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Renting in Mass
Joined: 26 Jun 2008
Posts: 381
Location: In a house I bought in December 2011
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 Posted: Mon Nov 09, 2009 7:38 pm GMT Post subject: Risk of inflation vs. the downside of low interest rates |
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Admin, somewhere you said that one of your triggers for buying is that the downside risk becomes small enough that it doesn't bother you. (I'm paraphrasing because I can't find that comment.)
One of the the ways you're evaluating the downside risk is to look at the potential for interest rates to rise. I agree with your thinking, but as I watch the value of the dollar drop and the price of commodities rise, I'm worrying about inflation. It strikes me that waiting for interest rates to rise carries some risk (I know that isn't exactly what you're doing, but bear with me).
I suspect that the Fed is going to try to continue keeping rates low until inflation gets really bad. That's going to leave a window where rates are still low but the purchasing power of your dollars in the bank is shrinking. How are you going to weigh the risk of your dollars losing value versus the risk of buying when interest rates are at unsustainable lows? |
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balor123
Joined: 08 Mar 2008
Posts: 1204
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| Posted: Tue Nov 10, 2009 4:12 am GMT Post subject: |
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If you've got the dollars in your bank account pegged to buying a house, then it doesn't matter if they're losing value compared to other currencies. What matters is how much house those dollars would buy you.
What you should really be concerned about is the Fed inflating way those dollars in the bank account with money given to homeowners so they don't have to sell at deflated prices. You're getting a double whammy - reduced buying power combined with increased prices. If they keep this up, then we'll be stuck between two evils - housing that becomes increasingly unaffordable and also increasingly risky. You don't want to buy and you don't not want to. |
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admin
Site Admin
Joined: 14 Jul 2005
Posts: 1826
Location: Greater Boston
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| Posted: Tue Nov 10, 2009 5:19 am GMT Post subject: |
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| Quote: |
(I know that isn't exactly what you're doing, but bear with me)
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True, but your resulting question is still very relevant...
| Quote: |
How are you going to weigh the risk of your dollars losing value versus the risk of buying when interest rates are at unsustainable lows?
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I'm afraid I don't have an entirely well formed plan for this - sorry. I do think about it a lot. I am vigorously crossing my fingers and hoping that we won't get stuck in this catch-22.
One possible option will be to abandon Boston. In my original post which you paraphrased, what I said was that I would buy a house regardless of affordability metrics if the value that I expected to lose were small enough for me to not care about it. (This is by no means my only criteria for buying, just one that would side step the affordability metric.) Hypothetically speaking, say that a return to historical norms would entail a further 25% drop in real prices and that a bad case scenario whereby real prices fell a full standard deviation below norm would entail a 50% drop. I would most definitely care about losing either amount for houses at say Newton prices. However, I wouldn't care too much about losing 50% of many exurb prices. To further recommend this option, I could also choose an exurb where affordability is already closer to historical norms, thereby lessening the risk of further declines. I don't relish the thought of moving out of Boston, but this could just be used as a temporary survival option until the camel's back breaks.
Another safeguard which I've been working on is to buy inflation protected securities from the government. I have been buying I Bonds for awhile and just started buying TIPS too. (I've been very displeased with recent I Bond rates, though.) If we enter a catch-22 scenario with high inflation and low returns on savings accounts, I'm theoretically covered since the returns are indexed to inflation. In practice, the government could fudge the inflation numbers, so this isn't foolproof. However, for the purposes of hedging against inflation, TIPS and I Bonds are currently a lot more attractive to me than leaving Boston.
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balor123
Joined: 08 Mar 2008
Posts: 1204
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| Posted: Tue Nov 10, 2009 5:29 am GMT Post subject: |
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Aren't gains of those taxable though? Do you think i-bonds and TIPS are better deals than, say, reward checking accounts yielding 3-4% right now?
A side benefit of saving for a downpayment in cash is that in the mean time it acts as an uber rainy day fund. You could get buy easily for 3 years off it if not more. I suppose state unemployment still beats that though. In fact, it is so good that I actually would prefer that my company do some layoffs so that survivors can get raises. If I get laid off, then I get, what, 1.5 years of unemployment benefits + severance (and entrepreneurial opportunities)? If not, then I get a raise 
There used to be a startup which provided insurance against losses on your house but I suspect that they paid themselves with the premiums and then declared bankruptcy when the market crashed. |
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admin
Site Admin
Joined: 14 Jul 2005
Posts: 1826
Location: Greater Boston
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| Posted: Tue Nov 10, 2009 2:13 pm GMT Post subject: |
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| balor123 wrote: | Aren't gains of those taxable though?
