The Bond Market: Beware of Junkyard Dogs

John Mauldin


It should come as no surprise that credit spreads are shrinking between what in theory are risk-free investments and other investments. Retirees and other investors are reaching farther and farther for yield, piling into all sorts of increasingly risky investments.

My friend Danielle DiMartino Booth, formerly at the Dallas Fed and now writing on her own at the eponymous website www.dimartinobooth.com, covers a wide range of topics that are affected by central-bank policies. Today she deals with credit spreads and specifically high-yield bonds. It’s not a long piece, and it’s easy reading, even if it won’t make you comfortable.

Danielle and I have been friends for many years, and I always enjoy being able to get together with her and share notes. I think she is going to be an increasingly visible voice in the world of central bank critics.

My only real problem with Danielle is that when I called to ask if I could send this letter to you, in the process of agreeing she mentioned that she had just sent off the final edits of her own book, while mine is still in the churning and development stage. Yesterday someone asked me if I enjoyed book writing. I quipped, “I actually enjoy sending off the final manuscript.”

The actual writing process is hard work. For whatever reason, I spend a great deal more time writing and editing a book that I do on my letters – which probably shows. There is something about calling a writing project a book as opposed to a letter that, at least for my generation, seems to provoke more effort and angst. The reality is that my weekly letters are actually far more accessible and will probably be on the Internet longer than my books, which so far haven’t been posted in toto.

And speaking of writing, I’m going to go ahead and hit the send button and go back to the process of creating a book. I hope your summer (if you are in the northern hemisphere) is going well. I have friends and business partners coming in this afternoon and evening, and we’ll be talking about some new offerings that I will soon be able to tell you about. Stay tuned.

Your thinking about new portfolio diversification methods analyst,

John Mauldin, Editor
Outside the Box

 
The Bond Market: Beware of Junkyard Dogs
By Danielle DiMartino Booth
 
 
 
Having spent a chunk of his youth “shopping” them, Jim Croce came to know a thing or two about junkyards. In those youthful days, should his clunker de jour be missing some vital part or parts, a trolling expedition through South Philly’s scrap heaps was always the enterprising Croce’s preferred method of procurement. 

Amid all of Croce’s parts foraging, it was a universal joint for a ‘57 Chevy and a ‘51 Dodge transmission, two must have and must-be-cheap or, better yet, free, parts that the legendary folk singer still recalled. He also reminisced that junkyards could and would provide a no frills, but highly motivated and easy way to get in some cardio, as in running for your life. 

“I got to know many junkyards well, and they all have dogs in them,” the late Croce said in a 1973 interview. “They all have either an axle tied around their necks or an old lawnmower to keep ‘em at least slowed down a bit, so you have a decent chance of getting away from them.”

So was born the junkyard dog yardstick by which to measure the meanness of one Bad, Bad Leroy Brown, Croce’s hit which landed at the top of the charts 42 years ago this week. 

As for high yield bond analysts, they aren’t exactly known for catchy turns of phrase.
 
However, in recent weeks, they’ve shed the dry and donned the dramatic, as you’ll soon see.
 
Such is the overheated state of the junk bond market this sweltering summer. 

In his latest missive, Deutsche Bank’s Oleg Melentyev, arguably the best in class high yield analyst among his sell-side peers, warned of the perils of investing in this “frenzied market.”
 
Legendary high yield investor Marty Fridson shares Melentyev’s concerns and has for some time. By his best estimate, high yield was already in “extreme overvaluation” territory on June 30th, defined as being one standard deviation above fair value. Flash forward two weeks, and he calculates that the standard deviation has doubled. 

(A quick Statistics 101 refresher: standard deviation tells you how tightly clustered or wide-of-the-center individual components of a given data set are from their mean. Remember the grade bell curve the engineering undergrads blew in business school? When all of the test scores came in on top of each other, the bell curve was super steep; when there was vast divergence, the bell curve was low and wide.) 

Defining bond valuation also requires one employ “spreads,” which compare the prevailing yields on a given credit to a supposedly risk-free Treasury of a comparable maturity. And that means you have to get down to the nitty-gritty of measuring risk in basis points (bps), or hundredths of a percentage point. 

In the event your eyes have rolled into the back of your head, listen up! This is important folks, your sweet grandparents could well own junk bonds in their desperate need to generate yield on their atrophying retirement funds!
 
With that preamble posited, on July 15th the option-adjusted spread on Bank of America Merrill Lynch’s High Yield Index was 542 basis points. That compares to 621 bps on June 30th. The lower the spread, the less extra compensation investors are demanding for taking on the added risk of being exposed to, well, junky bonds. 

Of the compression in spreads, an incredulous Fridson could only characterize the overvaluation which begat more overvaluation as, “more staggering.” 

Now in light of this, just how did mom & pop investors react to the price increase? Well how else? They poured $4.4 billion into high yield mutual funds, the second highest weekly inflow on record after March 2nd’s $5.3 billion inflow. 

Bloomberg caught up with yet another stunned strategist:  “They’re out there scrounging through the dumpster looking for yield,” worried Karyn Cavanaugh of Voya Capital Management. “When you have artificially low rates, you force people to go out and look for things they normally wouldn’t.”
 
The question is, will investor insouciance ever come back to haunt them? They, as in investors, certainly don’t seem to think so.
 
The Daily Shot is a must-read email proffering just about every graph that’s important for investors in one succinct one-stop shop, and it’s free. The Shot’s editor, the estimable Dr. Lev Borodovsky, is notoriously judicious with his editorial additives. So when he adds a quip, his readers understandably sit up and take note.

In Tuesday’s Shot, Borodovsky featured a graph of the VIX Index, the so-called ‘fear gauge,’ which depicts the perceived risk of owning stocks, which have traditionally moved in lockstep with junk bonds. Reflecting extreme complacency, the VIX is sitting at the lowest level since last August. “In the equity markets,” Borodovsky recapped, “the VIX hits a multi-month low. All is well.” 

Or not. The Shot goes on to depict the price-to-earnings ratio on the S&P 500 at the highest level since at least 2006. “These valuations rely on extremely low long-term rates,” Borodovsky cautioned. 

As a punctuation mark, as in exclamation, Borodovsky features two charts on the high yield market. At the risk of over-paraphrasing, the high yield market is apparently no longer concerned about energy prices, which have yet to stage the oft-predicted blistering rebound.

How so? 

Despite the defaults that continue to emanate from the oil patch, the performance of high yield bonds has completely divorced itself from that of still-depressed crude prices. The mirror image of this nonchalance is that investors are no longer demanding a premium level of compensation for owning high yield energy issuers vis-à-vis their non-energy brethren. 

