A m ba s s ad o r F i n a n c i a l G ro u p, i n c .
AMBASSADOR ALERT • 2011 • 2nd Quarter
When Does Transitory Become Permanent?
Since the inception of the U.S. credit crisis that took hold in the third and fourth quarters of 2008, and the subsequent
global economic crisis, there have been a lot of words and phrases used to describe the global market and economic
conditions. For example, the term “unprecedented” was extremely popular from the beginning and continues to be
used today when describing the severity of the crisis.
Recall in the first quarter of 2009, “green shoots” became an overused term to describe the early signs of a forthcoming
recovery. “New normal” was a phrase coined by the experts at PIMCO to describe a future of lower economic growth
expectations given the abundance of debt around the globe. And analogies like “kicking the can down the road” to “we are
in the eighth or ninth inning of the crisis” have and continue to be often used to define the current state of the recovery.
Currently, the word of the day is ”transitory.” In the Merriam Webster’s dictionary, the definition given for transitory
is “tending to pass away, not persistent, of brief duration.” In other words, the word transitory is used to describe
something as “short-term.”
Over the past number of months, Fed Chairman Ben Bernanke and countless other economists have consistently used
the term to describe economic conditions. Recall that oil and other commodity prices have spiked numerous times
since 2008 and remain elevated, causing an increase in both headline inflation and inflationary expectations. While
this increase in headline inflation has been a goal of the Fed in order to avoid a deflationary spiral, it has also had the
undesirable consequence of hitting the fragile U.S. consumer in the wallet.
Yet Mr. Bernanke has stated many times that the increase in commodities and inflation is transitory. He also describes
the recent soft-patch in the U.S. economy as transitory, and that growth will once again reaccelerate in the second half
of the year. So the question I keep asking myself is, at what point does transitory become permanent?
Let’s consider the possibility that PIMCO is accurate in its assessment that the U.S. and the world have entered a new
normal phase of subdued economic growth, a view that I share. This “new normal” is characterized by an economic
environment defined by a prolonged series of fits and starts where the economy expands for a period of time only
to be followed by a contraction. In fact, this is precisely how the economy has performed over the past few years and
there is a growing possibility that we are in the midst of a new normal, not unlike what Japan has experienced for roughly
two decades.
Stimulus programs of varying scale, including quantitative easing, the release of strategic petroleum reserves, and Cash
for Clunkers, will continue to be implemented to provide short-term Band Aids to long-term problems. So I ask the
question again, at what point do we acknowledge that the transitory issues of today are potentially permanent issues
of tomorrow? At what point will the Fed acknowledge this phenomenon?
For those of you who consistently read my morning market commentary, you can hopefully appreciate that I have been
saying for some time that I expect interest rates to stay low for a lot longer than people expect. Said differently, I don’t
expect low rates to be transitory. I hope you can also appreciate why I hope I am wrong. Low interest rates are associated
with a weak economy and global distress, both of which I obviously don’t want to see.
When Does Transitory Become Permanent?
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Ambassad or alert • 2011 • 2nd quarter
However, the reality is that there is a growing possibility that our economy might be in a prolonged new normal defined
by an interest rate environment that looks very similar to Japan. And while you might not fully agree with my assessment,
you need to consider the plausibility of that outcome and the implications for your bank’s financial performance.
So what are the potential implications? If you work under the same thesis as I do, which is the assumption that robust
quality loan demand won’t pick up anytime in the near or intermediate term, then banks, viewed in the aggregate,
will continue to hold a record amount of cash on their balance sheets. Clearly, if interest rates remain at historically
low levels and loan demand doesn’t accelerate, the opportunity cost of sitting on cash earning between 0.00% and
0.25% is significant. In fact, many of the large money center banks have experienced margin compression over the past
few quarters; we expect that trend to proliferate throughout the banking sector due to the aforementioned factors
of weak loan demand, excess liquidity, and low interest rates.
As margin compression sets in, banks will inherently feel compelled to eventually invest the excess liquidity, as the cost
of doing nothing will begin to outweigh the cost of doing something from an earnings perspective. Obviously as banks
begin to invest the record amounts of cash sitting on the sidelines, this could cap how high Treasury and other fixed
income asset yields climb.
So what can an investor do in an environment where interest rates remain low? First and foremost, keep in mind that
markets do not move in a straight line forever. Despite the trend to lower rates over the past few years, there are
always points in the cycle when rates back up. Rather than holding your breath in hopes of even higher rates, as it often
feels like rates will keep backing up further, don’t get greedy for yield. Put some cash to work on days that provide
opportunities for higher yields.
Secondly, consider adding duration to the portfolio on a selective basis to anchor some income on the longer end of
the curve. Obviously, if interest rates remain low for a longer period, longer-duration assets will outperform. Also keep
in mind that if and when interest rates rise, the yield curve historically flattens as short-term yields catch up with long-term
yields. Under that scenario, longer-duration assets will still outperform. This is precisely what occurred when the
Fed tightened during the 2004–2005 period. Municipal bonds are the optimal asset to utilize when adding duration,
and remember to focus on the cleanest credits.
Thirdly, while we are not generally fans of using the FAS 115 held to maturity (HTM) classification, as it reduces portfolio
flexibility, there are points in the interest-rate cycle when HTM serves a valid purpose. This is one of those times when
selectively placing certain security purchases into HTM can protect capital through the mark-to-market adjustment
when rates rise.
Realistically, at the end of the day there is no panacea for dealing with an extended period of low interest rates. However,
implementing any or all of the steps above can mitigate the growing risk that low rates, which have been described
as transitory for a long time, remain low far longer than anyone imagined.
–Matthew T. Resch, CFA
Managing Director
When Does Transitory Become Permanent?
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Chief Economist
The information presented is for informational purposes only. This is not an offer or solicitation to purchase or sell any security through Ambassador Financial Group, Inc.,
a current member of FINRA/SIPC. For more information contact us at 610.351.1633. © 2011 Ambassador Financial Group, Inc.