Recent developments in the debt markets have taken an astonishing turn. We are witnessing phenomena like negative real interest rates, which sound almost impossible. To our astonishment, banks are paying depositors less than zero for their money. In simpler terms, savers are effectively losing money by lending it to banks. What could be the reason behind this?
Negative real interest rates occur when inflation surpasses the interest rates offered on savings. This unusual scenario often arises from significant government interventions in the markets, such as quantitative easing. The idea is that during periods of negative real interest rates, savings accounts end up penalizing savers. The Federal Reserve’s intention with this strategy is to encourage spending and stimulate economic growth.
We find ourselves in such a scenario today. Surprisingly, the best course of action for savers in the short term may not be as straightforward as it seems.
Last Friday, we noted that Bank of America’s Certificates of Deposit (CDs) were offering an annual percentage yield of just 0.35 percent. Shortly thereafter, the Labor Department announced that the Consumer Price Index (CPI) had increased by 0.4 percent in April, equating to an annualized increase of 4.8 percent.
This indicates that, in less than a month, inflation will completely negate the CDs’ total annual real return. Over the course of a year, the CD will yield a real return of approximately -4.45 percent.
Under typical circumstances, a -4.45 percent return on a low-risk investment with minimal upside would be considered unfavorable. However, we are not living in typical times; we are experiencing rather extraordinary circumstances. For various reasons discussed below, we believe that in the coming months, preserving your capital will outweigh the quest for investment returns.
Stock Market Real Returns
For more than two years, the stock market’s recovery rally has surged forward with minimal interruptions. A quick glance at DOW charts may give the impression that this upward trajectory is unending. However, when we broaden the perspective to include the entire period since the dawn of the new millennium, a different narrative emerges.
The DOW opened at 11,501 on January 3, 2000, and as of last Friday, it closed at 12,595. Over the span of the past 11 years, the DOW has increased by about 9.5 percent, averaging a mere 0.86 percent annually. Yet, in real terms, the situation is far more dismal.
According to the government’s CPI Inflation Calculator, $1 in the year 2000 is equivalent to $1.31 in 2011. In simpler terms, it now costs $1 to buy what only required $0.77 in 2000.
This indicates that the dollar has lost approximately 23 percent of its value over this period. Furthermore, the DOW’s inflation-adjusted return during this timeframe sits at a staggering -13.5 percent. When compared to gold, the DOW has suffered significantly, losing over 78 percent since the year 2000.
What Does This Mean?
It is clear that the overarching trend has been one of rising gold prices and declining dollar value. While the stock market has remained relatively flat in nominal terms, it has experienced sharp declines and vigorous recoveries throughout this time.
The stock market’s rebound after its substantial crash in late 2008 and early 2009 has been primarily fueled by extensive debt monetization. This increase in the money supply has also contributed to the rising gold and declining dollar narrative. Without these interventions, the stock market would likely not have regained and exceeded its previous levels in the past two years.
Nothing in financial markets moves in a straight line, of course. Historically, over a long horizon of 25 to 30 years, the stock market has generally trended upward, though intermittent sharp declines can occur. Here at Economic Prism, we believe we may be approaching one of those unsettling periods.
Since the Federal Reserve announced QE2 on August 27, 2010, the DOW has risen by over 24 percent. However, with the conclusion of QE2 scheduled for June, does it make sense to invest in stocks right now? Historical price trends indicate a propensity for sudden sell-offs—akin to what transpired in the second quarter of 2010 between the end of QE1 and the announcement of QE2.
If stocks might not be a wise investment currently, what about gold? Like the DOW, gold has risen over 22 percent since QE2’s announcement but appears to be reaching a peak in the short term.
In the next six months, unforeseen events are likely to unfold, and they will probably be impactful. As quantitative easing winds down, it seems probable that asset prices will decline, forcing a stronger dollar. During such times, the preservation of capital will become far more critical than seeking returns on investments. In fact, even in a climate of negative real interest rates, holding cash could prove to be a prudent strategy.
It’s important to note that a significant correction in the stock market due to persistently high unemployment might compel the Federal Reserve to embark on further reckless measures, such as a new round of QE3. Should that happen, cash will become the last place any investor would want to be.
Sincerely,
MN Gordon
for Economic Prism
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