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Has the Fed Defused the Neutron Bomb?
Bruce Friesen of Global Investment Solutions forwarded Randall Forsyth's article which appeared in Barron's earlier this week, Deflation: the Neutron Bomb of Balance Sheets:
Low interests rates have made these the best of times for borrowers but the worst for savers and investors.
Blue-chip corporations never had it so good with the likes of Dow Jones Industrial Average members International Business Machines (IBM) able to issue new three-year notes at 1% and Johnson & Johnson (JNJ) paying less than 3% for new 10-year debt.
But
these historically low bond yields have a darker side: According to a
new report from Fitch Ratings, ultra-low interest rates will exacerbate
the underfunding of many U.S. corporations' pension plans.
Just as with American workers who have failed to save enough for retirement and have seen their assets lose value, companies also will have no choice but set aside more of their earnings. And just as that means belt-tightening for consumers, it means corporations have less to distribute to their shareholders.
The
burden of funding traditional pension plans—known as defined-benefit
plans—is why they have waned in Corporate America. More common are
defined-contribution plans—such as the ubiquitous 401(k)s—that have
supplanted DB plans in the private sector. As has been reported widely,
DB plans remain the standard in the public sector, which are decimating budgets of many states and municipalities.
But,
according to Fitch, the low-yield, deflationary environment is adding
to the problems of underfunded corporate pension plans. Again, the
problem is two-fold: The decline in the values of investments, such as
traditional stocks and commercial real estate, has hurt the asset side.
The rush into so-called alternative investments such as hedge funds
right at their peaks didn't help. The flip side is that low interest
rates increase the present value of future liabilities.
(Time
out for those who aren't finance geeks. If you put $1 in a savings
account at 7%, in 10 years you would have $2. Trust me on that. That
means the future value of $1 in 10 years, compounded at 7%, is $2.
Conversely, the present value of that $2 invested for 10 years is $1.
But
what if interest rates are just half as high, or 3.5%, a far more
realistic yield for a 10-year, high-grade corporate bond? The present
value of that $2 in 10 years is $1.42. Trust me again on that, or get a
financial calculator or find one on the Web. In other words, where it
took only $1 for you to wind up with $2 in 10 years if you invest at 7%,
it takes an investment of $1.42 to end up with that same $2 in 10
years at 3.5%. That means you have to set aside 42% more today to meet
your savings goal a decade hence.)
Thus,
a decline in bond yields can be as devastating to a savings plan as a
drop in the stock market. According to Kenneth S. Hackel, president of
CT Capital, a financial advisory firm, 1% cut in a retirement plan's
assumed rate of return is roughly equal to a 15% decline in stock
prices.
Fitch's analysts find the mean assumed return for
corporate pension plans in 2008 and 2009 was 8%. That's with an
allocation to fixed-income assets of 34% of the total. Treasuries and
investment-grade corporate bonds yield far less than 8%, which is
closer to the very long-term return from equities, which means they
haven't locked in much of yesterday's higher yields. And, in case you
need to be reminded, over the past decade or so, the return from stocks
has been practically nil.
In line
with Hackel's rough calculation, Fitch reckons a 1% cut in the assumed
discount rate for companies' DB plan can result in a 10%-20% increase
in the present value of future liabilities. How to bridge that gap?
"The
fact is that there are no shortcuts—prudent management will likely
require contributions well in excess of the minimum required given low
yields and low equity returns," Fitch analysts write. Simply hoping for
higher equity returns or bond yields simply isn't prudent, they add.
So,
what's the answer? You know those hefty cash holdings on corporate
balance sheets on which the bulls keep harping? Fitch thinks pension
funding requirements will have dibs on corporate cash flows, and then
the stock of cash on companies' balance sheets.
That's the thing about deflation; it's like a neutron bomb for corporate, public-sector and consumer balance sheets.
Asset values and returns get decimated while liabilities remain
standing. Except that falling interest rates make those future
liabilities more onerous, requiring more belt-tightening, which only
exacerbates the deflation.