In priceless understatement, Borodovsky concludes that, “High yield is definitely starting to look frothy.” 

As for Deutsche’s Melentyev, he isn’t bothering to wait for the ink to dry on the clear message written on the wall. In his latest note to clients, he ratchets up his expectations for HY (high yield) defaults to rise this year beyond his worst case initial scenario – and it ain’t just an energy story. 

“At this point, we have little doubt that our original forecast of a 4% ex-commodity HY default rate will be met by late 2016/early 2017. Moreover, we think there are now enough reasons to believe that defaults could rise to 5%, ex-commodities, sometime over the next year or so. Coupled with our 20% commodity HY default rate forecast, we are looking at 7.25% aggregate default rate sometime around mid-2017.” 

In the event you’ve fallen off Planet Earth in recent weeks, the global corporate default count, as in companies reneging on their promises to make good on those coupon payments, is at the highest level since 2009. And if your memory’s eye has erased 2009 to prevent permanent scarring, the economy was in a full meltdown state back then. 

Let’s get this straight. Defaults are going through the roof and investors are flocking to the sector in record numbers? And how.
 
Moody’s Tiina Siilaberg keeps an eagle’s eye on the concessions investors give to issuers in the form of protections they don’t demand. They’re called ‘covenants,’ which Investopedia defines as, “designed to protect the interests of both parties. Restrictive covenants forbid the issuer from undertaking certain activities; positive covenants require the issuer to meet specific requirements.” 

By Siilaberg’s latest tally, covenant protections are at their weakest level in recorded history.
 
To translate, investors’ collective interests are as vulnerable as they’ve ever been. Though the leveraged loan market remains open for business, Siilaberg is apprehensive about what’s just over the horizon given stretched valuations. 

“Issuance in the high yield bond market is still relatively weak compared to historic levels,” Siilaberg said. “I worry, though, because refinancing risk for many lower-rated issuers is close to an all-time high.” 

The culprit? That would be a delusional reliance on what Melentyev refers to as, “the new narrative,” and “its apparent reliance on (a) strong monetary response.” Unconventional monetary policy is delivering, “little tangible benefit.” 

Overreaching central bankers are in fact doing more harm than good at this juncture.
Though small investors may not be wise to the damage being wrought, veterans of financial market warfare are weary to the point of exhaustion. 

The endless waiting for Godot has apparently worn their resolve down to near nothing…with good reason. For all of central bankers’ Herculean efforts, expectations that U.S. job losses will accelerate are at a two-year high while households’ prospects for the economy over the next year have fallen to a two-year low. 

Pride will surely precede the fall of the orthodoxy of today’s accepted monetary policy framework. But at what cost? 

“Everyone in the world needs yield and nothing else matters,” Melentyev laments. “This has never ended in any sort of a problem before, so we can all go back to sleep.” And what happens when we’re abruptly shaken from our slumber?

Recognizing the painfully obvious, Voya’s Cavanaugh observed, “This isn’t a really normal environment.”
 
Thank you Chair Yellen & Co. for rendering snarling, lawn mower toting junk bond dogs cute and cuddly critters to retirees on fixed incomes.


Liquidity Traps, Secular Stagnation, Deflation, And The Legacy Of Keynes

by: Ben Comston

- For some good reasons from the past, some have become irrevocably opposed to anything with the label "Keynesian" attached to it.

- Despite limitations, Keynesian models, including liquidity traps and secular stagnation, are the best explanations available for the economy today.

- If the current gap between savings and investment is not closed, the chance for future deflation is far higher than zero.

 
Quick... What do a radio talk show host, an historian, an internet commentator, and a blogger have in common? They all have visceral reactions to the term "Keynesian".
 
"The Keynesians are pretending they have everything under control, but we know that's a fantasy. An even greater opportunity than 2008 awaits us, and we want to help guide public opinion and train a cadre of bright young scholars for that day. With your help, we can, at last, awaken from the Keynesian nightmare.

As the Korean translator of an Austrian text put it, "Keynes must die so the economy may live." With your help, we can hasten that glorious day.

- "
Keynes Must Die" by Tyler Durden, ZeroHedge, 2016 

"Interesting how a haughty snob is supposed to be celebrated. One explanation may be that this economic phantasy became government econ which per handouts to profs becomes university econ, is miraculously accepted by unions, much easier accepted with the poe (than the poverty-alleviating real economics), is miraculously cherished by the elite and military-industrial complex benefiting from gov't spending, and most definitely is a constant boon to banks required for the monetary expansion, not to forget bail-outs of the most irresponsible banks and companies. Nice move learned from the Nazis."

- Comment on
The Guardian's website, 2016 

"You want more people to know who John Maynard Keynes was. Okay, attention, class. John Maynard Keynes. If you want to know what Keynesian economics is, you're living it: Barack Obama, massive government spending, massive debt, massive redistribution of wealth, the lie that government spending, deficit spending can propel economic growth. She is dead right that they tricked everybody into thinking this is the way we're going to save capitalism! They had no intention of saving capitalism. Just like Obama, they wanted to destroy it and replace it with socialism or Marxism or fascism or whatever you want to call it. And they got pretty close."

-
Rush Limbaugh, 2010 

"True, not all those who intended to vote Tory showed their hand to the opinion pollsters, who have almost as much egg on their faces as the Keynesians. Next time, however, the pollsters can simply adjust their projections by using a simple economic model. Just so long as they make sure it's not a Keynesian one. Shame where shame is due."

- Niall Ferguson,
Financial Times, 2014
Wow... who knew that in reality, Keynes was a snobbish Nazi that returned from the grave to destroy both the British and American economies.
 
In reality, Keynes was many things. For one, he was an extremely successful investor. The money he managed for Cambridge University grew from £30,000 to £380,000 during the Depression. He was also incredibly astute at political economy - playing the role of prophet, while writing The Economic Consequences of the Peace in 1919, which accurately predicted the damage to be brought by The Treaty of Versailles - as well as a delegate to the Bretton Woods Conference following WWII.
 
The anger directed towards Keynes today, though, stems from his influence in macroeconomics. Specifically, the excuse that he gave to policymakers to intervene in the economy rubs many the wrong way. The pity is that ideological aversion to Keynes has kept many intelligent people from having a useful paradigm for understanding the state of the economy today, both in the United States and globally.
 
Before going on to discuss the economy today, it's worth mentioning that there are good reasons why many grew skeptical of the total umbrella of Keynesianism. There was a time when it was believed by some that any desired outcome could be engineered in some way. That arrogance had some consequences.
 
