Category Archives: Interest Rates


Carl Icahn Is Right, But When Will The Market Learn?

  • Carl Icahn has been warning us how dangerous low interest rates are as they create bubbles.
  • The most important bubble is the earnings bubble.
  • Repatriation and inversions are two crucial issues for the U.S.


We are continuing with our series of articles on successful fund managers. You can read more about Ray Dalio here, George Soros here and Peter Lynch here. Looking at what these successful managers are doing gives us a better understanding of the market, its potential and its inherent risks.

In today’s article we are going to look at Carl Icahn’s investing style and look at his current positions through his latest SEC filing.

Carl Icahn –  An Introduction

Icahn’s investing style is one that cannot be easily replicated by common investors. Few among us are able to invest enough to get a controlling position which is exactly what Icahn does. This tactic has given him the nickname “corporate raider” and the ultimate “barbarian at the gate,” but the $16.7 billion in wealth he has accumulated in his life makes him a person to listen to.

He has taken substantial or controlling positions in various corporations including RJR Nabisco, TWA, Texaco, Phillips Petroleum, Western Union, Gulf & Western, Viacom, Uniroyal, Dan River, Marshall Field’s, E-II (Culligan and Samsonite), American Can, USX, Marvel Comics, Revlon, Imclone, Federal-Mogul, Fairmont Hotels, Blockbuster, Kerr-McGee, Time Warner, Netflix, Motorola and Herbalife.

His activist actions are well received by shareholders as companies that he takes an interest in usually go through the “Icahn lift,” which is the Wall Street name for the bounce in price.

But more interesting than what he has done is what he thinks of the current market.

Carl Icahn – Current Opinion

His major investing thesis is that corporate management is dysfunctional. Therefore, he looks for broken companies that have management issues that he can influence.

Icahn is worried that politicians in general are focusing too much on the short term. We are going to skip the election related political issues but mention two issues that are very interesting for investors, repatriation and inversion.

Icahn sees a great opportunity for the U.S. if companies were allowed to repatriate foreign profits which currently amount to $2.3 trillion. Companies don’t repatriate that money because of the 35% tax on cash repatriation.

Repatriation leads to another issue, inversions, where companies move their headquarters abroad. As many U.S. companies have more revenues from abroad, it pays to move their headquarters to countries where you pay less in taxes.

Since 2012, 20 companies have made an inversion with the most notable examples being Medtronic, which became Irish, and Burger King, which became Canadian. Pfizer also tried to acquire Allergan and move to Ireland but was stopped by the government.

figure 1 invesrsions
Figure 1: Inversion deals completed each year. Source: Bloomberg.

Icahn is opposed to low interest rates because it maxes financial engineering. With low interest rates, companies are more encouraged to buy other companies or do buybacks than they are to invest in new equipment and machinery. This phenomenon inflates earnings for the short term but is detrimental in the long term.

On top of the financial engineering issue, Icahn is also frustrated with the fact that companies manipulate earnings by taking various costs out of the picture which distorts the true earnings figure. Management is especially guilty when it comes to earnings guidance.

figure 2 guidance
Figure 2: Earnings guidance is without the following items. Source: Carl Icahn.

This short-term activity can be seen in the current earnings guidance from the S&P 500 companies, 71% of which have issued a negative guidance for Q3 2016.

figure 3 guidance
Figure 3: Earnings guidance by sector. Source: FACTSET.

Low interest rates and financial engineering have managed to consistently increase earnings since 2009, but it hasn’t worked in the last 5 quarters and, according to guidance, it will not improve anytime soon.

Icahn also states that the majority of companies should not be doing buybacks because they are just a short term fix. Companies that should be doing buybacks according to Icahn are Apple, which has a PE ratio of 9, and companies that trade below book value. By doing buybacks at higher valuations or above book value, management weakens the balance sheet which is a disservice to investors in the long run.

Low Interest Rates

Icahn is in favor of immediately raising interest rates because low interest rates cause bubbles in real estate, stocks and even the art market. Low interest rates further push people to search for yields in very risky markets—like junk bonds—where very few people really understand what is going on. The iShares High Yield Corporate Bond ETF (HYG) has a yield of 5.57% and it has outperformed the S&P 500 in the last 10 years as people are desperate for any kind of yield. The S&P 500 is up 40% since 2007 while the high yield bond ETF is up 63% and has a higher yield than the S&P 500 dividends.

figure 4 high yield bonds
Figure 4: iShares high yield bond ETF performance since 2007. Source: iShares.

Icahn warns investors that any problem in the economy will create a rush for the exits and people will want their money, but there will be no market for junk bonds at that moment even if they appear very liquid today. Icahn’s cartoon below reveals this situation better than any words could.

figure 5 icahc on low interest rates and high yields
Figure 5: High yielders going towards a cliff. Source: Carl Icahn.

Icahn says that he saw the same pattern evolve in 1969, 1974, 1979, 1987, 2000, and 2007, and warns us that a time is coming that might make all those years look pretty good. His main message is that those who do not learn from history are going to repeat it, and that he is afraid that we are going down that road again.


One of the perks of being above a certain age is that you can say whatever you want, without fear of a lawsuit over what you say, as you will be long dead by the time those lawsuits are resolved. What we can learn from Icahn is something fresh while also getting an opinion from someone that has been around for a long time.

The question is not so much if all the negative things will happen, that scenario will for sure hit us eventually as boom and bust cycles are human nature. We are wired for instant gratification, even if that means less gratification in the future, therefore no one is going to stop the party by raising rates or lowering credit availability. That will happen sometime, but it will be very sudden and people will wonder why they didn’t listen to Icahn.

But, why don’t we listen? Because we don’t know if the negative scenario will present itself today or 10 years from now. If we immediately heed Icahn, sell everything and the bust cycle doesn’t come in the next 5 years, we will look stupid.

The main point is that Icahn is right, but all the folks buying stocks at high PE ratios and high yield junk bonds are also right for the time being, because no one can be right on the most important thing, timing.

If you own high yield ETFs, or stocks that use lots of the cheap leverage to do buybacks and acquisitions, know that there is also a risk of losing a big chunk of your money if credit tightens. Just be aware of the risks you are taking for the higher yield you are getting.


