Thursday, April 23, 2020

The best investment in the world

I've blogged about strange trades before. There's Kyle Bass's bet on 5-cent coins. The great Japanese gold trade of 1859. And the epic bull market in shares of the Swiss National Bank, Switzerland's central bank.

This post is about the best investment in the world. I won't leave you hanging. It's the U.S. "Series EE" savings bond.

The coronavirus pandemic has led to a huge collapse in U.S. interest rates. As of April 21, the 30-year U.S. government bond rate was at 1.17%, down from 2.33% at the beginning of the year. The 20-year rate was at 0.98%, down from 2.19%.

But there's one corner of the U.S. government debt market where a a juicy 3.5% interest rate is still to be had: grandpa's savings bond. Snap it up quick, because it may not last.

Savings bonds have been around since 1935, when Franklin D. Roosevelt came up with the idea of getting regular folks to help fund new Depression-era programs. Savings bonds have always had low face values; investors don't need much money to get started. Each savings bond is part of a series, and each series has different features. This post is about one of those, the EE series.

1935 advertisement for US Savings Bonds

On the face of it, the Series EE savings bond seems like an awful investment.

The government pays EE savings bond investors a paltry interest rate of 0.1% a year. Instead of getting interest payments in hand as you would a regular bond, the Series EE payments gets re-added to the bond every month. So no regular flows of income over time--you've got to wait years to get any return. (In bond-speak, it's a zero-coupon bond). To make matters even worse, the bond is non-marketable, meaning that it can't be resold. Once you own it, you're stuck with it.

But there's a odd feature that turns this bond from dud into stud. Here it is:

What this fine-print says is that the government guarantees that the Series EE will double in value in 20 years.

If you do the math, this works out to an incredible 3.5% yield. As I pointed out earlier, the regular 20-year government bond only yields 0.98%. So anyone who buys an EE savings bond is making over three times the market rate! It's not often you get a gift like this. Check out the chart below:

There are some catches. To earn this 3.5% return, you have to hold the thing for twenty years. No backing out! This sort of commitment isn't for everyone. Who might these terms appeal to? If you're 30 or 40 and planning to retire by holding a government bond ETF for 20 to 30 years anyways, you might want to switch into savings bonds. Or, if you're a grandparent or parent and want to gift a baby some funds for college, an EE savings bond is a great option. (They can earn interest tax-free for  education purposes.)

The other catch? The limit is $10,000 per year per social insurance number. So unlike most fancy arbitrage trades, this isn't meant for all of you fat cats out there. It's for regular Americans. Which is why I like it.

(I suppose a hedge fund manager could rig up system that evades these rules. This would involve gifting $10,000 to hundreds of straw men, using their identities to invest in savings bonds and harvest the 3.5% rate. But this seems like it might not be worth the cost.)

Hurry up. You have till April 30, 2020 to buy the current crop of  EE savings bonds. There's a chance that after April 30 the U.S. government will reduce the 3.5% interest rate on subsequent versions of the EE bond. The government would do so by replacing the guarantee to double the bond's value after 20-years with a 25-year, or 30-year, guarantee.

It's made this change to the doubling period before. Up until 2003, the government guaranteed that an EE bond would double in 17 years. But that year it changed the terms so that subsequent issues would require 20 years to double. (It doesn't make changes retroactively. So if you already own a bond, you needn't worry).

Given such a sweet deal, you'd think that EE savings bonds would be flying off the shelves. Not so. Below is a chart of showing the dollar value of EE bonds issued going back to 1999.

In March 2020, the U.S. government issued just $5.2 million in Series EE savings bonds. That's hardly anything! Back in 1998, it was issuing a cool half a billion dollars worth of EEs each month. (The big drop in 2011 is when the government stopped printing paper savings bonds. Conveniently, they could be bought at the post office. The government now only issues them in electronic format.)

The chart below shows the total quantity of EE savings bonds outstanding. Given the slow rate of issuance (and quick rate of redemption), the total quantity of EEs in existence clocks in at $80 billion and falling, far below its $130 billion peak.

The tiny trickle of new EE bonds being issued could be good news for today's investor. It might mean that an alteration to the crazy high interest rates (i.e. the 20-year doubling period)  is not on the government's radar screen. So if you buy $10,000 before April 30, you could be able to reload and get another $10,000 next year.

Why is no one interested in buying EE Savings bonds?

I'm only speculating here, but I feel that the population's general understanding of bonds is on the decline. Today's bond investor buys government bonds packaged up in the form of an exchange traded fund, or ETF. These are available on the stock market. Not so in the old days. People had to purchase bonds individually through their broker. And this process encouraged them to be somewhat attuned to the principals of a bond. Or they had to open an account at Treasury Direct, the government's investor portal, and make the purchase themselves. That's a very hands-on way to invest in bonds, and obliges people to learn about bond fundamentals. Or they could buy a paper savings bond at the post office, a route that has been closed.

