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The future of inflation and Fixing your mortgage rate

This morning I saw a chart about Fixed mortgage rates by FRED.

If reminded me I believe rates have reached bottom. I think it is the time to consider switching your mortgage to fixed rate.

I'm a believer of lower for longer but 3-5 years longer not mortgage duration longer…

It’s important to remind that no one can predict the future. It’s a bit easier with longer term ideas, but even then, it is almost impossible when considering a country like Japan that spent its last 30 years in roughly 0% inflation. 

Switching to fixed rate has a price – you start by paying more, until inflation and rates rise, in which case you end up paying less. When seeking clues for potential sources of future inflation, consider government Debt to GDP ratios (which I believe will eventually depreciate the yen for example), and for shorter term look at the DXY (dollar index) and remember that a weaker currency translates directly to imported inflation.

I have some difficulty in figuring out if market forces alone can push up inflation, even when politicians and central bankers behave “right” (assuming they know what “right” is). I know for sure that, proper policy can make, and break inflation. I happened to live through both policies. So at least in theory, policy makers can keep it lower for much longer. As for reversion to mean, research shows that long term rates do not revert to mean (Google interest rates reversion to mean for more).

For the purpose of this argument let’s assume then, that policy makers alone can control inflation, that there is no such thing as reversion to mean of interest rates, and that rates are not contagious (i.e. correlation between the 2 charts above is purely coincidental, and exogenous factors cannot affect multiple economies at once). I simplify and assume responsible people is both a necessary and a sufficient condition. The only remaining questions is: Can we expect to have responsible people for an extended period of time?

While it's possible to believe people in the helm will always be responsible (Google hallucinations) and that therefore inflation will not raise its head, there are some examples to the contrary (of responsible people, and of inflationary regimes). I could mention some names, but in 2017 you get quasi daily reminders about irresponsible, and if you want example of inflation – just Google hyper inflation and countries which defaulted. . .If you disagree on this point, read http://www.webmd.com/brain/what-are-hallucinations as there seem to be treatments.

Please consider 3 additional points:

1)      Does your government raise debt with flexible rates? Most chances are that it does not. Only countries that have been through hyper inflation are forced by markets to issue such debt. If it was such a good idea, maybe governments would voluntarily choose borrowing this way. They don’t. Borrowing Fixed rate, and generating enough inflation to never pay interest (and some would argue principal) is a better idea.

2)      Is your government debt rising or falling? I believe continuously rising debt can only spell future inflation. It’s like being married to an alcoholic or someone suffering from another addiction. There is rarely a rosy resolution for these situations. For countries which are lucky enough to issue debt internally, or externally in their own currency, gradual currency devaluation is not the only solution, but it’s certainly the most compelling one. In fact it’s so tempting for various reasons, that there’s currently an ongoing war of currency devaluation. If you happen to carry debt, being on the same wagon as your government makes a lot of sense to me…

3)     Fixed rates bring you certitude. If you weren’t there last time low tease rates did not equate “a good deal”, try to refresh your memory.

A decision about mortgage is a very personal one that only you and your family can make. If you’re thinking it might make sense, talk to some old people and ask what they think. They surely lived through more history than you did and can help you decide.

Last but not least. I keep asking myself about inflation because it has direct bearing on investments. I believe that the future remains in equities as an inflation hedge, and that this remains true with almost any inflationary/deflationary scenario, the exception being an irresponsible rate spike.

[iopticks-blog]

Will we have a 50% market crash in this decade? I think not.

In the currently frothy valuations, and 0 interest rate policies, I ask myself whether or not we going to have a 50-60% market crash? I think not.

The technician in me tells me that Warren Buffet is right in predicting very low returns over the next 10 years, due to current valuations. The saying that what goes up must go down keeps echoing. staying in such a market is still the right thing to do, unless you believe you are going to get this low return while the next correction is going to be as big as 2008. To me, the next big crash is going to be a 30% and not a 50-60%. Let’s try to build the basic scenario and ask how probable it is:

For a market 50%-60% crash to take place I consider we need to 3 things to happen:

1)      A “return to normal” of interest rates.

2)      That there’s no such thing as new normal (lower for longer).

3)      That central banks reaction function will be lagging and slow as in the past (e.g. 2008).