The Excesses of Keynesianism
 
A good way to illustrate the "overdosing" of Keynesianism is found in the Phillips Curve. This is an incredibly simple tool that plots the inflation rate against the unemployment rate. It originated in the observation of a New Zealand economist that there was a trade-off between the two measurements - in other words, a lower rate of unemployment could be "engineered" if you were willing to accept a higher rate of inflation.
 
Here is what a Phillips curve looked like for the 1960s in the United States:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
The results make intuitive sense as well as empirical. If the economy weakens and workers are laid off, they demand less goods and services, which will cause their price to decline and lower inflation; conversely, full employment implies higher demand for goods and services and higher prices.
 
There's a very obvious flaw in this logic. It completely ignores the supply part of the supply/demand equation. Politicians generally prefer full employment to low inflation. Of course, both are ideal, but voters tend to prefer a job with a little higher prices than no job and lower prices. Ultimately, supply shocks (mostly from oil embargoes) coincided with a Federal Reserve that was excessively political and believed it could "engineer" a lower unemployment rate through excess money creation. The fact that the Fed chairman at the time, Arthur Burns, was trying his hardest to get a Republican, Richard Nixon, re-elected does not alter the value of the lesson in excessive interventions.
 
As it turned out, while there is a short-run relationship between prices and unemployment, there is no long-term one.

 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
What causes the short-term relationship to hold but not the long-term one? Milton Friedman was among the first to suggest that there should be no long-term relationship between the two measurements. The explanation can be given through the concept of "rational expectations".
 
Consciously or unconsciously, everyone operates with expectations about the future, including expectations on the level of prices. If inflation has been mild and a Central Bank has the confidence from others that it will set policy to maintain low inflation, actors in the economy will make decisions with the expectation that prices will continue to be stable. So, if excess money creation causes prices for a particular product to rise, then the decision makers of a business would wrongly assume that the increase in prices is coming from increased demand for their products and supply more; thus lowering unemployment and raising economic growth. Eventually, though, the relationship breaks down, because while the rational expectations of firms are "sticky", they will reset in the long run. In other words, at some point people realize what's going on and stop responding to the price signals.

The stagflation of the 1970s was the first economic malaise that economists had experienced since the Great Depression, but the causes and appropriate policy tools to confront it were not the same as those needed during the Depression. The key difference is that the Great Depression was a shock to demand accompanied with too little money creation, while Stagflation resulted from a shock to supply accompanied by too much money creation.
 
The work of Keynes was no longer en vogue, as many pundits, policymakers, and economists dismissed his work. Again, some of that came about because, while Keynes did not directly suggest the policies that contributed to stagflation, many saw the permission he gave for market intervention as the real sin.
 
The perpetuation of that ideological rigidity has caused many to completely misunderstand the post Great Recession economic landscape. In essence, they have continued trying to fight the economic problems of the 1970s, while the economic problems of today are not the result of supply shocks - they have been a result of the shock to demand from excessive leverage, a situation much better paralleled by the Great Depression of the 1930s than the Stagflation of the 1970s.
 
Liquidity Traps and Secular Stagnation
 
A liquidity trap and secular stagnation are potentially overlapping, yet distinct, phenomena.
 
Liquidity traps exist when monetary policy reaches a lower bound such that it becomes ineffective in stimulating demand. Interest rates are what equilibrate the choices that are made between current and future consumption. Within a normal monetary policy framework, lowering real interest rates should stimulate aggregate demand because it makes it cheaper for firms and individuals to prefer current to future consumption. Once a lower bound is reached, for instance zero percent interest rates, then monetary policy becomes ineffective at encouraging current versus future consumption because the price of the trade-off is no longer affected. More money can be injected to the economy, but in this scenario, it will be "trapped" rather than lent, and stimulative to aggregate demand.

While not dispositive, the liquidity trap we're currently in can be seen in the relationship (or lack of one) between short-term interest rates and economic growth.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Another obvious clue to the reality of a liquidity trap is the steep decline that's been experienced in the velocity of money, or how often money changes hands. Consistent with money creation being trapped and not spent or invested, the velocity of money has never been lower than it is currently.
 
 
Unsurprisingly, a steep fall in the velocity of money also occurred during the Great Depression - another period of economic weakness caused by a shock to demand.
 
What is the underlying cause of a liquidity trap? One potential cause is a very high preference for savings, such that taking interest rates down to zero will not cause increased demand because of deleveraging or a dearth of good credit risks banks are willing to lend to. And indeed, we have seen a pretty dramatic increase in savings rates for several years now, despite a continual fall in long-term interest rates that should, ostensibly, discourage savings.
 
 



Secular stagnation describes a similar phenomenon, but takes as its focus a gap between investment and savings rather than consumption and time. There is some interest rate that will balance investment and savings in an economy, i.e., if there is too much savings and not enough investment, market interest rates should fall to discourage saving and encourage investment.

As the name implies, secular stagnation is a problem that could have long-range consequences due to under-investment in the economy.
 
 
There are a variety of reasons for relatively low investment, while real interest rates are still barely positive. In the article "The Age of Secular Stagnation", Larry Summers put forward one possibility that today's corporations - Google (GOOG, GOOGL), Facebook (NASDAQ:FB), Apple (NASDAQ:AAPL), etc. - are not as capital-intensive as past corporations that were more likely to be involved in autos, steel, or oil. This means that, all things being equal, the demand for capital and investment will be lower than would otherwise be the case.
Additional capital required to be held in banks is another contributor to lowered investment. Although it's proper that banks should be required to hold more capital than they were in 2006 and 2007, the decline in lending per dollar of deposits in banks results in lower investment.
Whatever the cause or causes, the result of secular stagnation is that the real interest rate required to balance savings and investment has declined, and without achieving that proper balance, excess savings and diminished investment should be expected to continue.
 
Deflation
 
Without a change in course by policymakers, the best-case scenario is that we continue to meander through low growth for some time until structural changes alter the equilibrium real interest rate necessary to spur consumption, and investment is increased. If you look at the example of Japan, that could be a very long time.
 
The worst-case scenario may be that we see endemic deflation in the United States and Europe (it's already in Japan). That would be an extremely unpleasant experience. But, if conventional monetary policy cannot deliver a real interest rate that the market demands to encourage consumption and investment, then the adjustment that the market demands could well come in the form of deflation, which would lower the real interest rate further from where it is today.

The economic participants in the US and the global economy are signaling that real interest rates today are still too high rather than too low. For whatever reason, a shockingly large number of people have confused themselves into thinking the opposite is the case.
 