Bond ETFs provide a relatively hands-off way to buy and sell government bonds. No need to understand how a bond actually works. And so today's investor has mostly forgotten what a savings bonds is. "It's that strange thing grandpa buys." Or "RobinHood doesn't offer it."

Compounding matters is the fact the the EE's magic 20-year doubling number (which is what gives it its kick) is buried under a miserable advertised interest rate of just 0.1%. You've got to be one of those folks who enjoys combing through the fine print to catch it.

So if you're already a committed government bond holder, consider making the switch to Series EE savings bonds, folks!

Sunday, April 19, 2020

Stephen Poloz needs to be honest with Canadians about negative interest rates

To soften the blow of the COVID-19 pandemic, the Bank of Canada is running what it sees as an expansionary, or loose, monetary policy. I think an expansionary policy makes a lot of sense.

The problem is this. The Bank of Canada has several tools it can use to loosen. Some are better than others. But it has stopped trying to use its best tool.

What is its best tool? Well, there are three ways that the Bank of Canada can loosen monetary policy.

Say interest rates are at 4%. Stephen Poloz, the Governor of the Bank of Canada, can either...

1) Cut the interest rate, say to 3.75%
2) Keep rates at 4% but do $20 billion or so in quantitative easing. This is just a fancy term for buying up assets like government bonds.
3) Keep rates at 4%, but promise to maintain them at 4% for extra-long. This is known as forward guidance.

Let me explain the third, forward guidance, because it's complicated. Basically, Poloz says that he will keep the Bank of Canada's interest rate at 4%, but promises to maintain it at that level for longer than would otherwise be warranted. The intuition here is that by committing to keep interest rates extra loose in the future, he can loosen monetary policy now.

I like to think about forward guidance in terms of raising children. Say that I want to modify the behaviour of my three-year old kid. To do so I might reward him with an M&M. Unfortunately I don't have any M&Ms on me. So I promise to give him an extra M&M after the next trip to the grocery store. Hopefully this "guidance" about future M&Ms is enough to get him to do what I want, now.  

So which of these three is the Bank of Canada's best tool?

The Bank of Canada's actual behaviour over the last few decades hints at what tool it considers to be the most useful. In 99% of the cases, it has chosen to loosen policy by dropping interest rates, not by embarking on quantitative easing or forward guidance. It usually does so in 0.25% increments, but when the economic shock is large, it'll resort to large interest rate cuts. For instance, after 9/11 it chose a 0.5% reduction.

What about the current episode? The Bank of Canada describes the coronavirus fallout as "unprecedented". In its recent monthly monetary policy report, the Bank says that the severity of the current shocks has inspired it to roll out a "bold policy response."

But if the Bank's policy response is so bold, why has it stopped using its favorite monetary policy tool? Having reduced interest rates to 0.25%, the Bank of Canada says it won't drop them anymore. According to Poloz, interest rates now sit at Canada's "effective lower bound." The implication of his  phrasing is that not even a force of nature could move rates below 0.25%.

But that's simply not true. The Bank of Canada's favorite tool isn't stuck at a lower bound. It would be pretty easy to implement another four interest rate cuts. This would take the Bank of Canada's interest rate from 0.25% to 0%, then to -0.25%, -0.5%, and -0.75%.

Don't take it from me. In this 2015 Bank of Canada working paper, researchers Jonathan Witmer and Jing Yang estimate that the Canadian effective lower bound is likely between -0.25% and -0.75%, with a midpoint estimate of -0.5%. Canada would hardly be unique if it went into negative interest rate territory. Other countries have tried negative rates, including Switzerland, Sweden, Denmark, and the European Union. 

There's a good chance we'll need it. If we look at previous recessions, we generally got about 4% in interest rate cuts. During the 2001 tech meltdown, the Bank cut from 5.75% to 2%. In 2008 it went from 4.5% to 0.25%. But in our current recession, we've gone from 1.75% to 0.25%. So all the Bank of Canada wants to give us in 2020 is a paltry 1.5%. What a gyp.

What about the Bank's other options for easing? In the last week of March, the Bank of Canada announced a quantitative easing program of $5 billion per week. But by the Bank of Canada's own demonstrated preferences, quantitative easing can't be a great tool—in previous easing periods, the Bank of Canada didn't bother with it.

The problem is that quantitative easing doesn't do much. It sounds big and hefty. But in actuality, big purchases of government bonds are a bit like trying to move a jet plane with a fan. They're certainly no substitute for another rate cut.

As for forward guidance, the Bank of Canada hasn't announced it yet. But any parent knows that a promise of future M&Ms just isn't good as M&Ms in the present. Kids are skeptical of promises, and for good reason.