Are You An Investing Optimist? Check Your Portfolio

  • Investors are very optimistic in bull markets and allocate much of their portfolio to stocks, increasing their risk.
  • Analysts and economists expect more spending which will consequently push GDP and inflation up, but low rates push people to save more for their retirement.
  • If the GDP and earnings don’t grow as expected, we could see a bear market in 2017.


Stock markets keep going up while fundamentals keep going down and the economic situation isn’t that great either. The S&P 500 is dancing around new highs despite corporate earnings for Q2 falling by 3.6%, and the economy only growing by 1.2% on an annualized basis. Economic growth for the whole of 2016 is only at 1%.

So, what is pushing stocks higher? The simple answer is optimism. It is assumed that next quarter’s earnings will be exceptional and economic growth will blow off the charts. In this article we are going to elaborate on the forecasts and assess their probability in order to take a look at what optimism can do to investors.

About Optimism

Being an optimist is nice. Optimists are happier, have a more positive view of the world, are ready to take risks in life and optimism helps one to cope with life’s uncertainties. We can say that in life, it pays to be an optimist. On the stock market it also pays to be an optimist but it pays even more to be a rationalist.

An old research project (1999) by behavioral scientists Benartzi, Kahneman (Nobel prize) and Thaler explains perfectly how investors approach stock markets after a few years in a bull market. Based on 1,053 Morningstar subscribers of which 84% were male with annual household income averages of $93,000, they found that investors had an average allocation to stocks of 79%, and 95% of their pension contributions were directly allocated to stocks. This bullishness derives from investors’ optimism. When asked what they focused on when thinking about financial decisions, a staggering 74% of investors focused on positive returns.

figure 1 optimism survey
Figure 1: Thinking about potential return or potential loss. Source: Behavioral Finance.

By being an optimist, you make bold investment decisions, but investors should also think about risks. Don’t forget, one of the most quoted of Buffett’s pearls of wisdom is: “Rule No. 1: Never lose money. Rule No. 2: Don’t forget rule No. 1.” The reason behind this rule is that if you lose 50% of your investment, it takes a 100% return just to get you even.

Optimistic Forecasts

Yes, earnings have declined and the economy isn’t growing fast at the moment, but analysts are highly optimistic that in the next quarter or the one after that, everything will grow. On June 30, most analysts expected earnings to return to growth in Q3 2016.  Now analysts expect a 2% earnings decline in Q3 2016 and don’t expect earnings to return to growth until Q4 2016.

figure 2 earnings
Figure 2: Forecasted earnings growth for Q3 2016. Source: FACTSET.

The same analysts that consistently revise their estimations downwards as actual earnings results are released expect S&P 500 earnings to grow 13.3% in 2017. At the end of June, the expectation was at 13.5%.

figure 3 earnings growth 2017
Figure 3: Forecasted earnings growth for 2017. Source: FACTSET.

The expected increase in earnings comes from an expectation that oil and other commodity prices will inevitably increase and push earnings higher, and that no sector will see earnings decline.

Additionally, GDP is expected to grow at a rate above 2% from this quarter onwards. The current 1.1% yearly growth is just a temporary slowdown according to interviewed economists.

figure 4 wsj gdp
Figure 4: Forecasted GDP growth. Source: Wall Street Journal.

But not all economists agree on that rosy view. Economist Stephanie Pomboy stated that analysts and economists are wrong because they use pre-financial crisis frameworks to make their estimations and the world has changed a lot since then. Despite the fact that interest rates have severely declined, people spend less and save more. Less spending means inevitable declines or slower GDP growth.

figure 5 savings
Figure 5: Total saving U.S. deposits. Source: FRED.

Why are people saving more? Well, with lower interest rates you need to save more to reach a satisfying level of income for retirement. As the population is getting older, they will save more and more. This speaks to how low interest rates have been beneficial for businesses but very detrimental for savers and an aging population.

In such an environment we cannot expect GDP growth and earnings to increase just because interest rates are low as it is clear that low interest rates have not worked thus far to stimulate economic growth.

If the GDP does not reach the expected 2% growth rate and corporate earnings continue with their decline, Pomboy sees a bear market in 2017, especially in discretionary stocks.

Discretionary stocks have really high PE ratios and, yes, if the growth from the past 5 years continues, those ratios might be justified, but any kind of bad news could quickly send those stocks down. Amazon (AMZN) has a PE ratio of 188.4, Home Depot (HD) 23.8, Starbucks (SBUX) 30.9, and Nike’s (NKE) is at 27.3. All these stocks could easily fall more than 50% if a recession comes along or people spend less because of their high valuations based on optimistic future projections.


It is good to be an optimist, but in investing it is also good to be a realist, or a diversified optimist. A diversified optimist is an investor that is positive about his returns, fully invested but well diversified among various uncorrelated assets and prepared for any economic environment.

The main point of this article is for you to assess your optimism and look at the risks in your portfolio. When you look at each component of your portfolio, ask yourself how much you can lose. Write that number down and then go through the list again and ask yourself how much you can gain. Where the potential risk is much higher than the gain you might want to look for other assets.


The Important Insights From The FOMC Minutes No One Is Talking About

  • The FED’s “protect the market at all costs” attitude minimizes the risk of a severe bear market but increases the risk for an inflationary environment.
  • Trade deficits and low productivity are not good signs for the long-term, no matter the positive data from the labor market.
  • Until the focus shifts from central banks to real structural reforms, sluggish GDP growth could easily turn into a recession.


There are more important insights that can be gained by going through the FOMC minutes than by just reading the news about an eventual interest rate increase. An interest rate increase of 0.5% won’t change much. It will give the news something to talk about for two weeks and from then onwards it will be business as usual. Structural risks and what the FED is ready to do or not do in the case of turmoil is what will determine our investing returns.