A Way Out?
 
What can be done in the face of the liquidity trap and secular stagnation we currently find ourselves? Or is there anything at all?
 
To repeat my argument from above, the central feature of both of these related scenarios is that the real interest rate needs to decline, and cannot through conventional central bank policy.
 
Quantitative easing is a completely reasonable response to such a situation, but has not been enough to lower the real rate of interest enough.
 
The obvious Keynesian response is to increase fiscal stimulus, which will increase overall investment in the economy, reduce aggregate savings, and thereby increase the real rate of interest that the market needs to achieve equilibrium.
 
Larry Summers, in the same article cited above, has advocated this approach through a dramatic increase in infrastructure spending. This approach has the dual benefit of providing hope that the economic situation we find ourselves in could be alleviated, but also achieves the needed infrastructure spending that would increase productivity, and thereby growth, for many years to come.
 
An unnecessary fixation on deficits has inhibited stimulus on this scale, with many holding to the illusion that lower amounts of gross debt along with an ageing infrastructure is preferable to higher amounts of gross debt along with greater economic output and productivity by enhancing the backbone to the economy.
 
What comes next?
 
The greatest danger remains the continual decline in inflation turning into prolonged deflation.
 
In such an environment, you would probably prefer to own long-term bonds as opposed to other investments, but with yields so low, it would be advisable to keep the duration of the bonds extremely short. (I know, if there is significant deflation then long-term bonds are your best bet, but over a full holding period, you're not going to be compensated enough to hold them.)

No one can say for sure what's on the horizon. For the time being, it's unlikely that there will be any coordinated effort from Washington to increase investment. The election this Fall could change that, or it may not. But, in the meantime, far too many policymakers continue to fight the malaise of the 1970s rather than the malaise of 2007 to today, even though the current situation of inadequate demand is much more akin to the 1930s than the 1970s. The attitude of many is reminiscent of the description of the Great Powers from WWI that Barbara Tuchman describes in The Guns of August, who spent most of the war fighting the enemy according to the rules of the previous wars, which had all changed. Or, as John Bolton put it, "Politicians, like Generals, have a tendency to fight the last war."
 
Let's hope we start fighting the war in which we find ourselves and stop fighting the war we wish we had.


Unburdening the Facebook Generation

Mohamed A. El-Erian

Newsart for Unburdening the Facebook Generation

LOS ANGELES – Once again, young people have gotten the short end of the political stick. The outcome of the United Kingdom’s Brexit referendum is but another reminder of a yawning generational divide that cuts across political affiliation, income levels, and race.
 
Almost 75% of UK voters aged 18-24 voted to “Remain” in the European Union, only to have “Leave” imposed on them by older voters. And this is just one of several ways in which millennials’ economic future, and that of their children, is being determined by others.
 
I am in my late fifties, and I worry that our generation in the advanced world will be remembered – to our shame and chagrin – as the one that lost the economic plot.
 
In the run-up to the 2008 global financial crisis, we feasted on leverage, feeling increasingly entitled to use credit to live beyond our means and to assume too much speculative financial risk. We stopped investing in genuine engines of growth, letting our infrastructure decay, our education system lag, and our worker training and retooling programs erode.
 
We allowed the budget to be taken hostage by special interests, which has resulted in a fragmentation of the tax system that, no surprise, has imparted yet another unfair anti-growth bias to the economic system. And we witnessed a dramatic worsening in inequality, not just of income and wealth, but also of opportunity.
 
The 2008 crisis should have been our economic wake-up call. It wasn’t. Rather than using the crisis to catalyze change, we essentially rolled over and went back to doing more of the same.
 
Specifically, we simply exchanged private factories of credit and leverage for public ones. We swapped an over-leveraged banking system for experimental liquidity injections by hyperactive monetary authorities. In the process, we overburdened central banks, risking their credibility and political autonomy, as well as future financial stability.
 
Emerging from the crisis, we shifted private liabilities from banks’ balance sheets to taxpayers, including future ones, yet we failed to fix fully the bailed-out financial sector. We let inequality worsen, and stood by as too many young people in Europe languished in joblessness, risking a scary transition from unemployment to unemployability.
 
In short, we didn’t do nearly enough to reinvigorate the engines of sustainable inclusive growth, thereby also weakening potential output and threatening future economic performance. And we are compounding these serial miscarriages with a grand failure to act on longer-term sustainability, particularly when it comes to the planet and social cohesion.
 
Poor economics has naturally spilled over into messy politics, as growing segments of the population have lost trust in the political establishment, business elites, and expert opinion. The resulting political fragmentation, including the rise of fringe and anti-establishment movements, has made it even harder to devise more appropriate economic-policy responses.
 
To add insult to injury, we are now permitting a regulatory backlash against technological innovations that disrupt entrenched and inefficient industries, and that provide people with greater control over their lives and wellbeing. Growing restrictions on companies such as Airbnb and Uber hit the young particularly hard, both as producers and as consumers.
 
If we do not change course soon, subsequent generations will confront self-reinforcing economic, financial, and political tendencies that burden them with too little growth, too much debt, artificially inflated asset prices, and alarming levels of inequality and partisan political polarization. Fortunately, we are aware of the mounting problem, worried about its consequences, and have a good sense of how to bring about the much-needed pivot.
 
Given the role of technological innovation, much of which is youth-led, even a small reorientation of policies could have a meaningful and rapid impact on the economy. Through a more comprehensive policy approach, we could turn a vicious cycle of economic stagnation, social immobility, and market volatility into a virtuous cycle of inclusive growth, genuine financial stability, and greater political coherence. What is needed, in particular, is simultaneous progress on pro-growth structural reforms, better demand management, addressing pockets of excessive indebtedness, and improving regional and global policy frameworks.
 
While highly desirable, such changes will materialize only if greater constructive pressure is placed on politicians. Simply put, few politicians will champion changes that promise longer-term benefits but often come with short-term disruptions. And the older voters who back them will resist any meaningful erosion of their entitlements – even turning, when they perceive a threat to their interests, to populist politicians and dangerously simplistic solutions such as Brexit.
 
Sadly, young people have been overly complacent when it comes to political participation, notably on matters that directly affect their wellbeing and that of their children. Yes, almost three-quarters of young voters backed the UK’s “Remain” campaign. But only a third of them turned out. In contrast, the participation rate for those over 65 was more than 80%.
 
Undoubtedly, the absence of young people at the polls left the decision in the hands of older people, whose preferences and motivations differ, even if innocently.
 
