The first thing any prudent investor must asks him or herself before committing their capital to any financial market, is return on equity. And that can be explained very simply under the CAPM model. What is CAPM, you ask? Of course, anyone who has formal educational on portfolio and investment management more or less understands the basics of a CAPM model. And can add to the fact the CAPM model takes into account both short-term and long-term investor goals. Let's just focus on the longer-end of the yield curve for the purpose of this entry.
In this current market environment, the best thing for any investor buying or selling fixed-income securities would be to follow the herd and establish long bullish positions in longer dated US Treasury debentures. The probability of interest rates rising from a bullish fixed-income investment strategy becomes inherent buying longer dated US debt. A risk free rate can be explained as the theoretical rate of return for an investment with no financial loss. In practice, to work out the risk-free interest rate in a particular situation, a risk-free bond is usually issued by a government or agency whose risks of default are almost non-existent. So now lets take a look i.e at an investor holding a 10 year US Treasury Note trading in 2016, issued from the beginning of the credit crunch right after the Lehman Brothers collapse. Again taking a medium to longer-term investor outlook on a yield curve, quantitative easing measures used by central banks across the global financial community during the credit crisis inverted the nominal yield curve pre-Lehman stirring today's current notion of deflation. Are you scared, yet? Ok. Let me scare you some more. An investor holding a 10 year US Treasury Note theoretically yielding 5% pre-Lehman against an investor holding US zero coupon interest bearing securities, was a steal when considering risk-free investments for bondholders willing to park their money longer-term. Now in 2016, holding that same 10 year US Treasury yield issue is collapsing making everyone second guess pre-Lehman expectations which were actually not that long ago on the US yield curve. So ask yourselves right now are investors really creating time-value for themselves holding and investing in US zero-coupon bonds in 2016? Because now the threat of deflation is real and threatens bond markets everyday to wipe out yield on all global debt and interest bearing risk free investments, which has already taken precedence in Japan and in Germany. And it does not end there.
Deflation, in economics, is a decrease in the general price level of goods and services. Economists across the board generally believe that deflation is a problem in every modern economy because it increases the real value of debt and may aggravate recessions which can lead to a deflationary spiral. That to me also sounds like deflationary pressures directly erode time-value of money on all fixed-income investments in every modern economy as well. Because deflation is also distinct from disinflation. Disinflation is merely a slow-down in the inflation rate when inflation declines to a lower rate but is still positive. Deflation, which can also be caused by massive quantitative easing out of the global central banking system, highlights proxies for the risk free rate. "The risk of a government 'printing more money' to meet their financial obligations systemically, may be perceived as a form of tax rather than a form of default." However, large bondholders and large retirement funds who continue buying or holding longer dated US Treasury debt during a period of rapid US monetary supply expansion, show displaced risk on the same loss of time value in relation with underlying systemic concerns. So focusing strictly on default does not include all risks related to a risk-free interest rate. Now we shift focus to our model for interpretation. Which is CAPM. The general idea behind CAPM, is that investors need to be compensated in TWO WAYS: time value of money + risk. Time value of money is represented by a risk free rate, in general terms, and this compensates investors for placing their money in any investment over a period of time. The other half of the CAPM formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk (Modern Portfolio Theory). The other half of the CAPM formula that relates to risk, is binary to a rising stock-market in 2016. But that is not the issue being discussed. The stock market is great, but the question remains where is US fixed-income headed in an excessively easy monetary system where US infrastructure and increased appetite for leverage shows enough sign of sustainability for the longer term? As investors across the global financial system continue to pile into US fixed-income looking for yield, United States monetary policy alone should be north of 6% on key interest rates with a rising stock market being a leading indicator into new highs. That would certainly be the case in taking the CAPM model, literal.
Basis points then become the next issue to tackle. 25 basis points is just not going to cut it. Fed Chair Janet Yellen continues to promote the notion that lower interest rates for longer is the most sustainable path for a US economy in recovery after the greatest recession after the Great Depression. And I agree with her Keynesian premise. However, this gradual lift from the ashes of the great recession will not vanquish the threat of stemming deflation. Especially, if only 25 basis points are in question. The stock market is booming as fundamental economic data in the US reads steady and inflation is tamed. There are even bullish pockets of aggegate demand in the commercial banking space rising for consumer mortgage financing in 2016 that is massively undermined, by stoking fears there is not enough strength in the US banking sector and that more lending regulation is still to come. Why is only 25 basis points in question, then? Even a 100 basis point hike from here will only get the US to... 1.25 - 1.50% on the key interest rate here in the US. That is still short about 475 basis points I just calculated above in the sample CAPM explanation, earlier.
So why only 25 basis points, Ms. Yellen? Do investors buying longer dated US Treasury debt really want to end up like Japan and Germany?