As I've repeatedly
stated, deflation is the arch nemesis of the financial sector and the
Fed will do whatever it takes to avert it. Moreover, in order to address
pension deficits, you need a rise in bond yields (lowers present
value of future liabilities) and a rise in asset prices. In other words,
you need a lot more days like Friday where stocks took off and bond
yields backed up.
The Fed's policy has been geared towards the
big banks and their big hedge fund clients. Reflate and inflate is the
official policy. By borrowing at zero and investing in higher yielding
Treasuries, banks lock in the spread, making instant profits which they
then use to trade risk assets all around the world.
Is this
policy succeeding? Yes and no. It's helping banks shore up their balance
sheets and some elite hedge funds who thrive on volatility, but doing
little to help the real economy which remains weak at this stage of the
cycle.
However, that all may be changing. Over the weekend, I
will go over some encouraging signs that receive little or no attention
in mainstream media. Below, listen to an interview with Nigel Gault,
chief U.S. economist at IHS Global Insight as he discusses his views on
the US economy and his take on Ben Bernanke's speech at the Fed's annual Jackson Hole confab.
»
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I believe that Obama's loss of the independent vote is partially due, among many other reason, to ZIRP. If you buy into Benron's point that households have entered a virtuous cycle of paying down debt and increasing their saving (the household savings rate has increased to 6%), then savers have every right to be outraged at the rotten 25 basis points that they are getting from their TBTF masters.
We get all of these bullshit proposals for putting money into people's hands, but nothing would help engender the virtuous cycle of domestic savings which leads to capital creation more than a simple bump up in the rate which savers are paid and, incidentally, help the problem described in the article. KILL ZIRP!
i'm continually surprised that you hear so very little about the negative effects of zirp.
are there so few savers out there?
is AARP saying anything?
or did all the seniors go out and buy $600,000 crackshacks too?
Truth is not allowed when fishing for new or resurgent Debtors on the Banks of deNile.
It's not fair to destroy the dollar and cheat responsible savers! - Ron Paul to Ben Bernankehttp://www.youtube.com/watch?v=9FhLNaop3oE
Life's not fair! - Ben Bernanke to Us and the Horse We Rode in on.
when everything is deflating, not earning any interest but simply not losing money, puts you ahead. I have got 3 percent on my 401k in 2008 and I was quite happy about it compared to my coworkers...
Their savings are earning more than that. It's not really saving that is going on, it's paying down debt that is carrying a much higher rate than ZIRP rates. There is no connection between credit card rates and ZIRP rates. Usury laws have been gutted.
Bruce,
Have you ever stopped to think that maybe, just maybe, the Fed's policy is working and that they won't need to engage in QE 2.0 (but will continue talking it up?). I think you and a lot of other growlers here will be very surprised with what will transpire over the next year. I don't care about what Krugman is writing or what Soros is saying out in public. I care about what the top hedge funds are actually buying and selling. Everything else is just noise to me.
There will come a point where, if he DOESN'T do anything, Benny will have to (properly) QE2. In the meantime all he has to do is intimate that he WILL do and the stock market rises. Why, with all the bad data this week (and a GDP figure of 1.6% against a forecast of 1.4% is NOT good news), are the Dow and S&P otherwise still above 10,000 and 1040?
The only bullet left in Ben's armoury (English spelling) is overt QE2 - he's not going to use it unless he really has to.
DavidC
leo - never have I have so wished someone was right when I so know someone is so wrong....its like someone telling me, after I buried my treasured pet cat myself, that my cat is not dead but is alive back at my house...I so wish it was true but I know, my cat is worm food.
Yes, a lot of people are going to be surprised -- surprised that debts hidden and postponed are still debts, and they cannot remain unserviced forever. Naïveté is cute in small children, but when I see grown men embracing it, it makes me cringe.
Hmm. Follow the leader?
You are aware that we had another flash event last Friday. This time INTC. Not some $4 micro cap. It only lasted 2 minutes and of course all the "bad" trades were reversed.
