Next Recession: Concentrating Future Losses & Bringing Them Forward In Time As Profits

If there is another recession in the next 1-2 years, then the Fed is highly likely to respond by swiftly moving Fed Funds rates back down to zero percent.

One likely result is that millions of investors will lose 83% or more of their future income over a period of years.

The money won't all actually be lost, however. Instead, much of it will be brought forward in time and passed through to a different group of investors as profits - in concentrated form.

In this analysis, we will focus on understanding how an unintentional - but necessary - byproduct of the Fed's dilemma and known plans when we enter the next recession, will be to strip wealth from some investors and to bring that wealth forward in time to be "caught" by other investors.

This analysis is part of a series of related analyses, an overview of the rest of the series is linked here.

Dramatic Profits From Zero Percent Interest Rates

We currently have multiple warning signs of a possible recession within the next one to two years. As explored in previous analyses in this series, if we do have a recession then we already know in advance what the Federal Reserve will likely do as a matter of policy (and what it is being discussing in meetings of the Federal Open Market Committee).

As a starting point, the Fed is almost certain to swiftly return Fed Funds rates back down to zero percent.

Most people are probably hoping that those rates were a brief anomaly, never to be seen again, but as previously reviewed - the Federal Reserve doesn't agree. Instead, the staff at the Fed thinks that episodes of zero percent interest rates "could become more frequent and protracted than in the past" (analysis link here).

The consequences could be dire for many strategies - particularly many retirement investment strategies - but what needs to be understood is that there are also likely be some extraordinary profits to be earned along the way.

As explored in detail in the immediately preceding analysis in this series (link here) a return to zero percent interest rates could very well produce a 21% one year holding period return for those who are invested in 10-year treasury bonds.

However, what is critical to understand is that the potential 21% return has a source, and it is not a true creation of new wealth but rather a transfer of wealth. Every dollar of the profits will be coming from other investors, with most of them having no idea that their earnings are quite literally being transferred to other people.

Understanding The Transfer Of Wealth

To understand the transfer of wealth that creates these stunning yields and price gains for one side - and major losses for the other side - we need to better understand the sources of wealth.

The graph above shows the value today of $100 in future cash flows, which is also known as the present value. At a 2.65% yield, we buy that $100 in the first year for $97.40, and we are ahead by $2.60 when we receive the full $100 in a year. As we go out five years, we pay $87.70, and we eventually get our money back plus another $12.30. If we go out 10 years - which is when we get the principal payment for a 10 year Treasury bond - then we pay $77 today, which means that we will get paid $23 dollars in future earnings.

However, to understand where that $77 purchase price comes from, we need to flip our perspective and look at the investment of cash over time.

When we flip our perspective, the blue bars are now our starting investment of 100 dollars. As we go out through time and we earn interest upon that investment at a 2.65% rate, then that cumulative income is being shown as the growing purple bars that are stacked on top. Each year's annual earnings are then reinvested so that we get not just interest, but interest on interest, i.e. compound interest.

The purple bars of the cumulative interest income from our investment steadily build over time. One hundred dollars becomes worth $102.65 at the end of one year, it becomes $113.97 at the end of five years, and our future value reaches $129.89 at the end of 10 years.

The two graphs may look like the opposite of each other, with one decreasing over time and the other increasing, but they are instead the exact same thing - presented two different ways.

The link between the two graphs and the two types of numbers is how we determine the $77 present value today of that individual cash flow 10 years out, in the first graph. We did it by dividing one by the value of our investment with compound interest in the second graph - which is the future value - 10 years out.  We start with 1, we divide by that future value of 1.2989, the result is .77, we multiply that times $100, so we pay $77 today for the $100 that we get 10 years the future, which locks in a 2.65% yield on our investment.

This above is a foundation principle for how prices and yields are determined with almost all investments. Yes, the trade can quite literally be done with bonds, it has been a lucrative trade for institutional investors with previous recessions, and at least hundreds of billions of dollars are likely to be made in practice with the next recession.

However, there are related (albeit somewhat more complex) calculations which on the most fundamental of levels help determine stock and real estate prices and returns as well. Those investment categories are where the great majority of the money is likely to be made from the application of these principles over the coming years, but it is easier to start with fewer variables and the simplicity of fixed cash flows.  

So, when the Federal Reserve slams interest rates around into ever more unprecedented places in the attempt to deal with the interest rate trap that it is currently caught in - then bond, stock and real estate prices and returns also get slammed around into every more unprecedented places, with potentially extraordinary profits and losses along the way.  

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Disclosure: This analysis contains the ideas and opinions of the author. It is a conceptual and educational exploration of financial and general economic principles. As with any ...

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