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Yes, with a bunch of buts. I Bonds are tax deferred, so the interest is tax free while it is compounding - that's huge. Neither I Bonds nor TIPS are taxable for state and local income tax purposes. There are a bunch of other tax fringe benefits, too. Also, I have been buying TIPS in a retirement account, so taxes don't matter so much for me. (Obviously, confirm this information before acting on it since I may have made a mistake.)
| balor123 wrote: |
Do you think i-bonds and TIPS are better deals than, say, reward checking accounts yielding 3-4% right now?
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I have to say I haven't looked too much into rewards checking accounts because what I envision is a perpetual treadmill of finding and opening new accounts every few months as the introductory offers expire. I also assume it's essential to read all of the fine print before opening these because I assume there are a lot of restrictions, and the time spent doing that is an opportunity cost in itself. Also, if you are constantly opening and closing accounts as the introductory offers are usable and then expire, might that show up on your credit report? It could work, I just haven't looked into it.
On top of that, I Bonds do enjoy a big tax advantage over reward checking accounts, and that does narrow the gap a bit. Actually, it probably goes beyond the gap and reverses the outcome for the I Bonds that I purchased before this year, when the rates have been paltry. Like I said before, my TIPS are in a retirement account, so I think that even my newly bought TIPS will beat reward checking accounts once taxes are considered.
I also like the idea of having a minimum real return locked in now.
| balor123 wrote: |
A side benefit of saving for a downpayment in cash is that in the mean time it acts as an uber rainy day fund. You could get buy easily for 3 years off it if not more.
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The same thing applies to I Bonds, after you have owned them for a year. There is a penalty for redemption within the first five years, but it's not that bad.
TIPS are a different story since their price can fall. I view them as a rainy day fund of last resort, and I am planning to hold them to maturity.
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john p
Joined: 10 Mar 2006
Posts: 1820
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| Posted: Tue Nov 10, 2009 4:38 pm GMT Post subject: |
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http://www.bloomberg.com/apps/news?pid=20601087&sid=aogAIdJC8sRc
| Quote: | | Yields on the benchmark 10-year note, which help determine rates on everything from mortgages to corporate bonds, never rose above 4 percent after the central bank began acquiring the debt. |
also from above:
| Quote: | | The difference in yield between 10-year Treasury Inflation Protected Securities and 10-year notes is 1.97 percentage points, compared with an average of 2.18 over the past five years. The gap, known as the breakeven rate, suggests investors expect inflation to remain low over the life of the securities |
The key for you guys to understand the risk of inflation is of course the deflation of the currency through massive debt, but the other side of the equation is GROWTH. Companies that invested in dot.com's believed that they would eventually create a product, sell the product and GROW. Investors are taking measure of both debt and growth. Further because the money is coming into society from a top down approach (surprisingly from a Democratic Administration), these corporations are gobbling up all this new money that has entered the system. Think about it, the DOW went up 200 points yesterday (Nov. 9,2009) the day they announce 10.2 percent unemployment. They don't give a shit about unemployment, they care that they can borrow money at 2% and buy a company that gets a 6% profit margin. This is why we are getting a HUGE amount of mergers and acquisitions and asset bubbles like on Gold.
A Government can give out / borrow money for (Government Intervention) to the economy five different ways: (think about how each way either helps or hurts growth)
Directly to the Government to dole out - which is how politicians like it.
Directly to the Banks - which we are currently doing
Directly to the Taxpayers - tax breaks to either individual tax payers or businesses.
Directly to the citizens - stimulus checks (citizens include taxpayers and non taxpayers).
Directly from foreign investors via tariffs.
The method I want is one that produces the best results or natural growth.
The risk in giving the money directly to the non taxpayers is that many are morons and they will blow it because they are irresponsible. The risk in not giving it directly to them is that they are the ones who are hurting. I think a certain amount of needs to go to the needy regardless if they are irresponsible; times are harsh. Paul Krugman pushes for this.