The Patient Needs Stronger Medicine

The FOMC minutes start with a discussion about the implementation of a monetary framework, clearly stating that since the 2009 crisis, heavier intervention is needed to stabilize the markets and the economy. Before the crisis, a few rate cuts or increases and minimal market asset purchases were enough to reach stability. This can be clearly understood by having a look at the FED’s balance sheet. It increased fivefold from 2009 to 2014.

figure 1 fed balance sheet
Figure 1: FED’s total assets. Source: FRED.


For investors, this is important because it tells us that the FED will use all the tools at its disposal to keep the economy and markets stable. This minimizes the risks of a severe bear market as capital injections will be immediate, but it also increases the risks for an inflationary environment.

The Economy & Inflation

The economy shows mixed signs. On one hand it is doing very well with the latest jobless claims data at only 262,000, extending the period below 300,000 to 76 weeks which is the longest since the 1970s. On the other, weak manufacturing data, a trade deficit and growth from consumption alone keep the FED from decisively increasing rates.

The unfortunate thing is that adding jobs is easier than solving structural issues. With low productivity and a trade deficit, it is difficult to expect miracles from the U.S. economy in the long term, which again indicates that some international diversification and inflation protection should be welcome in the long term.

Inflation is still only at 1% indicating that something isn’t working as planned. Low interest rates and lots of cheap capital have spurred investments which increases the supply of goods, sending prices down, not up. Such a situation enables the FED to keep rates low and sustain the economy, but nobody knows how long such a situation will last. The FED is just postponing the reach of the 2% inflation target, which is now set for beyond 2018.

The sluggish GDP growth forecast and an economy relying on easy-to-hire jobs and consumer spending indicates that monetary easing did what it can do and now it is time for something else to step in. Structural reforms, lowering student debt and investing in infrastructure might be reasonable ideas, but until the focus is on monetary policy, the risk is high that this slow growth will turn into a recession.

The Situation in Europe

The European central bank released its policy meeting minutes a day after the FED. Europe is still a few years behind the U.S., asset purchases and direct financing programs are the norm but have no influence on inflation or economic growth. Inflation in the EU zone is at 0.8% while industrial production is contracting and GDP growth is below 1%. For the ECB, the good news is that unemployment has decreased from 10.2% to 10.1% and youth unemployment is “only” at 20%.

Similar data clearly indicates that other actions are necessary for the reach of sustainable economic growth. The terrible unemployment rate signals severe structural issues that cannot be amended by monetary policy. At least the situation in the U.S. looks much better after taking a look at Europe.


Everyone expects miracles from central banks, but those miracles only work for a short while. Hopefully structural reforms will enable future economic growth. Until then, we have two situations on our hands as investors.

  • Situation Number 1 – Central banks will intervene at any sign of market and economic weakness with more stimulus, minimizing the risks for long term investments. This means that we can stay long, but we have to be careful to watch for the point in time when the majority of people in the markets understand that monetary policies do not suffice.
  • Situation Number 2 – Global economies are not that healthy, especially in Europe. Severe structural reforms are necessary in order to create real growth, not just financially engineered growth.

The primary conclusion then, is that you can stay long and grasp eventual price declines for rebound trades as central banks state that they will do whatever is necessary to keep things stable. In the longer term, as monetary policy is not working, watch out for the moment when somebody yells: “The emperor is naked.”



The U.S. Dollar: Should You Stick To It Or Diversify Now?

  • The dollar has been positively correlated with stocks for the last 4 years which is unusual.
  • Potential FED interest rate increases don’t make international diversification a great idea right now.
  • Any sign of a U.S. recession should be a good time to think about international diversification with emerging markets.


On big news sites like Bloomberg you often come across headlines related to the movement of the U.S. dollar. The headline below is a good example.

figure 1 bloomberg news

Such headlines relay what has been going on in the few hours before publication but are completely irrelevant for investors that aren’t trading pips on forex. This article is going to investigate the longer term relationship between the dollar and stocks, and discuss the best option for maximum return with minimal risk.

Recent Dollar & Stocks Movements

Before 2012, as the dollar strengthened, stocks went down and vice versa. The reason was simple, a strong dollar meant U.S. exports were less competitive and businesses suffered, while a weak dollar made U.S. goods cheaper across the world and increased corporate earnings. Since 2012, however, the story has been a little bit different. The dollar has gotten stronger and stocks have gone higher.

figure 2 fred dollar stocks
Figure 2: U.S. dollar vs. S&P 500. Source: FRED.

The reason behind this is the fact that no matter what we think of the FED, it is the most globally coherent financial institution. In an environment where the European central bank is continuing with stimulus and the Japanese think about printing money for direct spending, the FED is the only institution that contemplates raising interest rates. So the positive correlation between the U.S. dollar and the S&P 500 comes from the relative success of the U.S. economy and the global faith in the U.S. dollar as the only safe currency.

On one hand, the strong dollar lowers corporate revenue. But on the other hand, it also lowers corporate costs, something CEOs never talk about when reporting earnings. As the U.S. has a net trade deficit, the strong U.S. dollar makes everything around the world cheaper and therefore expenses should also be much lower. Don’t forget this in the next earnings season.

Long Term Dollar Strength

The long term perspective is a little bit different than the above. Since 1975, the dollar has slowly but consistently weakened in relation to foreign currencies.

figure 3 long term dollar
Figure 3: Dollar index since 1975. Source: FRED.

The slow decline of the dollar means that global trends are shifting, which is also normal given the development in China and other countries. As the rest of the world is expected to grow at a faster rate than the U.S., the long term trend for the dollar is clearly and slowly downwards. This point is essential for international diversification. We have discussed many times how ChinaIndia and other fast growing emerging markets are essential for healthy diversification.

Forecasts & Economic Factors

In the short to medium term, it looks like the dollar is going to continue to strengthen. If the FED increases interest rates and others continue with their stimulus, the dollar will surge even higher. The most recent FOMC minutes clearly indicate that we could see a rate hike by the end of the year. But, eventually the strength of the dollar will kick back as exports will be more expensive and the trend will turn and continue to follow the declining line seen in figure 3 above.