Millennials have impressively gained a greater say in how they communicate, travel, source and disseminate information, pool their resources, interact with businesses, and much else. Now they must seek a greater say in electing their political representatives and in holding them accountable. If they don’t, my generation will – mostly inadvertently – continue to borrow excessively from their future.
 
 



Wall Street's Best Minds

Jeremy Grantham Warns on Immigration, Brexit

Immigration from outside Europe is a potentially explosive problem and Brexit may be its fuse.

By Jeremy Grantham 



Preface

I set myself a task this quarter to give my views on why suddenly so many strange things are going on in the U.S. and in the U.K. and what they might mean. We in the U.S. can see the turmoil resulting from the Brexit vote, which seems to have been undertaken almost casually, without the normal planning for consequences. It has been likened to a dog that to its amazement catches the car – now what? The consequences for the remarkable experiment of the European Union are unknowable but potentially profound. The U.S. political scene seems to me to have plenty of similarities and perhaps we, too, will have our “now what” moment before long.

The economic and financial background to these apparently uncontrolled political experiments is also novel and risky. In a way never seen before, our financial establishments are driving interest rates toward zero and beyond. How will this end? I think of these political, social, and financial experiments as Black Hole Experiments in which the further we push them, the more the laws of physics, finance, or politics begin to change in unknowable ways. We live in interesting times.

[On the investment front the equation remains the same: pushing stock prices higher are the twin forces of the Fed’s policy and corporate buybacks. Trying to push prices down is an impressive array of everything else: disappointing productivity, growth, and profit margins together with all our domestic and international political uncertainties. And now Brexit! It is a testimonial to the strength of those two bullish forces that they can steady the U.S. market near its high, regardless, apparently, of what is thrown at it. I therefore remain, on the basis of those two remarkable pillars of support, for at least one more quarter where I have been for the last two years; despite brutal and widespread asset overpricing, there are still no signs of an equity bubble about to break, indeed cash reserves and other signs of bearishness are weirdly high.

In my opinion, the economy still has some spare capacity to grow moderately for a while. All the great market declines of modern times – 1972, 2000, and 2007 – that went down at least 50% were preceded by great optimism as well as high prices. We can have an ordinary bear market of 10% or 20% but a serious decline still seems unlikely in my opinion. Now if we could just have a breakout rally to over 2300 on the S&P 500 and a bit of towel throwing by the bears, things could change. (2300 is our statistical definition of a bubble threshold.) But for now I believe the best bet is still that the U.S. market will hang in or better, at least through the election. P.S.: Having admitted my error in commodities, I would like to clock in the seventh anniversary of my “7 Lean Years” prediction for the economy back in 2009. The speed of the recovery, and particularly productivity gains, has been very lean indeed.]

Immigration from outside Europe is the potentially explosive problem and Brexit may be the fuse

There is a consensus that social cohesion is the key to a successful society. It brings with it the broadest range of advantages: greater economic mobility; longer lives and better health; fewer babies born to teenagers; fewer traffic deaths, murders, suicides and robberies; a smaller percentage in prison; and less stress and higher levels of contentment, amongst others. Not bad.

The biggest simple input to social cohesion turns out to be income equality, which is correlated highly with every individual measure of social cohesion listed above. The exhibit below provides an example. Conversely, income inequality leaves the impression, probably correctly, that the political voice of the poor has been lost or weakened.

Gluttons for data on this issue must read The Spirit Level: Why Greater Equality Makes Societies Stronger by Kate Pickett and Richard Wilkins. It will make income equalizers out of all of you.

According to the authors, both professors of sociology, Japan tops the list for both income equality and social cohesion. It is closely followed in both by the Scandinavian countries. At the other end, the U.S. has deteriorated rapidly in both measures and now ranks dead last among developed countries, with the U.K. not too far behind.

Economic growth, in fact, has been tilted sharply toward the better-off in both countries. In the US, which for once is worse than the U.K., there has notoriously been no material progress since 1970 (45 years) in the real hourly wage, even as the income of the top 1% has more than tripled. Tax rates have not attempted to balance this but have actually changed to lower the relative burden on the well-off! Blue-collar work, especially in manufacturing, has been hard to get in both countries. Since 2009 in the U.S. about 10 million new jobs have been created and a remarkable 99% have gone to workers with at least some college education.

It might be expected that blue-collar and less well-educated workers would be disappointed in both countries, and they are. Parents now widely believe for the first time (ex the Great Depression) that their children will not be better off than they themselves are. In these circumstances, social cohesion has rapidly decreased and immigration has risen in importance, which we see in both the Trump campaign and the pro-Brexit arguments.

Moving on to other data, when asked point blank in polls, “Do you think there are already too many immigrants?” over 40% of the general public of most European countries have answered “Yes” for decades. (The Scandinavian countries and Germany were more favorably inclined in recent years.)

In the U.K. in the 1960s and 1970s, an admittedly difficult time for them, the “Yes” vote ran around 80% with a high of 90% in 1974! In the 1980s and 1990s, with better economic times, the “Yes” vote steadily declined. Ironically, in light of Brexit, by 2015 it measured its lowest at about 55%. But still 55%. If the issue of a referendum can be tilted toward immigration, 55% is obviously still a dangerously high number.

Looking at the effect of immigration on social cohesion, one must deal with a lot of obliqueness in academic work: most papers seem to be reluctant to appear anti- immigrant or racist. Yet most conclude that trust is usually lower in diverse groups than homogeneous groups: that religious and visible differences – dress and skin color – are less easily dealt with, not surprisingly, than immigrant groups with similar cultures. My interpretation of various carefully stated conclusions is that when times are good immigrant flows are perceived as a moderate and manageable stress to social cohesion. This is true even among groups that are not happy with the general principle of steadily increasing immigration.

When times are seen as bad, though, especially when jobs are scarce as they are for blue-collar workers now, new immigrants are seen as far more problematic. When combined with steady increases in income inequality (as they are in both the U.K. and the U.S.), weakened social cohesion, and high levels of dissatisfaction, immigration issues become very significant.

At times, this response appears to ignore the actual economic facts. The “Leave” vote in Brexit was uncorrelated with actual local wage gains over recent years, for example. Some towns with excellent recent wage increases still voted “Leave” and vice versa.

With considerable (and understandable) ignorance of economic details, the Brexit voters were expressing commonly held views that were often based on skewed data and were also very easily manipulated by politicians and the press – which in the U.K. often has editorial bias in all reporting. For Americans, think Fox News.

