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Summertime, And the Livin’ is (not quite so) Easy


The chart at the top shows the performance of the bond market over the past 30 years. This thousand foot view over a long period of time shows that you could have quintupled your money in long-term treasury bonds over the past 30 years with no exposure to the stock market. Its pretty amazing when you think about it.

But the question anyone that is loaning our government money should be asking is: how much higher can the bond market go AND how much lower can yields go? Prices and yields are inversely correlated for fixed income investors – as yields go down, prices go up, and as yields go up, prices go down.

If yields can’t really go down much more, you have to ask yourself whether the risk is to the downside on the value of the fixed income investments that you own. And, if the risk is to the downside, then what might be out there that could cause yields to rise and prices to go down.

Enter stage-left: St. Louis Federal Reserve Bank President James Bullard. Here is a link to a white paper he released on Friday (you’ll need to copy/paste it into your browser):

In the paper, he advocates that the US faces Japanese style deflation (falling prices for assets) that could last decades unless the Fed takes some action (this is paraphrased from the long paper). The action being implied is another round of Quantitative Easing (aka, QE) – remember the $1 trillion in mortgages that the Fed bought from Wall Street banks during the crash – it basically printed dollars and exchanged them for the mortgage loans. The concept is that the Fed prints dollars and gets them into the banking system – banks exchange them for treasury bonds to earn a positive return on this free money – and eventually, lending will increase as the recession wanes, pushing economic activity and GDP higher. Good theory.

Unfortunately, the first trillion dollars didn’t do much to stimulate economic growth as the treasuries never got converted into loans – it however did allow many homeowners to refinance their mortgages and positively impact their personal balance sheets, so that was a positive.

Bullard’s plan for the next trillion (or whatever the number ends up being – bigger or smaller) is for the Fed to print dollars and buy treasuries directly from the US Treasury who would spend it on “stuff” in the real economy, thus putting money into circulation that otherwise would not be there. This assumes that the US Treasury would spend it on stuff that impacts the economy in the way Bullard envisions, I suppose.

There are lots of conflicting debates going on about whether the Fed will actually take this step. They clearly do not want to be viewed as allowing the economy to falter along for a generation like Japan’s has, nor do they want to see it fall into that elusive double dip recession, especially in an election year. So there needs to be a catalyst that convinces them that the economy is softening to the point where such drastic measures are needed.

Enter stage-right: Ugly Economic Reports
1. Pending home sales came in at -2.6% in stead of the consensus forecast of 3.9% following up last month’s -29.9%.
2. Factory orders also dropped to -1.2%, versus expectation of -0.5%, after the prior -1.4% reading.
3. June durable goods number was revised from -1.0% to -1.2%.

The Fed has a couple hundred billion dollars of mortgages maturing soon, and if they simply allow them to mature and take the proceeds, that ends up being a de facto monetary tightening, which I can’t see them allowing based upon the above economic reports. These reports may not be a sufficient catalyst to cause them to go for the full enchilada of another trillion in QE, but my best assessment is that they will certainly buy a couple hundred billion in new mortgages or treasury bonds in order to avoid the de facto tightening.

Is this the right solution? No, but the right solution is too politically unacceptable – less debt (government and private), lower asset prices, and better industrial/economic policy, a freeze and means testing on entitlements, lower government spending (transfer payments and the military), establish a value-added tax and increase income taxes across the board (you can’t ever fix the economy if 53% of Americans pay no federal income tax – they just don’t have the skin in the game to buy into the draconian fixes that are needed). I just see no other way to pay off the $20 trillion in debt we will have by 2015, nor the $30 trillion we will have based upon estimates from Jack Welch, the former CEO of General Electric, that he anticipates will happen if we stay on the current trajectory.

But, these changes will never be implemented until they are forced on us by our creditors (smile and say xie xie) – maybe that happens at Jack’s $30 trillion national debt level or maybe before. Until then, we will simply have a long slow debasement of the dollar by printing more and more of them to keep our economy afloat as we kick the can down the road. That debasement leads to inflation, but you hope inflation of the manageable variety given that the dollar – for now – is the world’s reserve currency.

Sorry for the depressing commentary today, but I have to look at all sides of things to make sure we are managing money for clients correctly. Looking at the action in the Inflation Protected Bonds market (see chart below) there seem to be others that are concerned about what appears to be on the horizon – currency debasement and inflation:


We have added this TIP ETF to client accounts as well as the open ended TIP mutual fund from Goldman Sachs. We haven’t made a wholesale shift yet, but incrementally we are preparing for what could be our future.

Sometimes I get comments from readers that I only talk about the near-term movements of the stock market and not the long-term horizon for the broader investment markets, and I have to agree that I tend to focus on that in these blog posts. But, I do watch the long-term and wanted to give you something that you can keep an eye on that has generational impacts: next week the Fed meets and an almost certain topic on the agenda will be Bullard’s QE discussion.

Watch for the Fed statements that come from that and the speeches made in the days following – if you hear something about the Fed rolling over their mortgage holdings into new mortgages or treasuries, or if you hear about additional purchases of treasuries beyond the couple hundred billion in maturities, then you’ll know Bullard won the debate and we are likely kicking the can down the road by moving along some form of the path outlined above.

Oh for the good old days where Summer allowed for livin’ easy.