Central Banks Raise Risk Not Inflation

by: Alhambra Investment Partners

By Douglas R Terry, CFA

The Bank of Japan shouted down the debt laden economy on Thursday evening in the US. Following Europe's precedent, they took interest rates on a certain segment of bank assets negative.

News flash: Asset prices rise from a small change in investor asset preference, nothing else is expected to change.

Where's this all heading? When doing scenario analysis, I think it helps to look at the extreme case. Is this the path to a world where negative interest rates are the norm? Will we eventually pay companies to expand production, hire workers or pass dividends to shareholders? That world looks, to me, like a pseudo-Marxist state or perhaps the most backdoor inheritance tax or generational passing of wealth ever invented. If this sounds absurd or undesirable, it is.

If you're a commercial bank, what would you do? First, you ask your systems' providers if your software can handle negative interest rates. Then you sit and contemplate potential business transactions where you contractually give $104 in order to receive $100 at sometime in the future…. Finally, you run and get the largest Folger's can you can find, fill it with C-Notes and stick it in your vault. Sure seems like a sure-fire way to bring the whole premise of capitalism to a halt.

These supply side ideals are flawed. The demand curve is important as well. With a lot of debt, it is hard to shift the demand curve. With a lot of savings, this is more easily accomplished. When you force supply into an economy with flat demand, the price level goes down. I'm not sure these policies align with the stated inflation goals.

Central banks are not raising price levels. They are not even raising the expected price level. They are raising the range of possible outcomes for inflation. The factor that they're raising for all of us is Risk.

In this world, debt quality is an important consideration for correlations. The preference for the extreme Beta plays, both positive and negative, has increased. The preference for the risk-free asset has increased, as has the preference for extremely low and high duration fixed income. Overall risk in one's portfolio should decrease given the large range of possible outcomes.

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