What To Do

There are two options with currencies. They go up or down and do so for longer periods until the structural influences rebalance on a global scale. With interest rates low and good news from the U.S. economy, the FED will eventually raise interest rates and send the dollar higher. The moment of maximum strength of the U.S. economy and the dollar will be the time to diversify to other currencies but until then, sticking to the dollar is not a bad idea, especially for the majority of our readers who are living in the U.S. If the U.S. economy slows down and the dollar weakens, you will still have most of your assets in your home currency which will not represent a real change to your portfolio. But if you are exposed to other currencies and the dollar gets stronger, you will have to look at losses, which is never pretty.


U.S. investors have the benefit that if the dollar gets weaker, international diversification is just a missed opportunity while if the dollar gets stronger, it was a good idea to stay at home. International investors have to play it differently. With the FED eventually increasing rates, the dollar has no other direction to go than up which is a great diversification play when looking at the stimulus in Europe and Japan which weakens their currencies.

In the long term, it pays to be exposed to the currencies of the countries that are going to grow at a faster pace than the U.S. economy, i.e. emerging markets. We have seen the Chinese Yuan get weaker in the past two years due to some fears about China slowing down, but the longer term trend is clear.

figure 4 cny usd
Figure 4: Chinese Yuan per 1 USD. Source: XE.

With the economy expected to grow at a pace of above 6% in the next 10 years and the Chinese getting richer, there is only one way for their currency, up. Think about international diversification, but only when the dollar strength reaches its structural limits and the U.S. is close to a recession.



Euphoria & Denial Point to the Last Days of the Bull Market

  • Risks are cumulating and getting bigger.
  • U.S. GDP growth is slower than expected, earnings and oil prices continue to decline.
  • Japan is unable to grow while BREXIT risks are still unfolding.


It is difficult to find good news lately. The last really good news was the June jobs report when 287,000 jobs were added. Since then, most of the news seems dismal, however, it has yet to have a negative impact on financial markets. It’s as though investors are just hoping for something good to happen in the future. As hopes are an immaterial human feeling, they should not be the base for investment decisions.

In this article we are going to analyze what’s pushing the S&P 500 to new highs. Are we in a state of euphoria about stocks or are the valuations and price increases rational?

GDP News

The U.S. economy was expected to grow 2.5% in Q2 2016, but it only grew 1.2% (seasonally adjusted). U.S. economic growth for 2016 is currently at 1% which is the weakest start of a year since 2011. Saving the economy from a recession is consumer spending which increased by 4.2%.

Low interest rates create cheap money which fuels two trends, growth in both consumer spending and the S&P 500. Consumer loans have increased at a faster pace than consumer spending which makes it clear that spending growth is fueled by debt.

figure 1 consumer loans
Figure 1: Consumer loans at all commercial banks (blue) and consumer spending (green). Source: FRED.

Anyone who has studied economics will tell you that the economy works in credit cycles, when money is cheap and prospects good, people take on credit and spend it. But one can only take on so much credit, and all banks want their money back sooner or later. When sentiment shifts, a credit contraction arises and consumer spending falls. As this is inevitable, the only justification for the current hope of increased GDP growth can be explained with the most dangerous words for investors: “this time is different.”

figure 2 credit cycle
Figure 2: Credit cycle. Source: Loomis Sayles.

As we are in the expansion part of the credit cycle, a recession is going to hit us as soon as we reach the downturn part of the credit cycle because consumer loans are the only thing still boosting growth.

figure 3 gdp contributors
Figure 3: Contributions to Q2 economic growth. Source: Wall Street Journal.

If it wasn’t for consumer spending fueled by cheap loans, the U.S. economy would most likely already be in a recession.

The S&P 500

With economic growth largely missing expectations you would assume the S&P 500 would tank, but that’s not what happened Friday when the economic data was released. On the contrary, the S&P 500 reached a new intraday high at 2177 points. The main reason for the new S&P 500 high is hope of future economic growth, the same economic growth that didn’t realize itself in this quarter.

Another reason stocks have continued to rise has been the Q3 2016 expected corporate earnings growth, but that also vanished like the above described economic growth. As most companies have issued negative guidance we cannot expect higher earnings in Q3 2016.

figure 4 positive guidance
Figure 4: Q3 2016 earnings guidance for the S&P 500. Source: FACTSET.


It would appear the FED is also somewhat in denial about the true state of the U.S. economy and S&P 500 earnings, and is holding on to the hope of increasing interest rates as soon as the economy shows signs of strength, be we’ve been hearing the same story for a while now.

Last week the FED left the door open for interest rate increases as the economy seemed to be improving, but this was before Friday’s GDP debacle. With growth being lower than expected, the FED will probably continue with its status quo policy. As we now know that the only thing pushing the economy higher is consumer spending fueled by consumer debt, any interest rate increases would be detrimental for the economy and push it into the downturn part of the cycle because higher interest rates would increase the cost of debt.

Data on jobs, consumer spending and inflation will be available before the FED’s next meeting in September so we will closely watch that in order to see if the FED will eventually move, highly unlikely after the latest GDP debacle.

Global Situation

The BREXIT had only a short-term effect on markets as investors soon focused on other things and hoped that it would not have any long term effects. But any BREXIT effects won’t be seen in economic data for a few years as it will take the UK at least two years to exit the EU, if not four.

figure 5 brexit
Figure 5: Soon forgotten BREXIT. Source: Google.

News from Japan was also not that good. As economic targets have not been reached, the Bank of Japan decided to double the annual amount it uses to buy exchange traded funds, from ¥3 trillion to ¥6 trillion ($57 billion). This is only a modest increase to Japan’s easing policy, measured in hundreds of trillions, and brings us to the conclusion that Japan is out of monetary policy ammo. Even with constant increases in monetary easing, Japan has experienced a 0.5% deflation in June and slower consumer spending. This should be a warning sign for the U.S. as it is clear that easing has its limits.


All the above indicates that we are currently in the denial phase of a stock market cycle. We have had a bull market for 7 years now and no one wants to look at the above data as it indicates a turn in the credit cycle, lower business spending and earnings, a strong dollar and global uncertainties with the UK, Japan and China. We will analyze the situation in China soon as it requires a special article.

figure 6 stock market cycle
Figure 6: Stock market cycle. Source: The Gold and Oil Guy.

