2015 Interest Rates

Over the past weeks as I read the predictions for 2015, I have been mulling different points of view about where interest rates are headed in 2015.  I think I have made up my mind that interest rates will be heading lower in 2015.

This chart as highlighted in this Business Insider article is rather telling:

Looking at this chart, the yield on the 10 year US Bond (the white line) appears out of line with the other primary developed countries. If you believe the US economy will stay the course in 2015, in comparison to its foreign peers, you would expect the US yield to be closer to the others.  Interestingly, given Japan’s debt problems, the Japanese debt also appears to be mispriced;  .03% seems awfully low for a country with the highest debt load of any country – investors in Japanese bonds seem confident that they will get all of their money back in 10 years. I would not be that confident.

So how low will interest rates go?  After all, they are almost at 0% now.  Well, we are in historic economic times – and negative interest rates are spreading.  Look at this price chart of German Bund interest rates:

The Swiss Bond Index is also negative, so its not inconceivable that US Bond yields could go negative this year.  So conventional wisdom was rates have nowhere to go up – but this shows how we are in very unconventional times and it may be time for unconventional thinking.

I ran across this post regarding the increasing risk of deflation, and this chart caught my eye:

It is interesting to me how this shows clearly that as Quantitative Easing has winded down in 2014, the inflation that the Fed was manufacturing immediately died down.  So that got me thinking, is deflation such a bad thing?  Why has the government used such a historically drastic strategy  to try to spark inflation and avoid deflation?  On the surface, it would seem to me that deflation is a good thing for savers and workers ( wages typically do not keep up with inflation).  If you have huge debts (like the government)  deflation would be a bad thing as it makes your debt more expensive.

So I did some searching and found a couple good arguments on whether deflation is good or bad.   First up, Paul Krugman had a good article on why he thinks deflation is bad.  He gives three reasons why deflation is bad – I would encourage the reader to read the article and decide if the arguments make sense.

I also found this article covering how there is good deflation and bad deflation.  The article makes some of the same points as the Krugman article, but covers some different scenarios.

In reading these articles, I guess I haven’t made up my mind if deflation is good or bad. Arguably in late 2008 and 2009 we were on the brink of bad deflation due to the high household debt and drop-off in economic activity.  However now, it appears that the dropping oil prices and productivity improvements hint at ‘good deflation’.

I am going to keep mulling this whole issue over in my mind for awhile.  Because looking at the above chart – good or bad – it looks like we are about to be hit with a dose of deflation.

If you are an investor in Nordstrom (JWN) you should take a look at the December 2014 Investors presentation they released.  The chart from that presentation that got me thinking was this one:

Nordstrom’s is gaining traction on selling clothing online.  Nordstrom seems to have built the best of both worlds – with free shipping and their reputation for liberal return policies, they have given the consumer the ‘in-home dressing room’.

Business Insider also just ran this article discussing what Nordstrom is doing right.  So I wonder – who is  their biggest competitors in the online space?  There are the super high end retailers – i.e Tiffany’s and Nieman Marcus, but they don’t have the mass appeal as Nordstrom.  On the other end you have Macy’s, Target, and Amazon, who I don’t believe they draw the same class of consumer. So I think they have built a pretty decent spot fort themselves in clothing- a unique combination of online presence, customer service image, and brick and mortar stores.

Investors are taking notice – the stock is up 120% in five years, and is currently pretty richly valued.  But if you are a long term investor, or  if we see a pullback in their stock price,  I think Nordstrom is a company to consider for your portfolio.

A lot was written in 2008 about the moral hazard of the federal bailout of the banks and financial institutions during the great recession.  Then Treasury Secretary Henry Paulson was quoted  as saying 

the Fed made “the right decision” and expressed “great confidence” in its chairman, Ben Bernanke.  Paulson said that in the case of Bear Stearns, the risk to financial stability outweighed his concern about so-called moral hazard, in which investors come to expect government rescues.

I was reminded of this when I read this interview with hedge fund manager Hugh Hendry.  A self confessed bear who capitulated in the wake of central bank intervention.  The full interview can be read here, but this was what I thought was his most important point:

I have concluded that my risk tolerances were too taut and it was creating too much of my own intervention, in the portfolio, and it was damaging to the client’s performance. So I’ve pulled back or I’ve widened the tolerance of the portfolio.

Merryn (Interviewer): So your basic point here is that if the central banks have your back, there’s no need to have the same kind of risk controls that you used to have.

Hugh: There is less need. Less need. I tell you, I was at a conference with some of the great and the good global macro managers in September in New York and I asked them all the question, “If the S&P is down 12% what do you do? Are you selling more or are you buying?” Guess what? They’re all buying. So the central banks have created a behavioral tic which is becoming self-reinforcing and I believe we saw another manifestation of that behavior in October.

We have seen government/central bank intervention in the US, we are seeing government intervention in Japan, and we are about to see it in Europe.  Yet nobody is talking about the moral hazard this presents and, according to Hugh Hendry, is leading to a widespread increase in risk taking in the financial community.