The risk in giving the money to the banks or government is that they are greedy and irresponsible as well, and either dumb like a fox or dumb or both... I do not want to see more government hires unless they are temporary jobs and they are not eligible for pensions for essential government scope. (I believe in WPA spending provided that the work is beneficial and addresses a surcharge in the current system i.e. infrastructure jobs, because the infrastructure is aging since much of it was built in the 1950's). I am a big proponent of infrastructure investment because it is temporary, it feeds those that are constructive and industrious and can design and build things in society, and there is a huge need. Infrastructure also facilitates growth.
The risk in tax breaks to businesses and individuals are that somebody needs to pay the tab. Bush cut taxes to stimulate the economy and because people hate Bush it is hard to subscribe to this remedy. God forbid that the money go to the people that earned it.
The current philosophy is that the rich are bad and that they pumped out profits from companies, held wages in check and the money went to those that are already rich to begin with. You've heard my philosophy, I think this is true to some extent but globalization and emerging countries kept wages in check more than the rich draining the profits. In fact, the rich drained a lot of the profits from the emerging nations with skyrocketting growth.
My solution would be to target OWNERSHIP RICH. Today, CEO's are like managers who actually have to go out and work for a living. Sure they are rich, but the really rich are those that don't get up in the morning and go to work, those that live off of dividends and bonds (trust fund generations). We actually need the Jack Welch's and the Henry Fords and we want them to get rich because when creative, industrious, hard working people succeed many others too succeed. What I'm talking about is empower the George Baileys and let them get rich, and tax the Old Man Potters.
Specifically, I'd look at taxes on dividends. Back in I think 2003 they cut dividends taxes. Dividends are quarterly payouts to shareholders. Ownership rich who collect dividends were psyched.
http://www.heritage.org/research/Taxes/wm1891.cfm
Back then, people bought stocks for appreciation (buying at $20 a share hoping they could sell quickly for $30 a share). They wanted to calm the speculation and make more stable, larger companies more attractive so they cut dividends. Just like the real estate market was a sanctuary from the turbulent stock market, so too were "Income Stocks", or those that paid out dividends, and Bonds Funds.
The big risks now are that the low cost of capital are fueling large corporations and you're seeing a Ponzi Scheme of acquisitions and they are in a feeding frenzy of all this new money that has entered the market. The larger companies don't drive innovation and God knows we need to solve some problems. Large companies that dominate markets actually drive down wages because there isn't another company out there calling to lure you away; the one shop in town knows they've got you so they can increase their profit by pushing you to be more productive (Vampires).
This is the whole Differential Accumulation Theory I believe is relevant:
http://en.wikipedia.org/wiki/Differential_accumulation
Money is just raining down on these big corporations. Smaller companies are run by people in their 50's and if someone said hey, do you want $50 Million to cash out and still collect a $350k salary? What the hell are they going to say? The numbers foote because their company has a cash flow that is greater than the borrowing costs and that is the margin. So what we get are these bloated large companies where the name of the game isn't being productive, it is being a predator in a feeding frenzy and being political and getting your name as high up as you can in an ever changing organizational chart. People who actually work on projects are the prey. So companies now expand their breadth through acquisition and depth through squeezing their workers and keeping wages down. This is precisely what we don't want to encourage. The way this plays out guys, when we empower the predators and vampires in our society, is we go to fucking War. A society that encourages GROWTH and INDUSTRY and INNOVATION and HARD WORK are PEACEFUL societies. In this theory, capital isn't just money, it is who controls the agenda.
For this reason, I'd rather see capital go to the good guys. I think cutting the dividends taxes will put more investment into smaller capitalization companies and it will empower fresher organizations.
The problem with increasing dividends taxes is that the Babyboom are heavily invested in them because they are more conservative. So think about it, these larger companies are being invested in by a surcharge of lower risk investors and they are getting easy capital from the FED. So if they need money to expand, they can sell shares at a premium or go to the bank for cheap money. In economies of the past, there was usually one option. Greenspan lowered rates to make borrowing more attractive than selling stock. Now issuing stock (due to the surcharge in babyboom investors) and borrowing (due to the low cost of capital) are great plays which is why the larger companies are dominating.
During the early stages of Globalization, perhaps we needed US Corporations to consolidate so that we could dominate and acquire companies in emerging nations. This is why regulatory arbitrage and labor are so important. One way to protect our economy is professionalism: to have professional standards and licenses to practice in local areas so that companies don't offshore work and put our citizens at risk. I don't think that many "leaders" know how to deal with all of this confluence, so we'll see how things go. Feeding these big gorillas (the payroll of these enormous companies) is going to be interesting. I think the next wave of corruption is the Ponzi Schemes of insider trading, stock options, etc.