Why do I think each of the 3 is needed? As Buffet says, it’s all a question of interest rates. If the long term real interest rate is 2%, a revenue stream capitalized based on this rate is the equivalent of P/E of 50 in equities. If it’s 1% then it would justify a PE of a 100 (PV of perpetuity = annual return/annual rate). I’m the first to agree that an investor’s expected return and capitalization factor is not determined only by FED’s rate, but it’s certain that there’s a lot of influence. That is to say, I am convinced that if rates won’t return to previous normal, we can never expect the same PE levels or debt yields to serve as a reference point. If we agree with “lower for longer” on rates, we should embrace “higher for longer” for P/E ratios. In other words, I’m claiming that for a 50-60% crush to occur we have to ignore history, and hit the market with previously seen 6-7% rates. In lower rate environments of 2-4% any correction will be taken as an opportunity to enter the market. Furthermore I consider that even if the RATES OVERSHOOT, the FED, ECB MUST ignore the ensuing price reaction & economic slowdown for such a crash to take place. For a full blown crash people need to feel there is no bottom and there’s no one to bail them out. On the contrary, if (3) does not occur, I consider that central banks can re-flate anything back if acting fast enough. I’m not saying this system is good. Only that in such a system equities is the place to be.

So if you are convinced like I am that such a crash requires 6% or higher rates, as well as silent central backs, read on and ask yourself how probable it is.

Let’s assume that we will return to normal interest rates. Is it going to be the previous normal or a new normal? I think that post 2008, post QE and post the current negative interest rate policies around the world, there are new proven tools in the game, and new go to rules of response. It’s obvious to me that there will be a “lower for longer”, and that the new normal is a lower interest rate. The big reason, as I see it, is that until the monetary system somehow collapses via a meaningful migration to crypto currencies, it remains very beneficial to both corporate and governments to exploit the fiat money “tax by inflation” system. The erosion of fiat money is a tax. Now that you must use it, You must use it even if there isn’t an interest rate incentive to save it, and even if there’s negative rate incentive not to hold it. These are new circumstances where the only good usage is when you are a debtor – either corporate or government. The other side of this equation are today’s coerced suckers of monetary systems everywhere in the world. Until the current monetary system is abandoned (and this is very difficult to do legally), the sovereign can keep playing us with lower rates. And just because they can, they will. This, for me negates (2), and confirms a lower interest rate “new normal” will persist for the coming decade.

However, I believe central banks will test the water and continue raising rates until it’s too much, too late. It’s because they have near 0 control on the lead/lag/momentum of the resulting inflation. It’s not fly by wire but rather fly by telepathy. At one point, when inflation starts rising they’ll raise more, or too much. In other words, I don’t believe central banks will ever play this game “well”, or nail it to perfection. It has never been the case and will never be the case, and even if it was, there is always going to be another cause to trigger a recession. Every cycle comes to an end eventually.

So even with lower for longer, at some point, the markets will reverse, the central banks will be wrong or too late, and a considerable correction will ensue. With this decline in mind we will remain with evaluating the 3rd argument. Will central banks react?

The problem with crashes, is that they are quick and dramatic, and that central banks are slow to react. But if central banks have learned anything from the last crisis, it’s that there is ALWAYS more room for manipulating the markets with negative rates, and that there are tools for actually forcing negative rates, as well as bond yields. That is to say, central banks may make mistakes as in the past, but have become much more adept at reacting (or manipulating the markets as some say), taking more drastic measures to revive the credit markets and indirectly the equity markets. While that’s all they do - fixing the financial markets, the byproduct effects on the economy are real. After writing this last phrase I notice how well the term fixed fits. Now, maybe the word rigging comes to mind when you read this and live this, but if you don’t thinks this was is and will be the right response, then maybe you have not the last crisis hard enough. Kudos to Bernanke.

To conclude, I believe we can count on a faster stronger central bank response next time, and while I’m not happy that about 3 CB chiefs are somewhat rigging the global markets, it reassures me that a 50% crash will most probably be avoided. In other words: CB chiefs have seen and learned 2 things: that if they don’t act heaven can and will fall, and that monetary policy can do a lot to save the markets (even if it harms the average Joe).

Sadly, all this doesn’t tell you when and if the S&P will take a 30% hit, but I really don’t see how it will go to 1200.

There’s one more argument that will make such decline so improbable. Since the equity indices represent nominal currency denominated numbers and in 2017 the USD, EUR, and YEN are not remotely their equivalent of 2009. A return to 1200, is equivalent to a return to 900. The rest is just hidden inflation. You can take a 100 economists that will show you inflation curves to show the contrary, but for me, there is hidden inflation and measured inflation, and thankfully you have BitCoin, Gold, Real estate and Equity Markets (yes), to give you an alternative view of the decline in the value of the dollar and real purchasing power.

When listening to people like Mr Draghi, I become very confident that bankers won’t sleep again. There are many countries now that know how to pull their QE trigger, and will compete on who pulls it first and who pulls it harder. Hopefully, this will save you if you are in the equity markets.