Buy and be patient, and come out on top.

Minus 5.6 per cent.


That’s right. Since 31 March 2006, the ASX200 has fallen by 5.6 per cent. Now to be fair once you add in dividends you’d be in the black. But only just, and in risk-adjusted terms the long-term return is positively awful.

We’re sure that investing back in March 2006 looked like a sensible, low risk thing to do, especially if you were ‘investing for the long term’. After all, everyone else was doing it. But this type of thinking reveals the lie perpetuated by the financial industry.

Peddlers of financial products will tell you it’s always a good time to invest, as long as it’s for the ‘long term’.


It’s only rewarding to invest aggressively for the long term when stocks are cheap and perceived risk is high. That’s because the perceived risk is actually priced in. It’s what makes stocks cheap.

Right now, perceived risk is low. Investors think there is greater risk in being out of the market than being in the market. They think the crisis is over and we’re ‘recovering’. Sure, there’s lots of talk about risk but little evidence that it is actually priced in. The market has managed to rally through just about every impediment thrown at it lately. That’s not exactly discounting risk.

Are there any similarities between March 2006 and March 2011? Perhaps. Superficially the global economy looks robust. There is a credit boom going on. But this time the boom is in China and in government debt.

The effects are broadly the same though. Inflationary pressures are building and again we are hearing talk about the need to tighten monetary policy. (Although in 2006 we were still in the ‘sweet spot’…y’know, Goldilocks and all that?) So unless you’re a nimble trader, think about the long term here and how your portfolio might look, five years out after investing in a seemingly low-risk environment.

We’re not the only ones thinking about the long term.

Strangely enough, Thomas Hoenig, (outgoing) President of the Kansas City Federal Reserve, talked about the ‘long term’ in a speech he gave a few days ago at the London School of economics.

Hoenig is one of the few Presidents of the Federal Reserve System that actually realises there is a difference between short-term goals and long-term consequences. He has been a critic of the Fed’s prolonged low interest rate regime, and was the lone dissenter against QEII.

Here’s what he reckons should happen with US monetary policy.

‘The FOMC should gradually allow its $3 trillion balance sheet to shrink toward its pre-crisis level of $1 trillion. It should move the U.S. federal funds rate off of zero and toward 1 percent within a fairly short period of time. Then, after evaluating the effects of those actions, it should be prepared to move the funds rate further toward a level that could be reasonably judged as closer to normal and sustainable.’

We’ll show you why such an eminently sensible policy move is not going to happen in a moment. But first, let’s check out some more choice quotes from Mr Hoenig’s speech:

‘…the longer exceptionally accommodative monetary policies remain in place, the greater the danger that resources will be misallocated within and across world economies.’

‘The monetary policy being implemented currently within the United States and much of the world is more accommodative now than at the height of the crisis.’

‘A Swiss central banker once advised me that the duty of a central banker is to take care of the long run so the short run can take care of itself.’

‘Following this action, (1 per cent interest rate in 2003/04 – Ed) the United States and the world began an extended credit expansion and housing boom. From July 2003 to July 2006, the monetary base in the United States increased at an average annual rate of 4.9 percent, credit increased at an annual rate of 9 percent, and housing prices increased at an annual rate of about 14 percent. The long-term consequences of that policy are now well known. The United States and the world have just suffered one of the worst recessions in decades.’

‘The world for some time now has been experiencing rapidly rising commodity prices. While some of the increase may reflect global supply and demand conditions, at least some of the increase is driven by highly accommodative monetary policies in the United States and other economies.’

‘Central bankers must look to the long run. If current policy remains in place, we almost certainly will stimulate the growth of asset values and inflation. This may temporarily increase GDP and employment, but in the long run, we risk instability, damaging inflation and lost jobs, which is a dear price for middle and lower income citizens to pay.’

Unusually for a central banker, Mr Hoenig’s speech hit the nail squarely on the head. Attempts to make the short run look good always screw things up over the long run. And we are clearly heading down that path now. The trick is in working out the arrival date of the long run.

Mr Hoenig’s remedy is to quickly normalise interest rate settings in the US. He is obviously under the illusion he is meant to serve Main Street, not Wall Street.

Normalising interest rates, quickly, would crash the markets in the short term. Despite this being good for the long-term health of global economic growth, there is no way Bernanke will do that.

To understand why, you have to consider what ‘raising interest rates’ actually entails. We’ll have a crack at a simple explanation.

First, a definition. Another word for ‘the official interest rate’ in the US is ‘the fed funds rate’. That’s because the currency of the US is emitted by the Federal Reserve, and banks deal in ‘fed funds’.

The fed funds rate is the interest rate charged between banks for overnight funds. At the end of each day, for example, banks calculate all their deposits and withdrawals. Some banks end up with excess reserves (more money than they actually need, which earns no interest) while others suffer a net drain on their funds and are in need of overnight cash to balance the books.

So they borrow from the surplus banks, with the interest rate being the fed funds rate. In this way there tends to be very little in the way of excess reserves in the system. The less excess there is, the higher the fed funds rate. When there is an abundance of reserves, the fed funds rate is very low.

Since the onset of the credit crisis, the Fed has lowered interest rates by pumping a huge amount of reserves into the banking system. So much, in fact, that excess reserves are approaching now US$1.5 trillion.

So before you can start to even talk about raising interest rates, the Fed needs to shrink its balance sheet by US$1.5 trillion. That means selling LOTS of assets back into the market.

That is not going to happen. Not under Bernanke’s watch.

Bernanke has talked about raising the fed funds rate by paying interest on excess reserves. While that might sound OK from an ivory tower in Princeton, gifting the banks even more money, by paying them interest on the reserves you created for them, might not work out well.

The bottom line is the global monetary system is so screwed up it’s not funny. Talk about the possibilities of QEIII is quickly followed by this question: when will the Fed tighten?

The probability of QEIII is much greater than the Fed even having a 2-minute chin wag about shrinking its balance sheet.

Here’s how we see it. QEII will end. Markets will tank. Bonds will rally. After a few months, the Fed will announce another round of asset purchases (QEIII). There will be a knee-jerk rally. Then markets will realise that all this stupidity will lead to inflation, which – contrary to popular opinion – is not good for equities or bonds.
Inflation is a tax on everything. And as Mr Hoenig points out, it’s the middle and lower income citizens that will pay the higher price.

Greg Canavan
For Daily Reckoning Australia

One Response to “Short Term Gain For Long Term Pain”

  1. occasl says:

    Paul will really push for more despairingly required transparency of this now ‘hands off’ quasi-governmental organisation that's responsible to nobody. My private opinion is that he wastes all his time on the House Money Services Board ranting crazily.’ Really…he might understand less about financial policy than the average member of Congress? Who, Ms. He was the only one that laid it obviously at the feet of previous Fed Chair Alan Greenspan and current Boss man Bernanke.

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