Stephen Poloz has described negative rates as "not sensible". Here's what is not sensible. We are currently in the midst of the fastest slowdowns in Canadian history, and the Bank of Canada staidly refuses to even consider the possibility of using its favorite and most effective instrument; interest rate cuts. I'm not saying that another rate cut is warranted. But Poloz should at least unshackle his best tool.

P.S. I've been down this rabbit-hole before.

In that post, I speculate why Canadian policy makers seem loath to consider further rate cuts into negative territory.

Look, Canadian regulators have always had a close working relationship with the big banks. This certainly had its benefits. But here we are seeing one of its drawbacks. Canada's big banks are conservative and afraid of change. They probably don't want to incur the frictional costs associated with transitioning to a negative rate environment. And they have probably voiced their concerns to the Bank of Canada. And so the Bank is supporting the banks by declaring the effective lower bound to be at 0.25%. This decision comes at the expense of all Canadian citizens. We all benefit from the ongoing usage of the Bank of Canada's strongest tool: variations in the rate of interest. QE and forward guidance are poor fill-ins.

P.P.S. I just stumbled on Luke Kawa's series of tweets from a few weeks back on the topic of the Bank of Canada's effective lower bound. He captures my thoughts too.

Monday, April 6, 2020

Cash and COVID-19

"I work at a bank and some lady tried to microwave her money to clean it........ 🤦🏼" from Twitter

I've written a series of posts and tweets over the last month about cash and COVID-19.

The first set of posts has to do with the idea of banknote contamination.

Banknote contamination

In my research for BullionStar, I found that the odds of a banknote being contaminated by a virus depends to some degree on the type of banknote. Traditional paper banknotes like the U.S. dollar are probably a lot safer than plastic ones, since they have porous surfaces that are less welcoming to viruses. Polymer and coated banknotes, like what we have here in Canada, are non-porous and thus much more conducive to both virus survival and transferal to fingers.

Funny enough, one of my references for the article was an old presentation by the Federal Bank of New York's Gerald Stagg, an MD responsible for administering the FRBNY's staff compensation and comprehensive benefits programs. Appropriately enough, the doctor had a sideline interest in banknote cleanliness!

Presentation by FRBNY's Gerald Stagg on currency health concers (PDF)

I suspect when all of this is over, central banks will have to conduct more intensive research on banknotes and pathogens. That way they can provide a prompt and standardized response come the next pandemic. Because right now they are all over the board. Hungary's central bank quarantined banknotes and heated them up to 170 degrees Celsius. Meanwhile the Bank of Canada advised Canadians not to panic, just wash your hands. This divergence hurts the credibility of both central bank's responses.

In a recent report on COVID-19 and cash, Raphael Auer and the folks at the BIS provide the following illustration showing how central bank have reacted through February and March:

Source: BIS's Covid-19, cash, and the future of payments (PDF)

My next post, this time for AIER's Sound Money Project, focused on the sudden changes to our shopping and payments habits that the coronavirus has brought about. At my local grocery I can no longer pay with cash, and when I go in (after waiting in a long line to ensure social distancing) they issue me plastic gloves. I found that during the Plague pandemics that swept through England and elsewhere in the 1600s, Brits were just as quick to modify their trading practices.

To help cope with the possibility that coins and marketplaces might help spread the plague,  so-called "vinegar stones" or "plague stones" were setup in out-of-the-way places. Villagers could go to these stones to conduct trade in a self-distancing manner with wary country-folk. The coins were put in a vinegar-filled bowl carved into the stone. It was believed that vinegar could counter the poisonous vapour that was believed (erronesouly) to spread the plague.

Plague stone at Eyam, Derbyshire

The main conclusion from my two posts was simple: if you're going to handle banknotes, don't touch your face. Wash your hands immediately after. And while you're at it, wash your hands after handling your debit or credit card, too.

Cash demand in a pandemic

The next series of posts and tweets dealt with the impact of the virus on the demand for cash. In an article for AIER, I showed that the demand for U.S. banknotes exhibited the largest week-to-week change since the year-2000 changeover in December 1999. Charted out, it looks like this:

Let's not panic, though. This doesn't constitute a bank run. As I pointed out in the article, the total stock of U.S. dollar banknotes may have jumped by $70 billion in March. But that's nothing compared to the $15 trillion or so in checking and savings deposits in existence, not to mention trillions more overseas.

There are all sorts of ways to visualize the quantity of banknotes in circulation. I came up with what I think is a more intuitive approach below:

Here's what the Canadian data looks like:

And the Australian data:

Some degree of cash restocking makes sense in an emergency like the one we are living through. In fact, a number of governments advise citizens to hold cash as part of their emergency preparedness guidelines.

The US Department of Homeland Security advises Americans to always have a kit that includes cash and travelers checks. The Canadian government's Family Emergency Plan template suggests that Canadians keep "some cash in smaller bills, such as $10 bills and change for payphones". And Sweden's emergency guidelines also advise that Swede's keep small bills on hand.

Sweden's emergency preparedness guidelines (PDF)