You want to put all your oars in that water? One day this will happen to one of your Chinese solars.
Last at 14
Last at 14
Now on the bid at 3/4's
Now on the bid at a 1/2.
Offered at 13.
Offered at 11.
Offered at 9. No Bids
7 trading, 7 bid.
7 Trading, 6 offered.
5 trading.
Closed at 5.
If you do not think this is in our future you will be wrong. I'm telling you, read the Barrons.
bk
I was going to comment...but what's the point?
lol, when u r right the next time leo, it'll be a first for you. not to hate, but u really add nothing to the site unlike Reggie, Bruce et al.
Going to disagree with you on this one Sweaty. Leo adds a lot to this site. He is of a different mind then most that come here. He is an optomist. He believes that Ben and Tim can actually fix things and we will have a Goldilocks ending.
I always read his stuff. Not all his information is "rosy". And I love to argue with him.
If everyone said it was going to be black, it would never be black. We need Leo.....
bk
"If everyone said it was going to be black, it would never be black."
Dead-On.
Agree with Bruce...Leo adds to the conversation...I frequently take the other side, but at times I really hope he would be right...Bruce thanks for what you do also...
Now, if we could just get Johnny Bravo to take a hike...
Better be nice to Bravo RR, he's going to be the next Fed Chairman!
Buried canned ham in the backyard Biatchies!
+1000
I am not interested in competing with anyone on ZH, and judging by the institutional funds who regularly read my site, I think I'm adding enough to keep them coming back. :)
I am not interested in competing with anyone on ZH, and judging by the institutional funds who regularly read my site, I think I'm adding enough to keep them coming back. :)
And what do these "institutional funds" pay for regurlarly reading your site.....ZERO! That would appear to confirm their assessment of the value proposition.
Astute,
What a dumb comment. Plenty of free site sout there, including ZH. If they're reading blogs it's because they find value in the content or else they wouldn't waste their time.
Leo, there is plenty of free content out there and most of it is worthless so that's why it is free - users are unwilling to pay for the content. ZH is an exception because there is so much ORIGINAL and VALUE-ADDED commentary from Tyler et al, as well as a select group of contributors. I contributed $100 to ZH because there is so much valuable information and I'm guessing I'm not alone among the active participants. Also, there is a difference between people "reading" and "visiting" blogs. Articles on ZH generate thousands of comments which means people have actually read the articles. Does anyone even comment on your blog site?
I have visited Pension Plus and it functions more like a specialized Internet search engine for stuff related to pensions. It saves you time from doing your own Internet search, but your personal commentary and insight is certainly no where near the quality of what is found here on ZH.
By the way, how do you know that people that visit your site are "institutional funds" given blog participants / readers are essentially anonymous?
Excellent! So the huge run up in equities based on a presumption that QE^2 was a given will crash in epic style once it become evident that it's 'not needed'.
Right...sure...uh-huh...
It's all a big hoodwinking and unemployment is really improving, housing is on the mend, pensions aren't collapsing, the money supply isn't shrinking, trade deficits aren't climbing, and the Detroit Lions don't still suck.
What kind of fairy dust do you snort and where do you get it?
Boilermaker,
I am not a permabull or permabear. In fact, my concern over the credit bubble got me fired back in 2006. I was considered "too negative", but after researching the nonsense going on with CDO-squared and CDO-cubed, I knew we were flirting with disaster.
But policymakers around the world got the wake-up call of their lives and they have responded. Could it happen again? Sure, anything can happen again. Some large hedge fund can blow up tomorrow, and the ripple effects might cause serious damage. But I doubt we will see something like 2008 anytime soon.
I know a lot of you think it's going to get much worse before it gets better, but in my opinion, you're way too emotional, way too focused on your current situation, and are falling for the classic behavioral trap of using recent events to extrapolate the future.
I think the world's power elite will do whatever it takes to quash deflation. This doesn't mean they'll succeed, or that massive hyperinflation is a given, just that they will continue feeding the banks until the financial system has stabilized.
