Saturday, April 30, 2011

Does the Bond Market have Inflation Wrong?

You arrive from another planet and are told that inflation is a big problem in the United States. You pick up a copy of the New York Times and based upon your reading of the headlines you would believe it to be true. You read the front page and see stories about increasing oil and other commodity prices and the sky rocketing price of gold and the impact of high energy prices on the spending habits of the consumer. You think that inflation is rampant.
 
On your home planet you learned a great deal about investing in your market from a very early age. Your teachers told you that with increased inflation you have to have higher interest rates. Interest rates have to increase in order to compensate the investor for buying bonds today for the decline in the value of their money caused by inflation.
 
In looking at the Business section of the paper you go to the US Government Bonds pricing section and you see a chart similar to the one on this page. You look at the return on 90 day T-Bills at 4 basis points per year. You stop and think about how little 4 basis points is in 12 months. You calculate that 4 basis points on $100 is about 4 cents a year. That doesn’t seem like much so you look out 5-years and you earn $1.97 per year for your $100 investment. So, one more time you look out 10-years and you find that you can earn $3.29 a year for every $100 you invest. None of these returns make sense if  inflation is truly out of control.
 
If you look at the yields in the Government market place you would not see any signs of inflation that you read about on the front page of the New York Times or any other newspaper. The big question is, “what is the bond market telling us and is the bond market wrong on inflation?" I think there is another concern that the bond market is telling us. It is more important to investors than inflation. We had a GDP report this week and the government said that the initial estimate for GDP in the first quarter of 2011 was annualized to 1.8%. Now the GDP will go through two more adjustments, but right now most economists think we will stay around the 2% level or perhaps a little less.
 
What the bond market is screaming that nobody, but perhaps me, is concerned about or is even talking about, is not inflation or deflation, but a new recession in the economy. Notice I didn’t call it a double dip because we have had a recovery albeit tepid it was still a recovery.
 
I have written in this column in the past that the Federal Reserve is in control of the short-end of the yield curve, but the “Bond Vigilantes” have control of the rate of interest out past a year in maturity. The “Bond Vigilantes” do not seem to be worried about the credit markets at least at the moment. We talk about all the debt we have and how we are spending our childrens and grand childrens wealth to pay the debt. Yet interest rates are falling not only in the United States, but also around the world. The British Bankers Association publishes a daily London Inter Bank Offered Rate (LIBOR). The US Dollar LIBOR interest rate has dropped to its lowest level in the last 14 months, 27 basis points annually for 90-day term.
 
Back here in the United States we have 90-day T-Bills at 4 basis points, The European Central bank moved their short-term interest rate up this past month, but has indicated that they will not move again until the US increases interest rates. They could be waiting a long time.
 
I think that much later, perhaps as late as 2013, we will see an increase in interest rates and that is why we own TBT as a hedge against increasing interest rates. Interest rates will go up and down in the interim, but if  I’m right and the economy turns negative in the fourth quarter  of 2011 to  the first quarter of 2012 then the greatest risk in investing now is the American stock market or for that matter any stock market that is driven by growth expectations. If the US economy turns south later this year, then look for the commodity markets to sink under the sheer weight of their unchecked advance.
 
Wasn't it fun to read this blog? Seriously, they may not all be of good cheer but  they are at least my honest opinion. We will see if my crystal ball is any better than others.
 
 
Dan Perkins
 

 

Thursday, April 14, 2011

You have to wonder if Washington is listening to us.Do they really think we are stupid?

The government cut $38 billion out of this year’s budget and one could ask if they were serious about controlling our debt. You have probably already read about some of the games that were played to come up with the $38 billion. Things like money that wasn’t spent but appropriated in previous years. Then we have money from programs that were being cut because of duplication.

Pew Research Center conducted a poll to find out one-word answers as to how people felt about the budget process. The list to the left shows the one word answers people used to describe how they felt about the most recent budget cuts and the process congress used. This was before we found out on Tuesday, April 12 how they really did it. Scroll down the list and see if you can find a word with which you agree.

The Ipsos/Reuters poll found that 71% of those surveyed opposed increasing the debt limit even though they were told that, "not raising the debt limit would damage the US sovereign debt rating, which is like our credit rating. It would seriously damage our credibility abroad, would make it much more difficult for us to borrow in the future, and would likely push up interest rates."  50 percent of those polled didn’t care. In fact, in a later poll, the number jumps to above 60% that do not want the debt ceiling raised, regardless.

It seems to me that these agreements to cut the budget $38 billion was a drop in the bucket when compared to a $3.8 trillion budget for this year.  The $38 billion is equal to just over 1% of the budget. As you read where the money really came from it isn’t much of a budget cut.

I’m sure that you know that the debt ceiling will be reached around May 12. As was pointed out above, over 60% of Americans do not want the budget ceiling raised, in fact they want to start seeing the budget come down.

I recently heard a news clip of Andrea Michel from NBC news interviewing a congressman about the percentage of Americans opposed to increasing the deficit. She asked the question, “How do we educate the American people about why the debt ceiling has to be raised?”  Perhaps the American people have already spoken Andrea. They want congress to cut the size of government. I think implied in the question is the belief that the American people are not smart enough to understand why we have to keep raising the debt ceiling.

Americans have come through a very difficult time since the financial meltdown of 2008. Their actions speak volumes as to what Federal, State and local governments must start doing to get their financial houses in order. If we get to May 12 and the congress has failed to make a commitment to seriously reduce the deficit we may well go into default and I suspect we may see recall elections all over the country this fall if the debt ceiling is raised. The congressmen, and women, and Senators won’t have to worry about the 2012 elections, they will have to deal with massive recalls in 2011. 

Dan Perkins1.