Not to mention oil prices coming close to $40 dollars per barrel, which will push energy earnings down, again.

All of the cumulating risks we’ve discussed send a strong message. Investors have to start thinking about risks and rewards. In the late stage of a bull market, many are overweight stocks, which means they can expect a beating if any of the above mentioned risks trigger a bear market. The options are to increase one’s cash in order to have liquidity when a market decline comes, or to own more uncorrelated asset classes. I’ve written more on this in our recent article on Ray Dalio’s strategy.

For stocks, simply ask yourself, how much are you willing to risk for a 4% long term expected yield?



Higher Interest Rates Aren’t A Given, But Investors Should Prepare Anyway. Find Out Why.

  • Rates cannot go lower but higher rates would destroy wealth and lead to a recession.
  • The FED is in a difficult position and rhetoric shifts can be expected.


It is every central banker’s target, the elusive 2% rate of inflation. We cannot know when, but should expect that it will be achieved and prepare accordingly. Since rising interest rates help to keep inflation in check, once the target is reached, as strange as it sounds, rates should also rise to compensate. This article is going to analyze what is happening, what will probably happen, and how it will affect investments.

Current Situation

The current situation is one of persistently low interest rates on a global scale. The U.S. recently increase short-term rates by a negligible amount, while Japan and Europe continue with their easing policies.

figure 1 historical interest rates
Figure 1: Interest rates in Japan, Europe and U.S. Source: FRED.

Once inflation reaches the 2% target, inevitable consequence will be higher interest rates since it is the only option that prevents inflation from escalating. It’s hard to imagine now, but with all central banks hell-bent on achieving their “goal,” it will become a reality, maybe sooner than most expect. It might take central banks putting money directly into our hands via “helicopters,” but eventually the target will be reached and we will see interest rates come back to normal historical levels.

The FED forecasts its funds rate to be between 2% and 3.5% in 2017. If achieved, it means that all other interest rates, from bond yields to mortgages, will be higher than that. A plausible scenario is that 10-year bond yield is 1.5% higher than the fed funds rate and the expected stock yield 2% above that.

figure 2 FED forecast
Figure 2: FED’s funds rate forecast. Source: Federal Reserve.

Such an evolution means that a lot of things are going to change in financial markets.

Implications of Higher Interest Rates

It’s pretty simple, rates go up, asset prices go down. The consequence is less wealth which leads to lower consumption which leads to a recession. This forecast is unpleasant but is also a reality. Hopefully, the economy will be ready for higher rates.

One consequence of higher rates is that mortgage rates will also be higher. Usually, the 30-year fixed mortgage rate is a few percentage points above the federal funds rate. If you do not have a fixed mortgage, or are unable to buy now while rates are low, your future monthly payments will be higher, leaving less money for investments and consumption.

figure 3 fed and mortgage
Figure 3: 30-year fixed mortgage rate and federal interest rate. Source: FRED.

Higher mortgage rates might influence a decline in home prices. Figure 4 below shows that declining mortgage costs have supported a continuous rise in home prices.

figure 4 mortgage rates and home prices
Figure 4: Home price index and mortgage rates. Source: FRED.

As interest rates go up, so will bond yields. Consequently bond prices must fall. It’s that simple. As bond yields go up, expected stock yields rise as well since stocks are considered riskier and carry a premium. The current expected yield from stocks is around 4% given a PE ratio of 24.85 for the S&P 500. If we add 2% to the expected yield from stocks, we get to 6% which implies a PE ratio of 16.6. Given the current earnings, a PE ratio of 16.6 would mean the S&P 500 would trade at 1447, which is 33% below current values.

In addition to declining asset prices, due to higher expected yields, many corporations have taken advantage of the low rate environment to borrow money. If interest rates go up, financing costs will follow which will lower corporate earnings. Lower corporate earnings means less investments and less investments mean less economic activity.  Therefore, the S&P 500 could drop even further.

On a positive note, savers will appreciate higher rates as they have been getting almost nothing for the past 7 years. Higher yields will also benefit Insurance companies that live off of their float and pension funds that are desperate for higher yields.

Is the Above Scenario Possible?

When this scenario begins to play out, investors will get the short end of the stick as higher rates will directly translate into lower asset prices. This shouldn’t come as a big surprise for investors, since the total U.S. net wealth is $80.3 trillion, of which $37.1 trillion is in real estate and $28.7 is in equity. In total, 80% of U.S. wealth is concentrated in assets whose value is strongly correlated to interest rates.

Higher interest rates mean less wealth, less wealth means less consumption and less consumption leads to a recession. Therefore, it will be very difficult for the FED to implement the forecasted interest rate increases without inflicting a lot of pain on U.S. households.

And then there is the issue with the dollar. Higher interest rates mean a stronger dollar, unless Europe and Japan coordinate their rate increases simultaneously. A stronger dollar means less exports and, again, less economic activity.


It’s possible, given the above scenario, that buy and hold investors won’t fare as well as medium term traders and active investors might, since the FED will be forced to see saw back and forth with interest rates. Maybe we will see a rate increase in the coming months, but those rate increases will have a negative effect on the economy and household wealth, and the FED will be forced to lower rates again. The implications of this back and forth rhetoric can already be seen in the 6-month U.S. 10-year treasury note yield chart, where yields have experienced constant up and down movements in relation to nothing more than market sentiment surrounding expectations of higher yields.

figure 5 yield
Figure 5: U.S. 10-year treasury note yield in the last 6 months. Source: FRED.



Negative Yielding Debt: A Party for Investors or Pure Stupidity?

  • Almost 30% of global sovereign debt comes with a negative yield.
  • The situation is much worse in Japan and Europe than it is in the U.S.
  • Investors should enjoy the asset inflation party while it lasts but also be prepared for the worst.


Negative yielding debt seemed impossible and illogical for a long time, but it suddenly became a reality a few years ago and now we are seeing it slowly become the new normal.

This isn’t just strange, it’s dangerous as risk averse investors—like pension funds and insurance companies—are forced to invest in assets that have traditionally been considered safe but that have now become risky, and their returns minimal. Those low returns will result in lower pensions and lower savings which will create new troubles in the future.