The U.K. voters’ knowledge of the salient facts did not look impressive in Brexit. According to the number of Google hits, many were not too sure what the EU actually is, let alone the precise implications of leaving it. There was considerable confusion between Syrian refugees and intra-EU migrants. Above all, there was a strong expectation that free trade with the EU could be retained without both payments to the EU and free intra-EU immigration continuing (the conditions Norway agrees to). There is absolutely no hope of that. If the U.K. really means to have its own immigration policy, it will have to negotiate new treaties with the EU and the rest of the world, and it will need to do so without experienced trade negotiators, who have not been required in the U.K. for many years.

In that eventuality – no EU free trade agreement – many firms will slowly or quickly move some of their business out of the U.K. and into the EU to avoid tariffs. London’s financial business will be especially vulnerable.

With most voters substantially ignorant and many deliberately misled, there may be an interesting consequence: extreme and rather rapid regret. As business and consumer confidence quickly weakens, economic activity falls, and racist incidents jump (at least 60% recently), there could be and should be disillusionment at the many misrepresentations and apparent complete lack of preparedness and willingness to actually lead by Brexit advocates.

The lack of clear constitutional rules around referenda in the U.K. and the uniqueness in the EU of a country’s withdrawal provide waffle room. There can be plenty of time before an irrevocable decision is made, and much can happen. Both Denmark and Ireland reconsidered EU votes. My semi-educated guess is that there is a substantial one in three shot that the U.K. will also reconsider.

If Brexit holds, pretty clearly Scotland will leave the U.K. as might Northern Ireland. This will make a painful irony out of the single most frequently quoted reason for leaving: “Make Britain British Again.” They will probably have to settle for “Make England (and Wales) English (and Welsh) Again.”

In total, if Brexit occurs, the U.K. economy will be hurt for several years. In the longer term, though, there may be some offset for the U.K. economy by virtue of having a smaller financial sector and a more balanced, less London-centric economy.

Brexit may even stimulate the EU to reconsider its many weaknesses. It is a particularly complicated exercise in government and as such is prone to unfortunate decisions. It is less democratic than it needs to be, but it appears to be much less democratic than it really is. It has been overconfident about its acceptability to the general public of its member states and badly needs better P.R. Brexit may be seen in 20 years as having woken up and revitalized the EU.

On the other hand, and perhaps more likely, Brexit may cause the failure of a noble experiment that above all has brought peace to Europe. Germany just experienced 70 years of peace for the first time in its entire history. Adding to the long list of EU deficiencies, Brexit may be the straw (or bale of straws) that breaks the camel’s back.

The key issues here are risk and unintended consequences. When you are muddling through okay, as was the U.K., with no wars or other complete disasters, why rock the boat?

The precautionary principle should apply. The unknowable, unintended pain from Brexit for the U.K., the EU (especially some of its more vulnerable members), and, perhaps, the world are simply not worth the risk. By far the worst risk, and one that is most underestimated to a weakened or collapsed EU in my opinion, is from immigration or refugees from outside Europe.

The truth about immigration to the EU, in my view, is bitter. As covered in earlier quarterlies, I believe Africa and parts of the Near East are beginning to fail as civilized states.

They are failing under the pressure of populations that have multiplied by 5 to 10 times since I was born; climate for growing food that is deteriorating at an accelerating rate; degraded soils; insufficient unpolluted water; bad governance; and lack of infrastructure. Country after country is tilting into rolling failure.

This is producing in these failing states increasing numbers of desperate people, mainly young men, willing to risk money and their lives to attempt an entry into the EU.

For the best example of the non-compute intractability of this problem, consider Nigeria. It had 21 million people when I was born and now has 187 million. In a recent poll, 40% of Nigerians (75 million) said they would like to emigrate, mostly to the U.K. (population 64 million). Difficult. But the official UN estimate for Nigeria’s population in 2100 is over 800 million! (They still have a fertility rate of six children per woman.) Without discussing the likelihood of ever reaching 800 million, I suspect you will understand the problem at hand. Impossible.

I wrote two years ago that this immigration pressure would stress Europe and that the first victim would be Western Europe’s liberal traditions. Well, this is happening in real time as they say, far faster than I expected. It will only get worse as hundreds of thousands of refugees become millions.

The EU and Europe may support a few years of increasing numbers of these failing state refugees, but that is all. They will fairly quickly have to refuse to take even legitimately distressed refugees. The alternative – to take all comers – would likely be not just a failed EU, but a failing Europe. The key question now is what social and political problems will be caused by the stress of getting from here to there: from today’s chaos to a time when European borders will have uniform and controlled immigration.

Brexit is an early warning of how sensitive this issue will be. A serious country, or at least a formerly serious country, the U.K. is risking a lot at a small whiff of the immigration problem that is coming. (Immigration problems in the U.S. are trivial in comparison to what Europe faces, yet they have already become a serious political issue.)

The EU (with or without the U.K.), and indeed the whole of Europe, must get a uniform policy on immigration as soon as possible. Yet, based on what they say, they do not yet appreciate the long-term seriousness of their predicament. They are, though, behaving like headless chickens faced with the problems they already have. Problems that will, when viewed from the future, appear to have been just moderate in scale.

By far the biggest downside of Brexit is that it serves to weaken the EU at exactly the wrong time — as external immigration begins to seriously stress governance and political cohesion.

In the larger context of immigration, because I believe I have no serious career risk on this issue (touch wood!), I should say that I believe that the U.K. and many other European countries have not had a net benefit from immigration. In 1945 they were, in most cases, culturally and ethnically homogeneous. This was absolutely not the melting pot situation of North America. Steady immigration was supported by the elite-intellectual, political and economic. It occurred largely against the will of the people in that more were nervous about increased immigration than were enthusiastic. It seems likely that in most cases immigration made social cohesion more difficult.

Any offsetting economic advantage for the U.K. has to be on a productivity basis, for driving GDP forward by population increases alone is no bargain in a small, overcrowded island that feeds barely half its own population (although business support for growth of any kind is often forthcoming). Possible productivity gains from immigration seem at best to be insufficient to offset increased social stresses. There, I said it.

This does not mean that a country based on immigration (trained, if you will) cannot integrate not just immigrants, but the whole idea of immigration. If times are good, or good enough, for a sustained period and income inequality is held in some check and social welfare is fine, you could end up like Toronto, everyone’s heroine in this respect. If not, you could even easily end up with a melting pot history and the current conflicted attitudes to immigration that we have in the US.

In case you missed it, my sympathies are split between admiration for Toronto and sympathy for the voters of Doncaster, my hometown and a former coal mining center. Its population has made moderate economic progress since 1945 despite the loss of mining and other industrial activities, like most northern towns. But in looking at the more important relative progress, inhabitants cannot avoid seeing how obviously the fortunes of London bankers, the top 10%, and, indeed, the south in general have left them in the coal dust. (Poetic license given Thatcher closed most of the mines and the very last one closed recently.) They voted over two to one for Brexit.

