Here are some things I think I am thinking about:
1. Bill Gross is mad about short-term interest rates being so low. The latest monthly update from Bill Gross details the many reasons why the Fed is causing low returns and hurting the financial markets. I always find this view to be so strange. It’s as if some people think the Fed is some omnipotent entity steering the economy around at will. The reality is that the Fed is just one entity (yes, a powerful one) in a much bigger system and they’re constantly responding to the current environment trying their best to influence it in a certain direction. But we should be very clear about the state of interest rates. Rates aren’t low because the Fed has set them low. Rates are low because the Fed responded to weak economic growth and low inflation.
Think of it this way. If the Fed set overnight rates at 10% you’d almost certainly have an immediately inverted yield curve. Banks would be borrowing at 10% and lending at a 30 year fixed rate of 5% or so. The reason long rates wouldn’t jump very much is because the economy couldn’t handle it. If there’s low demand for mortgages at a 4% interest rate then 5% or more is just more punitive. In other words, you suffocate demand for debt by making it more expensive. This would crush the banking system and the private sector and very likely cause a recession during which the Fed would have to revert right back to where it was before they made their policy error.¹
What’s weirder about these complaints from Gross is that Gross is clearly talking his book. According to Bloomberg the Janus Unconstrained Bond Fund has a 85% weighting in bonds with a duration of less than 5 years. That’s been making life very difficult for Bill Gross because there’s no yield out there. So, by calling for higher rates Gross is basically saying that he wants a risk free subsidy from the government. So yes, the Fed might be hurting certain investors. But as I’ve noted before, the Fed is hurting investors who haven’t been wise enough to diversify their financial assets outside of cash and cash equivalents. For those investors who did diversify outside of these assets the financial markets have been quite good to them….
2. Young People Still Don’t Have a Higher Risk Tolerance. I got a lot of good feedback on my post about young people and why they don’t have a higher risk tolerance just because they have a longer time horizon. The most common response was that Modern Finance specifically states that a young investor should be aggressive with funds that are for long-term needs.
Okay, but life is a lot messier than that. Most of us have no idea what life will look like in 5, 10 or 20 years. Most of the young people I talk to don’t know if they’ll buy a home, how many kids they’ll have, where they’ll be working in 10 years. Being young and having high expenses relative to net worth makes the need for certainty all that much more important. And being young is all about uncertainty. The thing old age creates is certainty because you can be certain that you don’t have that much time! Of course, there are lots of young people who have a high degree of clarity on these matters, but my point was simple – be very careful with overly simplistic risk profiling processes and oversimplified rules such as “your age in bonds”. Your financial life is a lot more dynamic and complex than simple rules make it out to be.
3. Risk Parity Didn’t Do it. There was a lot of fancy sounding analysis out of JP Morgan and other “quants” in the last few weeks trying to explain the flash crash that occurred last month. One of the popular culprits was risk parity funds. I spoke to a friend of mine who works at a rather large risk parity fund who said that their portfolio barely even changed during the stock crash. His basic conclusion was – I don’t know how our strategy could have even caused something like this because most risk parity strategies are relatively passive in nature. And that’s the basic conclusion we’re hearing from the really big risk parity players like Ray Dalio and Cliff Asness. Despite some of the obvious inabilities for these strategies to cause such a thing, this didn’t stop numerous news outlets from publishing what was little more than a scary sounding and sort of plausible explanation.
Personally, I still think the crash was the result of a strange confluence of algo driven momentum trading in the futures markets. This isn’t the first time we’ve seen this sort of death spiral in what is clearly a computer driven crash. And it just makes too much sense that, if you have a bunch of momentum algorithms chasing what looks like a one way momentum trade then that momentum feeds on itself until it resembles a vortex and swallows the market. I could be wrong, but one thing that’s probably not wrong is that risk parity doesn’t have the turnover or scope to cause a major global market crash.
¹ – Just to be clear on this point: banks do borrow from one another in the overnight market, however, they do not borrow reserves in order to be able to create new loans. They make loans and borrow after the fact if they must.