Monday, September 28, 2009

What Is The Bond Market Telling Us About Inflation?


Recently two powerhouses took different stands on the merits of owning or not owning the longer-term Treasury Bonds. Bill Gross the President and co-founder of PIMCO the largest fixed income manager in the world. Mr. Gross said he had increased his long Treasury positions to the highest level in many years. While on the other hand Jim Cramer of CNBC Mad Money said that he believed you should sell out of any long dated Treasury positions you owned. So far Bill Gross is winning the battle of the forecasters.

Only time will tell if either is correct, but I think the more important issue at hand is what the bond market is telling us about the prospects for inflation and growth. As I write this blog the yield on the 30-year bond is just above 4% while the yield on the 10-year bond is 3.25%. I suggested in a previous blog that I thought that the yield on the ten-year bond could reach 3% perhaps even go below.

When the majority says that something will have to happen it usually doesn’t. The majority is telling anyone who will listen that inflation is just around the corner and the Fed should be raising interest rates now to stem the tide of potential inflation. I believe that bond market is telling a much different story. The bond market is beginning to price in deflation.

The stock markets are going to 10,000 on the Dow Jones and 1,100 to 1,200 on the S&P 500 if you believe the majority of annalists on the street. The S&P 500 has moved almost 60% off of its March 9 bottom. Lets say that the forecasters are correct that the S&P 500 could go to 1,100 from this level by the end of 2009. If the S&P 500 were to go to 1,100 from this level then the upside is 3.7% of additional return not much risk reward opportunity.

Some time ago I suggested that there were a few simple things you could watch to tell you about the recovery in the economy. One was Jobs and another was the real estate market or single-family home sales and prices. I would like to add one other item to your short list of things to watch and that is the price of gold. Gold is supposed to be the great inflation hedge and everybody should have some right. If you adjust the current price of gold for inflation the comparable price to the previous high is $870. If you were to buy gold today at $1,000 it pays no income and if we are in fact headed for deflation you could loose a great deal of money.

I have been saying for some time that I felt that the recovery, when it came, would be weak and unemployment would stay above 8% for an extended period of time, perhaps several years. It appears that a very small minority believe that we could be in for difficulty for several years to come. I just can’t see the Fed raising interest rates with unemployment above 8%. I still expect to see a slow and low recovery and no change in interest rate policy for several years.

I believe that the bond market is giving us a warning. The bond market is saying that inflation is not a problem and it will not be a problem. People keep asking the question; why are people buying all of the excess of US Treasury debt. They can’t understand why this debt is being sold at such low interest rates and with high demand. I believe the answer is that the buyers don’t see inflation and are more concerned about deflation and a US Government bond is still the safest place to have your money. I also believe that people are trying to put a round peg in a square hole by saying this is what should happen based on the past. There are some people who remember the great depression of the 1930”s. I think all the rules are off the table when it comes to investing money today and the demand for the treasury debt is sending a loud and clear signal.

The people who maintained their wealth in the last depression did so by buying Treasuries not common stock. If you are not convinced that the future is not as rosy as many are predicting then you are buying or should be buying Treasuries across the entire maturity curve. My money is on Bill Gross.

Dan Perkins




Friday, September 25, 2009

Who is Buying all of our Government Debt and why? Understanding the Carry Trade.

A carry trade may be a new concept to many of you so let me explain what a carry trade is for investors. In its simplest form a carry trade is a leveraged transaction. If an investor can borrow money at a low enough cost they might be able to invest the money in something that will pay a higher return than the interest expense to borrow the money thus earning the difference called the spread.

If an investor could borrow money in Japan at lets say one quarter of one percent (25 basis points) and can buy US Governments with a yield of 3.4% then he makes the difference between the cost of money and the actual cash flow. In our example the spread is the difference between borrowing at 25 basis points and earning at 3.4% or 3.15%. This spread is 12.6 times greater than the cost of funds, the net of 3.15% divided by.0025 (the 25 basis points).