On the margin, the Brexit vote was won because some key groups expected to lean Brexit produced unexpectedly high margins: medium and small northern towns (such as Doncaster), the elderly, and the less well-educated.

Codicil: the real blame for Brexit

The lack of serious political intent to narrow growing income inequality. This has caused a growing disgruntlement of the bottom half of the economic order and the usual weakening of social cohesion.

A lack of success in mitigating economic weakness in the formerly industrial north. As globalization took their jobs, an epic effort was required to retrain and re-employ these workers. Little was done. Northerners never much cared for London government and Southerners in general at the best of times. Now feeling mistreated, with justification, they took delight in making a rude gesture to the establishment.

Calling for an utterly unnecessary referendum by the Prime Minister for superficial and short-term political gain. He could have muddled through anyway. Referenda are dangerous. They allow for the true will of the people to be voiced, informed or ill-informed, manipulated or not. Dangerous. As Churchill said (now much quoted), “The best argument against democracy is a five-minute conversation with the average voter.” He might also have commented about the willful laziness of the one-third who never vote.

The U.K. press, the most egregiously editorialized in the developed world. The broad circulation papers goaded and badgered their readers toward Brexit.

As for the politicians, forget it. Whimsical theories, back-stabbing disloyalties, a glaring lack of planning and foresight. Above all, completely ignoring the precautionary principle, playing with fire like children. Now those Brexiters that haven’t run away can reap what they have sown, as unfortunately will the whole U.K. If you will, the pack of dogs can now try to work out what to do with that darned car.


Grantham is founder of GMO, a Boston-based asset management firm.


If You Can’t Touch It, You Don’t Own It

by Jeff Thomas
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The pending Brexit has, not surprisingly, caused a shake-up in the investment world, particularly in the UK. Of particular note is that, recently, asset management firms in Britain began refusing their clients the right to cash out of their mutual funds. Of the £35 billion invested in such funds, just under £20 billion has been affected.

For those readers who live in the UK, or are invested in UK mutual funds, this is reason to tremble at the knees.

So, why have these investors been refused the right to exit the funds? Well, it’s pretty simple.

The trouble is that quite a few of them made the request at about the same time. Of course, the management firms don’t keep enough money on hand to pay them all off, so rather than spend all their money paying off as many clients as possible, then going out of business due to a lack of liquidity, they simply announce a freeze on redemptions.

Those who are outraged may read the fine print of their contracts and find that the fund managers have the right to halt redemptions should “extraordinary circumstances” occur. Who defines “extraordinary circumstances”? The fund managers.

Across the pond in the US, investors are reassured by the existence of the Securities and Exchange Commission, which has the power to refuse this option to investment firms… or not, should they feel that a possible run on redemptions might be destructive to the economy.

Countries differ as to the level of latitude they will allow mutual fund and hedge fund management firms to have on their own, but all of them are likely to err on the side of the protection of the firms rather than the rights of the investor, as the firms will undoubtedly make a good case that a run on funds is unhealthy to the economy.

The Brexit news has created a downward spike in investor confidence in the UK – one that it will recover from, but nevertheless, one that has caused investors to have their investments locked up. They can’t get out, no matter how much they may want to. This fact bears pondering.

Presently, the UK, EU, US, et al., have created a level of debt that exceeds anything the world has ever seen. Historically, extreme debt always ends in an economic collapse. The odiferous effluvium hasn’t yet hit the fan, but we’re not far off from that eventuality. Therefore, wherever you live and invest, a spike such as the one presently occurring in the UK could result in you being refused redemption. Should there then be a concurrent drop in the market that serves to gut the fund’s investments, you can expect to sit by and watch as the fund heads south but be unable to exit the fund.

As stated above, excessive debt results in an economic collapse, which results in a market crash. It’s a time-tested scenario and the last really big one began in 1929, but the present level of debt is far higher than in 1929, so we can anticipate a far bigger crash this time around.

But the wise investor will, of course, diversify, assuring him that if one investment fails, another will save him. Let’s look at some of the most prominent ones and consider how they might fare at a time when the economy is teetering on the edge.

Stocks and Bonds

Presently, the stock market is in an unprecedented bubble. The market has been artificially propped up by banks and governments and grows shakier by the day. Bonds are in a worse state – the greatest bubble they have ever been in. This bubble is just awaiting a pin. We can’t know when it will arrive, but we can be confident that it’s coming. Rosy today, crisis tomorrow.

Cash on Deposit

Cyprus taught us in 2013 that a country can allow its banks to simply confiscate (steal) depositors’ funds should they decide that there is an “emergency situation” – i.e., the bank is in trouble. Unfortunately, the US (in 2010), Canada (in 2013), and the EU (in 2014) have all passed laws allowing banks to decide whether they’re “in trouble.” If they so decide, they have a free rein in confiscating your deposit.
 
Safe Deposit Boxes

Banks in North America and Europe have begun advising their clients that they cannot store money or jewellery in safe deposit boxes. Some governments have passed legislation requiring those who rent safe deposit boxes to register the location of the box, its number, and its contents with the government.

Each year, the storage of valuables in a safe deposit box is becoming more dubious.

Pensions

Pension plans tend to be heavily invested in stocks and bonds, making them increasingly at risk in a downturn. To make matters worse, some governments have begun to grab pension money.

Others, such as the US, have announced plans to force pensions to invest in US Government Treasuries – which, in a major economic downturn, could go to zero.

These are amongst the most preferred stores of wealth and are all very much at risk. But there are also two choices that, if invested correctly, promise greater safety.

Real Estate

The Mutual funds in the UK that are presently in trouble are heavily invested in real estate. But real estate that you invest in directly does not face the same risk. However, any real estate that’s located in a country that’s presently preparing for an economic crisis, such as those mentioned above, will be at risk. Real estate in offshore jurisdictions that are not inclined to be at risk is a far better bet. (An additional advantage is that real estate in offshore locations is not even reportable for tax purposes in most countries because it cannot be expatriated to another country.)

Precious Metals

Precious metals are a highly liquid form of investment. They can be bought and sold quickly and can be shipped anywhere in the world, or traded for metals in another location. Of course, storage facilities in at-risk countries may find themselves at the mercy of their governments.

However, private storage facilities exist in Hong Kong, Singapore, the Cayman Islands, Switzerland, and other locations that do not come under the control of the EU or US. Precious metals ownership provides greater protection against rapacious governments, but storage must be outside such countries.