This article will analyze how we arrived negative interest rates, what the current situation is globally, and what the long term implications will be for your portfolio.

History and the Current Situation

Negative interest rates started with a few European central banks cutting their interest rates below zero in 2014 (Switzerland and Sweden), followed by Japan in 2016. The EU is not far behind with its 0% interest rate. Apart from central banks’ negative interest rates, high demand for bonds also pushes the yields below zero. With the European Central Bank buying 169 billion of bonds per month with its asset purchase program, it also distorts the markets, and pushes bond prices up, creating negative yields.

It is now estimated that 30% of global sovereign debt has a negative yield.

figure 1 negative yielding debt
Figure 1: Global debt by yield. Source: Wall Street Journal.

Per country, the worst situation is in Switzerland where the complete yield curve is negative, even for bonds maturing in 2049. Germany and Japan have negative yields on debt maturing in 10 years with yields of -0.17% and -0.28% respectively, while The Netherlands and France are not far away with yields at 0.02% and 0.12% respectively. The situation is much worse for debts with shorter maturities.

figure 2 euro yield curve
Figure 2: Euro yield curve. Source: Financial Times.

For perspective, it is wise to compare this to how the U.S. nominal yield curve looks as it is much healthier. If economic news from the U.S. continues to be similar to the latest job news, we could expect an interest rate rise in one of the next FED meetings, which should normalize the U.S. yield curve even more.

figure 3 us curve
Figure 3: U.S. yield curve. Source: U.S. Department of the Treasury.

With longer term yield being above inflation, the U.S. debt market looks much healthier and more rational than the EU or Japanese markets.

Economic Reasons and Implications

Many of the World’s most renowned investors have warned that this negative interest rate experiment in Europe and Japan will backfire. Pimco’s Bill Gross stated that a new supernova is being created and BlackRock’s Larry Fink has warned that it will have huge repercussions on the ability investors have to save and plan for the future.

The main goal central banks had in mind by lowering interest rates was to stabilize the economy and increase employment. However, given the length of time yields have been at zero, or even negative, without the accompanying benefits to the economy, one could conclude that the experiment has not worked. In fact, the World Bank has now trimmed global economic growth prospects from 2.9% to 2.4%.

One of the reasons why it may not have worked, is because the whole world is pushing for liquidity by lowering yields, and the positive effect low yields should have on an economy has been diluted and the only thing that has been inflated are asset prices, which isn’t bad if you are fully invested.

Since central banks were unable to create a healthy inflation rate of 2% with what they deemed the appropriate amount of liquidity, they then flooded the global economy with too much liquidity. And instead of having the desired effect of raising prices, it has actually increased competition with more goods and services being offered, which has lowered prices.

We might now start to see some inflation in the U.S. as the unemployment rate is getting close to the natural unemployment rate but Europe is still far from it with unemployment at 10.1%. Until consumers increase spending and create inflation this negative interest environment will persist and we cannot know when it will change, what we can is prepare for when it will change and analyze the current risks.

Implications for Investors

The most painful consequence of negative yields is that savers are penalized and that investors desperate for any kind of yield pay a high risk premium for low yields. A global snap back in interest rates, or a fall in credit quality, would put the financial world under extreme pressure as investments that are usually considered the safest could lose a substantial amount of value depending on how high interest rates rise, since bond prices move inversely to yields. Goldman Sachs estimates that an unexpected 1% increase in U.S. treasury yields would trigger $1 trillion of losses. If you are highly invested in bonds please be aware of the risks you are running if interest rates rise and ask yourself if the low yield is worth the risk.

Inflation would put pressure on interest rates and companies which cannot transfer increased financing costs onto customers would have huge difficulties in refinancing their debt. The current S&P 500 debt pile is the largest in history and companies are taking advantage of the low interest rates in order to borrow as much as they can.

figure 4 net debt
Figure 4: Net debt issuance/reduction. Source: FACTSET.

Investors should take advantage of the situation as most of the corporate debt is used for repurchases that further inflate asset prices but be careful for the moment when the party stops. At some point, the party has to come to an end someday because corporations are not using the fresh capital to invest but instead are only using it mostly for repurchases and dividends, thus not thinking that much about the future.


As there is no historical precedent to the current situation, all that one can do is make an educated guess as to when it will end. We all know that this situation is artificial and we also know that it has not been that beneficial to the global economy in the last few years.

As the more mature investors reading this will know, the economy works in cycles and we will see this asset inflation end but we cannot know when. When it does turn, it will certainly be an ugly scenario as investors will sell inflated assets in panic, corporations will find it difficult to refinance debt and central banks will not have maneuvering options with interest rates already negative.

But, as central banks continue to hope that more of the same—which is clearly not working—will eventually work, and which according to Albert Einstein is the exact definition of stupidity, let us enjoy the party while it lasts, hope that it will last for a long time, and always stay prepared for an eventual change.



Watch Out: The FOMC’s Current Stance Could Impact Your Portfolio in the Long Term

  • Bonds are becoming riskier as yields are falling.
  • Inflation is at 1.2% and very likely to get higher as full employment is approached.
  • The FOMC predicts stability which could create a great environment for traders.


On July 6 the Federal Open Market Committee (FOMC) June meeting minutes were released. As they give clear insight into how the controllers of our monetary policy think, it is very important to analyze the minutes in order to better position one’s portfolio and also execute short- and medium-term trades. The FOMC gave a clear indication of their expectations in relation to future GDP growth, unemployment, inflation and its federal funds rate. All of the mentioned indicators will have different effects on various investments.

Summary & Indications for Investors

“Prudent to wait” are three words that summarize the FOMC meeting. For investors this means that you should prepare for anything as the FOMC doesn’t know what will happen.


In more detail, the low treasury yields is what worries the FOMC. As investors shun foreign sovereign debt and repatriate their cash, U.S. yields go down. This decline in U.S. yields is not only caused by global political and economic turmoil—think Europe with BREXIT and Italian banks, and Brazil—but also by the FOMC’s indecision.