I bring up all of this because part of the "Inflation" discussion is prospective growth and we need to advance our understanding in that regard... |
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admin
Site Admin
Joined: 14 Jul 2005
Posts: 1826
Location: Greater Boston
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| Posted: Tue Nov 10, 2009 4:53 pm GMT Post subject: |
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| Quote: | | The difference in yield between 10-year Treasury Inflation Protected Securities and 10-year notes is 1.97 percentage points, compared with an average of 2.18 over the past five years. The gap, known as the breakeven rate, suggests investors expect inflation to remain low over the life of the securities |
I don't follow how a somewhat lower than usual gap implies that expectations are that inflation will remain low. My first thought would have been that the gap is lower than usual because the yields on normal Treasuries are being pushed down through quantitative easing and are therefore not an accurate reflection of market expectations. Regardless of the cause, this only serves to further recommend TIPS as a hedge against inflation since the premium you are paying for them is lower than usual.
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Renting in Mass
Joined: 26 Jun 2008
Posts: 381
Location: In a house I bought in December 2011
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| Posted: Tue Nov 10, 2009 5:09 pm GMT Post subject: |
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| Quote: | | Another safeguard which I've been working on is to buy inflation protected securities from the government. |
That's a possibility. I've got TIPs in my Roth IRA, but maybe I should consider putting some of my downpayment into TIPs.
In addition to the downside of the government fudging the numbers, it also makes me nervous that when the economic situation gets wacky, investment vehicles don't always act as they "should." Here's an example from Krugman of TIPs behaving strangely during the credit crises.
I agree that the idea of chasing 3% checking accounts isn't very appealing.
So, in the meantime I've got my money earning 1.3% at ING Direct. What a kick in the teeth! |
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admin
Site Admin
Joined: 14 Jul 2005
Posts: 1826
Location: Greater Boston
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| Posted: Tue Nov 10, 2009 5:22 pm GMT Post subject: |
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| Renting in Mass wrote: |
That's a possibility. I've got TIPs in my Roth IRA, but maybe I should consider putting some of my downpayment into TIPs.
In addition to the downside of the government fudging the numbers, it also makes me nervous that when the economic situation gets wacky, investment vehicles don't always act as they "should." Here's an example from Krugman of TIPs behaving strangely during the credit crises.
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I'm not putting my down payment into TIPS, at least not yet. They can lose value if not held to maturity and my down payment is something that will (hopefully) be needed in the near to medium term. I Bonds, on the other hand, won't lose value due to market swings - you redeem them directly from the government rather than the market, and the price is therefore much more predictable and not going to go down (government fudging aside). I have just started dollar cost averaging into TIPS as part of a multi-year plan to shift savings there, and maybe I will end up putting part of my down payment there, but that's not nearly as an attractive option for this purpose as I Bonds, in my opinion.
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Renting in Mass
Joined: 26 Jun 2008
Posts: 381
Location: In a house I bought in December 2011
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| Posted: Tue Nov 10, 2009 5:28 pm GMT Post subject: |
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| I need to read up on I Bonds. Thanks for the idea. |
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admin
Site Admin
Joined: 14 Jul 2005
Posts: 1826
Location: Greater Boston
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GenXer
Joined: 20 Feb 2009
Posts: 703
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| Posted: Tue Nov 10, 2009 5:44 pm GMT Post subject: |
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Liquidity and other problems make I bonds worse (or no better) than a CD. I posted my analysis here before. You can buy secondary issue CDs and build a nice ladder.
TIPs are even worse. Here's the problem. The security itself is 7-20 years in maturity. The volatility of TIPs is so huge that compared to other types of bonds, CAP GAIN plus INTEREST does not make TIPs an attractive investent. You are better off investing in an intermediate term treasury or a bond index fund. Much less volatillity. Volatility is what kills returns. You can actually invest in a long term bond index and do better than TIPs, but I prefer to keep maturity to less than 10 years, again, because of volatility. When I'm talking about TIPs, I mean TIPs mutual fund, simply because individual TIPs are not liquid enough and do not diversify enough. |
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admin
Site Admin
Joined: 14 Jul 2005
Posts: 1826
Location: Greater Boston
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| Posted: Tue Nov 10, 2009 6:10 pm GMT Post subject: |
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| GenXer wrote: | Liquidity and other problems make I bonds worse (or no better) than a CD.