US Government bonds can be leveraged at pennies on the dollar. Let us assume that we stay within the acceptable leverage that the government thinks is reasonable for US Banks and that leverage ratio is 10 to 1. If we take our example and leverage it 9 more times then our potential return is the 3.4% interest on our initial buy and 3.15% times 10 times. The potential outcome is 3.15% time 10 plus the initial 3.41% on the first bond. The bottom line in this carry trade is the potential of just under 35% return.

Look at the chart below at the bottom you will see the light green line. This line represents the cost of money in Japan.

For over 10 years you could borrow money in Japan for less then three quarters of one percent. The rest of the charts show all the places you could take this money and leverage it as we illustrated above in a carry trade transaction.

There is now a country that is offering interest rates lower than Japan. Can you guess who that country is? The good old US of A. The cost of short-term money in the United States is almost half of what the cost of money is in Japan. Japan has kept interest rates low for over 10 years trying to stimulate its economy but to no avail. The US Central Bank has provided over $1.5 trillion dollars of liquidity in the credit markets to avoid a serious depression in the United States. The US is now in the carry trade business in a huge way. If Japan has had to keep short interest rates low for 10-years to try and protect its level of economic growth then why are so many people talking about the Fed and its exit strategy and begin to raise interest rates. As I have said before I believe that this recover will be low and slow the Fed will be reluctant to increase interest rates with unemployment at almost 10%.

People keep asking why are investors are buying up all of out new issue Government debt? The real answer is that US Government debt has one of the lowest costs and the greatest opportunity for leverage—the carry trade than almost any other fixed income security. If the Fed keeps interest rates low and I think they will, the American carry trade will be around perhaps as long as the one in Japan.


Dan Perkins

Tuesday, September 1, 2009

So what if the dips don’t hold this time?


As the stock market rally continued throughout the summer one of the cries from the talking heads was to buy the dips. With all the put and call activity there is a floor under the market that will keep it from falling below 3% so they say.


We should find out soon if the buying power of buying the dips will hold. The S&P 500 closed down 2.21% on Tuesday. If the dip is going to hold, the dip bottom should be around 991 on the S&P 500. If we break 991 then I believe we could have a series of downdrafts that could take us down to my original target of 900 to 910 on the S&P 500.


Over the summer, as the market rallied, the talking heads were spouting about how much the market is up from its bottom. The S&P 500 is up about 48% from the March 9th bottom, but the rest of the story is that, on a year to date basis, the S&P 500 is up about 11%. If we fall to the 900 to 910 on the S&P 500 we would be, in effect, winding up flat or with zero return for the year. The idea of losing all of the recovery will cause people to react quickly.


We may well have seen the high for the year in the market and if we get to a point where the market drops 5 percent then look for panic selling to increase by those investors who want to protect any profits they have left.


Buying the dips reminds me of the story about the little Dutch boy who stopped the leak in the dike by putting his finger in the leak until someone could come and plug the hole. The pressure of all the water behind the Dike could not be stopped by one finger.


The pressure from many investors who have seen some recovery in their portfolios will act like the water behind the dike. Once the crack begins to open it becomes impossible to stop the onslaught of water coming through the dike. Investor psychology is like the water behind the dike. Once the water starts flowing through the crack more water wants to get through the dike. When the market psychology changes to the point that investors want to get out, the pressure on the markets increases. If we look at what happened in the period from September to March investors were panicked and wanted out at any price. While I do not envision that type of panic selling this time around people will react quickly to get out of stock positions because they do not want to see again the losses they experienced over the last 12 months.


When you start getting nervous about the market and you want to get out you need to think about what you are going to do with the money. According to Barron’s online the average US Government Money Market Mutual fund is yielding on average 3 basis points with On the other hand hundreds of them offering zero yield.general money market mutual funds are yielding 6 basis points but like many of the Government Money Market Funds many of the general money market funds are also yielding zero.


Know where you are going before you go. The old Chinese proverb says, “If you do not know where you are going any road will take you there.” Don’t make decisions under stress. Look at what you own and ask yourself where else you would go with the money. If you can’t find a really good alternative then stay where you are. You need to look around and see how many other people have their finger in the dike.

Dan Perkins