Yields went up when the FOMC increased interest rates back in December and forecasted three more increases during 2016, which obviously will not happen. This change in policy has pushed yields down again.

figure 1 u.s. yield
Figure 1: U.S. treasury 10-year yield. Source: Bloomberg.

With consumer price inflation at 1.2% with projections at around 2% in 2017 and a yield of 1.36% on the 10-year note, buying 10-year treasuries doesn’t protect your capital. Such an artificially created situation by the FED is unfair towards savers.

As the price of a bond moves inversely to its yield, the current low yield means that investors have to pay a lot for little. For example, if you invest $100,000 now in 10-year U.S. treasuries and next year the yield climbs up to 2.3% where it was a year ago, your $100,000 investment will become $59,130, which is not a great way to protect your capital, especially if you don’t plan to keep the debt until expiration.

Astute traders might want to grasp the opportunity given by the clear indications of higher inflation which should produce higher interest rates and consequently lower bond values in the medium term by shorting bonds.

On the labor side, the FOMC is worried about the low number of new payrolls added in May as the fall from 5% to the 4.7% unemployment rate was mostly influenced by a large number of people exiting the labor force. The FOMC estimates unemployment to stay in the 4.5% to 5% range in the next three years and in the longer run. This stable forecast is very strange as the unemployment rate has historically never been stable.

figure 2 unemployment rate
Figure 2: Unemployment rate from 1948. Source: FRED.

As the figure above demonstrates, since unemployment has been measured there has never been a period of stable unemployment for a longer period of time except for a one-year period in 1955 and a two-year period in 1965. Perhaps the FOMC is forgetting that the economy works in cycles. Investors should understand that the reach of full employment increases costs for corporations which should finally spur inflation. This again reinforces the above described risk of holding treasury notes and also indicates that investors should look for stocks that will perform well in an environment with higher inflation and higher interest rates. One example is energy stocks as they can raise their prices pretty quickly in relation to inflation and if they have their debt maturing in the distant future with fixed interest rates, even better.

The FOMC’s view on economic growth is a mixed one, again reinforcing the sit and wait strategy. Weakness in the mining sector is continuing, declining corporate earnings and high inventory levels lower business investments that “could portend a broader economic slowdown” according to the FOMC.

On the other hand, the committee is also optimistic due to a turnaround in energy prices and greater optimism in business surveys. So, for the FOMC, pessimism from actual figures like lower business investments, higher inventories and lower corporate earnings is equalized by survey optimism and a turnaround in energy prices. Such statements indicate high risks because even if there was a recession looming, the FOMC isn’t allowed to tell us that because such an admission has the power to influence markets. If the FOMC said that a recession would come in the next year, that recession would begin the same day of the statement and not next year.

Fed governor Daniel Tarullo stated that “This is not an economy that is running hot” and that the Fed has limited tools if the economy slows down as the interest rates are already at their minimum which increases the risks for investors.

To sum it up, the figures below are the FOMC’s forecasts and forecasted ranges for GDP, inflation and unemployment:

figure 3 fomc forecasts
Figure 3: FOMC’s forecasts. Source: FED.


As the FOMC forecasts stability on all levels, investors can expect sideways market movements because as soon as negative news like the BREXIT lowers market values, positive news like monetary interventions will push the markets higher again. If things will be as the FOMC forecasts, it will be a heaven for traders. Long term investors will see their current low yields eaten up by inflation, so a portfolio should be rebalanced accordingly.



How to Prepare Your Portfolio For The Next Recession or Stock Market Crash

  • The risks of a slowdown are higher than the upside.
  • Fundamental trends are negative in advanced economies while emerging markets show higher growth rates and are cheaper.
  • It is important to create a diversified portfolio with uncorrelated assets.


In an environment where it seems maximum potential for the U.S. economy has been reached, the St. Louis FED chief, James Bullard, has said in his most recent report that he favors only one interest rate increase through 2018, which would at best keep things stable. His view is further supported by the fact that the unemployment rate is sitting at below 5%, and the Personal Consumption Expenditures PCE inflation—measured by the Dallas FED—is at 1.84%, both of which signal that the economy has reached its maximum potential.

1 figure trimmed inflation
Figure 1: Trimmed mean PCE inflation. Source: FRED.

The scary part of the report is where Mr. Bullard describes how forecasts are made based on the current situation, which will most definitely change. What is difficult to predict is the direction of the change therefore, forecasts are bound to be incorrect and under the influence of various risks like a return to the normal Phillips curve influence where low unemployment triggers inflation, or a recession even if no current data indicates the possibility of one. Thus only an extremely positive scenario would trigger interest rate increases if fundamentals like inflation or productivity stay stable.

2 figure fed stlouis
Figure 2: St. Louis FED’s U.S. macroeconomic outlook. Source: St. Louis FED.

The conclusion is that practically anything can happen, and the FED has absolutely no idea as to where the economy will be in a year or two. Even FED Chairwoman Yellen admits that the 2013 expected interest rates of 4% for 2016 were too high and that an aging society and a slump in productivity growth will keep the subdued economic indicators persistent.

In such an uncertain environment, an investor should look at the best ways to protect his downside and maximize his upside.

Investment Ideas

Let us start with bonds where interest rates have been declining since the start of this century.


3 figure bonds
Figure 3: 10-year government bonds yields. Source: Wall Street Journal.

As bond prices are inverse to bond yields, any increase in yields would precipitate bond prices, thus bonds are currently low yield and high risk. Usually considered safe havens in recession times, bonds currently do not provide such protection as it is better to keep cash than bonds with negative interest rates. There is the option of further bond price increases, but that is a highly unlikely scenario as bond yields are at historical lows.

The Stock Market

The S&P 500 is still holding well, but does not manage to break the previous highs despite having come close several times.

4 figure s&P 500
Figure 4: S&P 500 in the last 12 months. Source: Bloomberg.

The S&P 500 dividend yield is 2.12% which might look tempting when compared to the extremely low bond yields, but it is meagre when compared to the historical mean of 4.39%. A return to the mean would result in a drop of 50% or more of the S&P 500 index. The conclusion here is the same as with bonds: High risk, low returns.