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From a liquidity perspective, they are only worse than a CD during the first year, equivalent to a CD for the next four years, and then better than a CD thereafter. Given that the annual purchase limit is only $10K, even the one year window does not pose any practical liquidity concerns for my down payment since I could not tie up the majority of my down payment in newly purchased I Bonds even if I wanted to.
| GenXer wrote: |
TIPs are even worse. Here's the problem. The security itself is 7-20 years in maturity. The volatility of TIPs is so huge that compared to other types of bonds, CAP GAIN plus INTEREST does not make TIPs an attractive investent. You are better off investing in an intermediate term treasury or a bond index fund. Much less volatillity. Volatility is what kills returns. You can actually invest in a long term bond index and do better than TIPs, but I prefer to keep maturity to less than 10 years, again, because of volatility. When I'm talking about TIPs, I mean TIPs mutual fund, simply because individual TIPs are not liquid enough and do not diversify enough. |
The goal is to minimize losses, not maximize returns. We are specifically talking about minimizing camouflaged losses which would result from high inflation. Your alternate suggestions of intermediate term Treasuries and bond index funds do not do offer this protection, which was the whole point.
I also want to lock in longer term protection and therefore want to buy maturities as far out as possible. I therefore don't want to diversify over maturities and have intentionally avoided TIPS funds because the average maturity of their holdings is much shorter than I want.
Yes, the tax treatment of TIPS can be a disadvantage, but like I said, I'm buying them in a retirement account, so it is a non-issue. In fact, it works to my advantage because the market price for TIPS is set by those who will discount their price due to the tax treatment.
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GenXer
Joined: 20 Feb 2009
Posts: 703
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| Posted: Tue Nov 10, 2009 6:22 pm GMT Post subject: |
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| You want to get a 'protection from inflation'. And I'm arguing that you are better suited to do this with intermediate term bonds. Its all about total return in the presence of volatility. You are NOT getting better return with TIPs. I can call a security 'God's Chosen Security To Guarantee My Retirement', but it wouldn't make it so. Its just another security, and in the total returns department, TIPs is not a high ranking security. Just because its called 'Inflation Protected' doesn't make its total return better than securities with EQUIVALENT volatility and maturities. Do you see my point? This is going back to the point about 'gold being a hedge against inflation' (it is not). Just compare total returns of TIPs, retirement account or not to bonds with equivalent maturities, and you'll see what I'm talking about. It is much safer to invest in intermediate term bond funds (preferably index). You'll get lower total return, but it will be with LESS volatility, so I'm going to argue that less is more here. |
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admin
Site Admin
Joined: 14 Jul 2005
Posts: 1826
Location: Greater Boston
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| Posted: Tue Nov 10, 2009 6:37 pm GMT Post subject: |
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| GenXer wrote: | | You want to get a 'protection from inflation'. And I'm arguing that you are better suited to do this with intermediate term bonds. Its all about total return in the presence of volatility. You are NOT getting better return with TIPs. I can call a security 'God's Chosen Security To Guarantee My Retirement', but it wouldn't make it so. Its just another security, and in the total returns department, TIPs is not a high ranking security. Just because its called 'Inflation Protected' doesn't make its total return better than securities with EQUIVALENT volatility and maturities. Do you see my point? This is going back to the point about 'gold being a hedge against inflation' (it is not). Just compare total returns of TIPs, retirement account or not to bonds with equivalent maturities, and you'll see what I'm talking about. It is much safer to invest in intermediate term bond funds (preferably index). You'll get lower total return, but it will be with LESS volatility, so I'm going to argue that less is more here. |
I never said that my criteria for selecting TIPS was that they have "inflation protected" in their name. I actually read up on how they function and decided that the way that the principal is adjusted using the CPI addressed the risk that I was worried about.
I think a bond fund would be a horrible hedge against inflation. As inflation goes up, yields go up and bond prices go down. It is exactly the opposite of what I am looking for.
Your point about volatility might apply to TIPS funds (I haven't thought about it since it doesn't apply to me), but it does not apply to individual TIPS held to maturity. Their real return is exactly predictable, which seems to me to be as low volatility as you can get.
And I don't think that I have ever argued for gold in this forum, so I don't know where that came from.
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