The lesson to take away here is that if you can’t touch it, you don’t own it. Banks and fund management firms can freeze your wealth so that you can’t access it. Governments and banks can confiscate your wealth. If you don’t have the power to put your hands on your wealth on demand, you don’t truly own it.

This evening, make a list of all your deposits and investments and determine what percentage of them you do truly own. If you decide that that percentage is too low for you to accept, you may wish to implement some changes… before others do it for you.


How to Save Public Pensions, No Federal Bailout Needed

It isn’t unprecedented for the feds to spur local pension reform. Kennedy and Reagan both did.

By Ed Bachrach

    Photo: Getty Images/Ikon Images


The pensions of states and local governments are, collectively, trillions of dollars in the hole.

This debt is crippling budgets and will dump an enormous burden on future generations. Yet state and local politicians have proven that they cannot, or will not, solve the problem. The federal government ought to step in. But how?

Instead of bailing out these pensions, Congress should pass a law allowing states and local governments to reduce promised benefits—something that is now illegal under some states’ statutes or constitutions. Congress should stipulate that pension plans must be in very bad shape to qualify for relief, and the politicians in charge of them would have to voluntarily seek it. Most important, pensions should be required to uphold their original intent: to keep retirees who can no longer support themselves out of poverty.

Even with those restrictions, significant savings could be made. Many pensions allow retirement at age 55; states and local governments could mandate that benefits cannot be drawn until age 65.

Payments could be capped at 150% of the median income in the local jurisdiction. Automatic cost-of-living increases that now exceed expected inflation could instead be tied to increases in the median income.

Troubled plans should qualify for relief only if their funding ratio falls below 50% and has failed to improve over the past five years. These are the plans that are in fiscal quicksand and cannot be saved without significant changes.

Local governments must also be required to terminate their defined-benefit plans. These should be replaced with defined-contribution plans, like 401(k)s or 403(b)s, or active employees could be enrolled in Social Security. Responsible officials are already taking this step: The board of the Tennessee Valley Authority voted in May to switch to a 401(k)-type plan and lower the cap on cost-of-living adjustments.

Once these steps are taken, the local government should be required to fully fund the remaining pension liability with a tax increase. That should be the deal: To receive the relief of reducing promised benefits, they must agree to solve the pension problem once and for all.

What would this look like in practice? Let’s say that a retired firefighter in a troubled pension plan is set to receive $70,000 annually. If that is below 150% of the median income in his local jurisdiction, under federal relief his annual benefits would never be subject to the cap, since they would rise as the local median income increases.

What about a retired cop who became a city councilman and later a county supervisor—an extreme, but not unheard of, case? The cop would not be able to collect three pensions and would have his benefit reduced to meet the cap. Both the firefighter and the politician would have to wait until turning 65 to receive benefits.

No one wants to see his benefits reduced. Yet keep in mind that a retiree who receives a $75,000 pension for 30 years, with 3% compounded cost-of-living adjustments, gets total payments of more than $3.4 million. This has become common in cities like Chicago.

I am not the first person to suggest federal intervention. Rep. Devin Nunes (R., Calif.) proposed withholding federal aid to government entities that don’t accurately report pension funding. That would be a step forward but would not solve the problem of underfunding.

Diana Furchtgott-Roth of the Manhattan Institute has proposed a law that would allow local governments to seek relief from pension debt in bankruptcy court. But this leaves too much discretion to judges and could lead to wildly different outcomes. Plus, such open-ended relief would be fiercely fought by public-employee unions every step of the way.

Federal intervention is not unprecedented. The Windfall Elimination Provision of the Social Security Act, an amendment that was passed in 1983, allows the federal government to reduce Social Security payments when recipients also receive pensions from public employment. This has curbed double-dipping and protected the Treasury.

Nor should a new plan for federal relief be seen as a purely partisan issue. In 1961 President John F. Kennedy established the Committee on Corporate Pension funds. This eventually led to the Employee Retirement Income Security Act of 1974, which outlawed abuses and forced private firms to put required money into their pension plans each year.

The plan outlined here would create a consistent and concrete path toward making pensions manageable for taxpayers. At the same time, it would protect retirement income for those unable to support themselves. The next president and Congress should take action to allow local governments to address this monumental problem—which gets worse by the day.


Mr. Bachrach is the founder and chairman of the Center for Pension Integrity.


Watch the Dollar, Not Rates, as Fed Meets

A Federal Reserve rate increase could do more to strengthen the greenback than raise Treasury yields

By Justin Lahart

     The Federal Reserve is considered unlikely to tighten policy this week, but it may signal a rate increase could happen as soon as September. Photo: Zuma Press


The Federal Reserve is laying the groundwork to raise rates again. The dollar, rather than bonds, will likely bear the brunt of the increase.

While there is little chance the Fed will tighten policy this week, it will likely use the meeting as an opportunity to signal that its next move on rates could happen as early as September. A series of stronger-than-expected economic reports has allayed fears that the economy was slowing, and with the stock market hitting new highs, worries about Brexit’s effects on the U.S. economy have faded.

But rather than push Treasury yields higher, a hawkish turn from the Fed might instead strengthen the dollar—a repeat of what happened in the run-up to last December’s rate increase.

Increasingly, it seems like the old playbook, in which the Fed raises short-term rates and long-term rates follow, doesn’t work like it used to. It is a playbook that treats the economy as closed—one where international trade and global financial markets have only a negligible effect. For big economies like the U.S., such closed-economy models have been a useful framework.

But the U.S. isn’t as closed as it used to be, and that is making the Fed’s job harder. Trade, as measured by combined exports and imports, was 28% of gross domestic product in 2015, up from 20% in 1990.

America’s exposure to global financial markets is much higher. Foreign-exchange trading in the dollar has nearly quintupled since 1995. The Fed got its first real taste of the downside to this exposure in the mid-2000s, when heavy demand from emerging-market investors pushed Treasury yields lower even as it raised rates.

With the world’s central banks easing policy, an open-economy model, traditionally applied to smaller, trade-exposed countries like the Netherlands, may be the better framework. In it, interest rates are set by the world rather than the central bank. Capital flows to countries with higher rates, pushing those rates lower.

Higher demand for those higher yielding bonds pushes the currency higher. This slows the economy, but it slows it in a different way than higher long-term interest rates do. Rather than raising borrowing costs, it hurts domestic businesses by making their exports more expensive and imported goods cheaper.

The statistician George Box was fond of saying that all models are wrong, but some are useful.

For now, the open-economy model may be the useful one for U.S. investors.