But there is an option with stocks that should limit the downside. Dividend stocks that will not see their cash flows affected by a slowing down in the economy are always assets toward which investors run when trouble comes. Examples can be found in telecommunication, consumer staples and healthcare.

Emerging Markets

If the reason for economic stagnation in the developed world is an aging society, slow productivity growth and emerging markets competition, a contrarian thesis would be to invest into emerging markets.

Emerging markets have a relatively young population and are currently shunned by investors as too risky amidst a commodity price slump. But no matter the current issues, the World Bank expects emerging markets and developing economies to grow at rates north of 4% in the long term, while advanced economies are expected to grow below 2%.

Currently, advanced economies are preferred by investors as they regard them as secure, but long term structural trends are strong in place even if we do not choose to see them. What China has done in the last 15 years could be the same as India is about to do. Brazil will probably also return to growth someday.

The following figure will show that the current developed world impression of asset security is mostly funded by debt which is unsustainable in the long term.

figure 5 investment position
Figure 5: U.S. net international investment position. Source: Bureau of Economic Analysis.

On top of that, emerging markets are much cheaper than developed ones according to the Cyclically Adjusted Price Earnings (CAPE) ratio which takes into account earnings from the past 10 years.

figure 6 global cape
Figure 6: Global CAPE map. Source: Star Capital.

For long term investors, the less risky option might be to dig for good investments in emerging markets with positive demographics and a strong growth outlook. Currently those investments are out of favor, but this is exactly the environment where investments give the best returns.


Gold is a doomsday investment, it protects you against inflation and is the metal that surges in difficult times. Typically as the economy does well, stocks grow and gold declines because gold has no yield. The opposite happens in turmoil.

7 figure guardian precious metals
Figure 7: Gold and stocks cycle. Source: Guardian Precious Metals.

You can invest in gold by buying it physically, through ETFs or by buying gold miner stocks.


As always, good diversification should provide sufficient downside protection but a portfolio has to be diversified with uncorrelated assets.

If you have Ford in your portfolio and then you add some Caterpillar, that is not real diversification. Gold, emerging markets, cash, and quality stocks should enable a portfolio to weather economic hardships.

Don’t forget that after every recession comes a recovery, so be ready to increase your exposure to stocks when assets are cheap, even if everyone will be thinking that there is no tomorrow.


Will There Be A Long Term Impact To The Fed’s Shift In Rhetoric?

  • A positive outlook seems more political than realistic as the FED is out of maneuvering power.
  • Keeping interest rates unchanged is the best and the only thing the FED can currently do.
  • Low interest rates will weaken the dollar, boost exports and increase corporate earnings in the upcoming earnings season.


In FED’s Chairwoman Yellen semiannual policy report, the rhetoric has significantly changed since the last report in February. In short, the full employment target is almost reached but the inflation rate is still below the targeted 2% and the expectations for the reaching of that target have been changed from short term to medium term. Further, the latest job reports show a slowdown in jobs increases which creates a bit of a scare. The FED estimates the slowdown to be transitory.

On the positive side, wages seem to be finally picking up which is a good sign for inflation. Weak data comes from the economy where the U.S. GDP grew only 0.75% in Q1 2016 on an annual basis due to the fact that the expensive dollar weighs on exports, low oil prices and weak business investments.

The FED On The Economy

On one side, Yellen says that the slowdown in employment should be only transitory and that data from one quarter does not mean much, while on the other side she states that the quarterly pickup in consumer spending and increase in household wealth will bringfurther improvements in the labor market and the economy more broadly over the next few years.

As always, in order to show the other side of the medal Yellen mentions risks like lower employment and business investments that might lower domestic demand, the general slowdown in U.S. productivity potentially continuing, a stronger slowdown in China and a possible Brexit. All of the mentioned possible scenarios might have a negative impact on investors’ perception of risk and therefore abruptly change the current stable market situation.

Monetary Policy

The FED decided to keep interest rates unchanged and even more importantly, keep the FED’s holdings of longer-term securities at an elevated level.

The most important part of the report is related to the fact that interest rates are expected to increase only gradually as the economy is too weak to withstand sharper increases. The necessary rate needed to keep the economy operating close to its full potential is low by historical standards. Only if the above mentioned uncertainties and productivity, and employment slowdowns fade will the FED increase interest rates gradually, if not, rates will remain like this for a longer period of time.

The report is concluded with the case that if the economy were to disappoint, the FED would lower its interest rates.


In relation to the potential lowering of the interest rate in adverse economic situations one might ask:

Lower the interest rate to where?

As the interest rate is at historical lows, a lowering from 0.5% to 0% doesn’t seem at all significant. It is highly unlikely that demand for houses in a recession will increase if the mortgage rate decreases from 3.75% to 3.25%. In order to be significant for the economy, interest rates have to really have an influence on demand as they had in the previous monetary interventions.

figure 1
Figure 1: FED interest rate changes. Source: Trading Economics.

Probably everyone expected that the economy would pick up like it did in the 1990s and 2000s, but it hasn’t in the last several years, at least not enough to ignite inflation or allow interest rate increases. This puts the FED in a difficult position as it has no maneuvering space if any economy shocks happen. The good news in the bad news is that a similar situation is affecting Europe, Japan and China, so the FED can keep interest rates low without severe outflows of capital.

Long Term Outlook

Keeping the interest rates unchanged is probably the only thing the FED can do at this moment as there are no clear indications in where the economy is going. The current home sales are at a nine-year high, but this again does not change the structural problems like the low productivity because with a sold home no value is created, only on paper due to the increased asset prices further fuel the asset bubble. The median house price increased by an astonishing 4.7% compared to last year.

The low interest rates will weaken the dollar in relation to other currencies and thus make U.S. exports more attractive. Also, corporate earnings will be higher when translated to dollars which should have a good impact in the upcoming earnings season.

figure 2 dollar
Figure 2: Dollar index has been falling in the last 6 months. Source: Bloomberg.

But, the structural issues are still lingering behind the good news and sooner or later, hopefully later, will have an impact.

The FED will continue in trying to keep things stable which is remarkable, and no one can know how long the FED will succeed in this. Perhaps even for years as it has already been doing this for more than 7 years.