As deflation and inflation headwinds compete, you will see lots of speculative activity in the markets. You can sit on the sidelines, earning nothing, or learn to adapt and make money.
I realize the latter option is not realistic for the majority of the population who cannot compete with the algos and wolves manipulating these markets, which one of the reasons why I think we need to have a global forum on bolstering our retirement systems. Too many people are slipping through the cracks and my biggest fear is that they won't enjoy the retirement they worked so hard to achieve.
>I think the world's power elite will do whatever it takes to quash deflation. <
I think the world's power elite will do anything to save their own asses. That doesn't necessarily mean life will get better for the rest of us, or that they will save the economy. Quite to the contrary- Bennie, Turbo Tim, and the rest of the banker elite would destroy this country and enslave the people, as long as they keep their wealth and power. Stick around Leo, it's happening now.
I am not a permabull or permabear. In fact, my concern over the credit bubble got me fired back in 2006. I was considered "too negative"...
Is it possible you got fired because you were not very good at your job???
"just that they will continue feeding the banks until the financial system has stabilized."
The issue I have Leo, is how will the financial system stabilize when all of the bad real estate debt, both commercial and residential, has not been dealt with? How will the financial system rationalize when the world is awash in liquidity and you see overnight bubbles form in currencies like the one that formed in the euro and has now run to the yen and will then run to another currency thereby causing imbalances throughout the world? How will the financial system stabilize when your beloved Greece takes a 25% haircut on its debt and makes the European banking system insolvent?
And finally, why do you believe that the same people who got us into this mess are the same people who will get us out?
"And finally, why do you believe that the same people who got us into this mess are the same people who will get us out?"
Always ask yourself, what do the power elite want? Who benefited from the financial crisis? Is financial power more concentrated post 2008? Do the power elite prefer inflation or deflation?
When a parasite kills its host, we wonder why? After all, as long as the host is alive the parasite can prosper. Why would a parasite want to see its host expire? Well, in many instances the parasite simply lays eggs in the dead host and preparations are made for a new parasite generation. The upper levels of both financial and political strata are preparing to benefit from the death of the current system. They will arise from the carcass and begin anew -- stronger, more adapted, and spreading further.
I would also add that if we follow the smell to the corpse, and we watch the process carefully, we will see the parasites digest all the gold, silver and other hard stores of value as nutrition for the new eggs.
I know of a few small pieces they won't get...
In the economy, it seems there has been no debt deflation yet, reflation has postponed the inevitable as the sovereign debt black hole gets bigger. How long can Bernanke out muscle deflationary forces? Until sovereign defaults begin?
When that begins, will the baby boom voting bloc sacrifice their bond holdings to save their entitlements? Or, sacrifice their entitlements to save their bond holdings?
Somebody should ask AARP.
The constituency of the elderly is also the biggest competitor to bond holders because of the considerable size of the direct claim it has on the government balance sheet in the form of pensions, social security and health insurance, etc.
http://www.zerohedge.com/article/morgan-stanley-says-governments-will-default-only-question-how
Consumers have actually taken on $500 billion of additional debt since the end of 2008; consumers haven't cut back at all. They're still spending and borrowing. It's beyond my comprehension that no pundits or mainstream media outlets can do the simple math to realize that this deleveraging story is a fairy tale.
http://www.zerohedge.com/article/guest-post-great-deleveraging-lie
Gross OTC Notional Picks Up, $605 Trillion (10% Increase) In Gross Notional Derivatives Outstanding
http://www.zerohedge.com/article/gross-otc-notional-picks-605-trillion-10-increase-gross-notional-derivatives-outstanding
U.S. Trade Deficit Unexpectedly Widens to $49.9 Billion in June
http://www.bloomberg.com/news/2010-08-11/u-s-trade-deficit-unexpectedly-widens-to-49-9-billion-as-exports-decline.html
Leo confused?!?!?
This is supposed to be news, Bruce?
Here's a good one;
http://truthingold.blogspot.com/2010/08/gld-managing-director-jason-tous...
