Ground Zero

I’ve had many mentors during my career who shared with me their wisdom. One friend told me, Sarel there are two business rules that you must comprehend and apply. The five finger rule and the two finger rule. Showing his right hand and counting from the thumb he said: “The five finger rule is, What’s-In-It-For-Me?” The two finger rule he said is, “Buy low, Sell high.” Silly rules easily made off as platitudes yet they sneak up upon you when you analyze your investment and economic environment.

So we ask of the stock exchange; is it time to buy or time to sell? Buy low and sell high. Perhaps we look at residential property and ask if it is time to buy or sell. Buy low and sell high. What about commercial and industrial property? Buy low and sell high. How about government bonds? Buy low and sell high.

These questions are asked within a relative frame of reference but when we ask the bond question it is when we hit ground zero. The “risk free” short term interest rate is set at zero. Zero is as low as it gets, it simply cannot go lower. Zero interest rates plus a risk premium for term funding and one has the bond rate. Bonds are an inverse investment, thus a zero short interest rate is the highest price base possible for bonds. Bonds are as expensive as they can get. That is ground zero for bonds and it originates from a zero interest rate policy

The zero interest rate policy is at the epicentre of the economic distortion. It sends shock waves via investment channels to distort the investment landscape into a twisted and contorted vision of what aught not be. No market can exist without buyers and sellers yet a zero interest rate policy gives zero interest to the saver. The seller of savings is offered nothing, zero and is driven out of the market to be replaced by the central bank providing liquidity. It is an ultimate distortion, one that cannot be corrected unless the central bank withdraws from the position of the saver. That can only be accomplished by increasing interest rates and the economic consequences that follows such structural re-adjustment. It is a ground zero trap.

Having driven the saver out of interest bearing investments is but the start of the process. Where will the saver turn? The three pillars of investment, interest bearing securities, property and shares. Bonds will suffer huge capital losses if interest rates were to move away from zero. So investors must choose between recovery or permanent zero short interest rates. Residential property is a bubble in deflation. Commercial property is a bubble in deflation. Any professional investor in property will know that property is valued on a yield basis and that yield is tied to interest rates. Property has the same inherent pricing structure as bonds; its value is at a maximum when interest rates are at its lowest. Again lower than zero it cannot be.

The first two pillars of investment look decidedly shaky. The saver moves along and plunges into shares but in the search for yield start behaving just as mortgage bankers did taking on the sub prime debt, the no documents - no questions asked investment decisions. Investment funds are channelled into emerging markets on the flimsy argument that these economies can do the heavy lifting to get the global economy on the road to recovery. Exactly how that is supposed to take place is shrouded in mystery.

So we stand back and observe how the structural aberration of zero interest rates forces investment funds into classic stock exchange inflations and see the absence of harmony with the real economy. The participants in this asset inflation are well aware of it but hoping for a rescue from a recovery which by definition cannot co-exist with zero interest rates.

Yet even the stock exchanges are unable to contain the push of zero interest rates. Investment funds spill over into commodities and further distort emerging market investment. Exchange rates between weak economies and strong economies express as strong currencies for minions and weak currencies for giants. We note leading indicators measuring the stock exchange exuberance and the results of relentless “green shoots”, “better than expected” and “stimulations” propaganda to mislead investors further into risky assets. Emerging markets pile on debt and stock exchange investments in “strong currencies” which their populations can never hope to repay. Debt, which is uncovered for exchange rate risk since the currencies are appreciating. Debt, when it is called will drop their currencies faster than the mercury in a tropical storm. These emerging markets will default as they must just as weak unsuitable debtors had to default on their mortgage loans. The only difference is the bubble in residential property and the bubble in emerging market currencies. “House prices never fall” is a much stronger hope to cling to as opposed to “emerging currencies will keep rising”. Pushing giant economies’ stimulation liquidity into emerging markets is no panacea for the global economic woes, nor will it restore any of the structural deficiencies of abused monetary and fiscal policies. A weak currency policy of giant economies is the script for sovereign defaults. Special Drawing Rights from the IMF cannot prevent sovereign defaults. It will only deepen the debt trap when the illusion of bubble currencies is exposed.

Here is where we need to apply the five finger rule? What’s in it for the emerging markets (or what was in it for the sub prime borrower)? What’s in it for the investor in emerged markets who looks beyond the yield pick-up (or what was in it for the mortgage and investment bankers who dabbled in sub prime debt and its securities and did not consider the liquidity trap of rising residential property prices)? What’s in it for investors to participate in stock exchange inflations, (or what was in it for those who fell over the cliff)?

The ultimate “what’s in it for me?” question is the one governments will soon be asking about stimulations. What is government looking to get out of stimulations? Government will look at its own pocket and will ask the question, “do we get more tax as a result of our stimulations?” and the answer will be patently clear. Ground zero for fiscal policy will be the realisation that stimulations are not a miracle economic cure and as with zero interest rates, a fiscal choice will be made for permanent structural distortion or a new beginning. Japan chose the former on monetary and fiscal policy. Will all leading economies follow the example of Japan into a twenty year economic wilderness?


Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
25 October 2009


© Sarel Oberholster



Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .