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Money Talks

By Dr. Gregg Dimkoff
Professor, Grand Valley State University
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A good many investors are scared, and who can blame them? So far this year, the S&P 500 Index is down 6.5 percent, foreign stocks are off nearly 10 percent and housing prices have yet to reach bottom. There is a little good news: The Dow Jones Equity Real Estate Investment Trust Index is up 0.6 percent year-to-date, and the S&P 500 Index generated an average annual return of 0.4 percent over the past decade. Wait, is that good news or bad news? As we’ve all said many times, it could be worse.

As I write this article, the yield on 10-year maturity treasury bonds is at an historical low of 1.9 percent, while yields on 30-year T-bonds are 3.2 percent. Why are treasuries yields so low? Why now? The answers to these two questions reflect economic policy and investor fear.

The Federal Reserve completed QE2 (a second round of quantitative easing to stimulate the economy) at the end of June, using $600 billion of new money to purchase long-term treasury securities. QE2 purchases increased demand for T-bonds, driving up their prices the same as higher demand for almost anything increases its price. For example, suppose a $1,000 treasury bond pays 4 percent interest. In other words, it pays $40 of interest each year. As the Fed begins buying these bonds, the price will rise above $1,000, decreasing the yield (return). If the price rises to $1,200, the same $40 of interest now represents a 3.3 percent yield ($40 ÷ $1,200 = 0.033, or 3.3 percent). As treasury bond yields fell, interest rates on other long-term debt securities fell as well. And that was the goal of QE2: to lower long-term interest rates, stimulating business borrowing, business expansion and ultimately increasing employment.

Did QE2 work? Yes and no. It certainly lowered long-term interest rates. But that outcome was a no-brainer: Buying $600 billion of treasury bonds was sure to drive up bond prices, lowering long-term interest rates. A bigger question is whether QE2 stimulated the economy. Judging by unemployment numbers and job creation, it doesn’t seem to have worked. Now some economists are calling for QE3, but because QE2 wasn’t successful, a QE3 program isn’t likely.

Compounding the effects of QE2 on interest rates, stock prices dove over the summer. Many investors were so frightened of a financial market end-of-days scenario that they were willing to park money in treasury securities even though prices were unusually high and yields were unusually low. Investor demand drove up bond prices even further, reducing yields to their current levels.

And that’s how a bubble is created. Long-term bond prices are exceptionally high and yields are exceptionally low because of QE2 and investor fear. QE2 is history and eventually investor fear will subside. When that happens, bond prices will crash. Because interest rates on all types of bonds tend to move together, treasury bonds, corporate bonds and muni bonds will crash together.

No one really knows when bond prices will reverse course, but they always do sooner or later. If you have money invested in bond mutual funds, be careful. Now is not the time to add to your bond holdings. If you own individual bonds and plan to hold them until maturity, there’s no need to worry about price fluctuations. You’ll receive the bond’s par value at maturity no matter how much prices change between now and then.

Low interest rates and stock market angst have combined to create a second bubble: the price of gold. Many investors and their advisors are convinced gold is the only safe investment during economic turmoil and just about the best way to make money. After all, the price of gold increased nearly seven-fold over the past 10 years, equivalent to an annual rate of return exceeding 20 percent.

Yet, no one invests in gold; they speculate. Gold is not an investment because it generates no income and pays no dividends or interest. Its price can fall as quickly as it rises. Buying any asset when its price is at an all-time high is asking for trouble. Yes, some will make money and gold prices might rise even more, but the risk of losing money is very high. My advice: If you own gold, sell now. Cash in your 31 percent year-to-date gain. Don’t be greedy. If you don’t own gold, good for you. Don’t buy it.

What should investors do who are too frightened to invest in stocks and who wish to avoid the risks associated with bubbles in long-term bond prices and gold? For now, keep your money in an FDIC-insured bank account. Inflation isn’t enough of a concern yet to worry about a loss of purchasing power. When the inflation rate starts to rise, it will be time to decide where to invest.

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