Jason Toussaint own's exactly ZERO shares of GLD...ROTFLMAO!!!
Further;
"Note that on page 76, as Jeff Nielson picked up on from the BNN interview, that NO officers and directors of the World Gold Council or of the GLD Trust own ANY shares. No insiders own shares. Why would that be the case? If GLD is as good as owing physical gold, and is fully backed by physical gold, why would Toussaint admit to owning his own physical gold, but not express confidence in the fund that he oversees by owning some the stock in GLD? We would NEVER own any mining stocks in our fund in which insiders did not own a meaningful amount of shares. In fact, with our junior mining stock holdings, insiders typically own 10-20% of the company."
I think I cracked one of my ribs ;-)
yeah last week these WGC guys were hyping some sort of claim that gold demand was way up, you can't believe anything they say, they're just talking their book and selling their product best they can.
I believe Mr.Toussaint is one fiduciary ski short while trying to compete in the slalom.
"Finally, Toussaint makes the statement that the bars are held in allocated form, meaning that within HSBC's vault, all of the GLD bars are placed in a separate holding area and the shareholders of GLD have direct claim to those bars. If HSBC blows up, something that is within the realm of possibilities, the GLD Trust gold is not part of HSBC's asset/liability list. HOWEVER, the prospectus specifically states that gold which is being transported in and out of the vault and the gold which is being held for redemption by an authorized participant exchaning a minumum of 10,000 shares for bars in the Trust, sit in unallocated form. And the bars at the subcustodian are in unallocated form."
Questions.
http://www.youtube.com/watch?v=IBsdHoTdOmc
I don't think that is a neutron bomb in that picture. Do the research...
Thanks Leo,
Always good to know what the enemy is (not) thinking and where the propaganda arms are located.
Leo...Thank you for the assessment.
So now I will ask, other than Chinese solars...what are your thoughts on Brazil and like countries "post meltdown" for investment?
Thanks!
I am not an expert on Brazil but believe in the secular BRIC story. There are ETFs, but most of the top funds were buying Petroleo Brasileiro in Q2:
So the guys you are following bought stock at 45 and now it is 35. Actually the trade has been to short big oil. It still is. What are they going to do when the economy slows down? Raise prices? doubt it.
Bruce,
Top funds are accumulating energy stocks, including solar stocks. Do what you want with this info, but it shows me they think the global recovery will continue and they want to be long energy.
are top funds always right?
looking at that chart CBR may have found support at the 32/33 level. worth a shot from the long side at this point. if it breaks 32 hit the sell sell sell button.
As I've repeatedly stated, deflation is the arch nemesis of the financial sector and the Fed will do whatever it takes to avert it. Moreover, in order to address pension liabilities, you need a rise in bond yields (lowers present value of future liabilities) and a rise in asset prices.
Deflation and low rates kill future savings, inflation and higher rates kill wealth already saved. If we inflate our way to a point where pension obligations can be met, almost by definition those pension funds then won't be able to purchase the necessities for retirees as intended because they will no longer be worth much: good news! - your pension is secure! bad news: your first check won't buy you more than a doughnut and a cup of coffee.
Absent Fed and Muni governments cutting themselves in half overnight there is no way to avoid economic collapse. It will be painful but value will be re-calibrated, leverage will melt away and it just might be the catalyst to ignite the American animal spirits necessary for any kind of robust economy in the future. If we turn into Japan for 25 years (non-collapse fantasy scenario) those animal spirits may be gone forever.
Almost all developed Western economies are headed for the same inevitable endgame. After the deluge I think the U.S. still could have the best shot at eventually roaring back to life - which would piss just about everybody else off royally but cause near-sexual arousal for Mercury.
Pretty insightful. Less the arousal part, of course.
Probably putting the cart before the horse there...just trying to identify the silver lining for once.
Leo you write " I will go over some encouraging signs that receive little or no attention in mainstream media "
How about the apocalyptic
signs that receive little or no attention in mainstream media also ?
Thank you.