Agora Financial’s Rude Awakening

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Laguna Beach, California

· Reflections on the good ol’ days when $800 billion still “meant something,”
· The cost of the crisis so far and what it will mean for your future dollars,
· The inflation bone’s connected to the DE-faltion bone, and plenty more…

Eric Fry, reporting from Laguna Beach, California…

Remember when $800 billion seemed like a lot of money? Or when government officials used to pretend to care about spending money the country did not actually have?

Well, call us old-fashioned, but your editors here at the Rude Awakening still think $800 billion is a lot of money… and we still think government officials should pretend to care about deficit-spending. (For the record, we also still think that a milkshake should contain actual milk, and not a powdery substitute).

Unfortunately, your editors seem to be in the minority. The Federal Reserve announced another new $800 billion bailout package yesterday, fresh on the heels of a $326 billion bailout package the day before, and almost no one seemed to notice or care.

These enormous, budget-busting initiatives barely raise an eyebrow on Wall Street anymore…or raise the price of a share of stock. The Dow mustered a measly 36-point advance yesterday.

But $800 billion is still a lot of money, particularly when you don’t really have it. $5 trillion is also a lot of money, particularly when you don’t really have that either. And $5 trillion, give or take a few hundred billion, is the staggering quantity of greenbacks that the Federal Reserve has doused on the credit crisis so far.

As the Federal Reserve conjures up all this money from the bubbling cauldrons of currency creation on its balance sheet, it might also conjure up a frightening dose of inflation. A forward-looking investor could be forgiven, therefore, for wondering if today’s deflationary interlude might yield very suddenly to a vicious inflationary spiral…or at least a mild inflationary uptick.

Central banks around the world have pumped trillions of dollars into the global money supply in order to resuscitate the worldwide financial system. In the last 12 months, agencies of the U.S. government alone, have provided, or promised to provide, an astronomical $8 trillion worth of bailouts, loans and guarantees.
Out of that $8 trillion total, the Federal Reserve is providing $5 trillion, more than $2 trillion of which is actual cash. These funds don’t exactly come out of nowhere, but almost.

When central banks pump lots of credit and currency into the financial system, good things can happen for a while. The cost of borrowing money falls, which encourages people to take chances they might not otherwise take. When lots of people take lots of chances at the same time, the economy tends to expand, share prices tend to go up and everyone is happy. But over the long term, an excess of money-creation tends to produce an excess of inflation.

That’s why our colleague down in Australia, Dan Denning, asserts that the bull market in Treasury bonds is “the last big bubble.”

“The yield on the 30-year Treasury bond has plunged to 3.62%,” Dan notes, “the lowest since regular issuance of the security began in 1977. This is the last big bubble. There’s going to be a stiff penalty for staying in Treasuries as the supply increases (the three-year note is coming back, monthly auctions for ten-year notes will resume). Plus, you know, all that new stimulus. All that new borrowing. And all those new bailouts! Yields will be going up for sure.”

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Beat the Rush; Sell Treasury Bonds Now
By Eric J. Fry

Everyone knows that a deflationary deep-freeze is paralyzing the global economy. Everyone also knows, therefore, that inflation is as good as dead. The sellers of stocks know it; the buyers of long-dated Treasury bonds know it; and the sellers of TIPs (Treasury Inflation-Protected bonds) know it better than anybody. When so many financial market participants are certain about anything, a forward-looking investor might want to challenge the thesis…and try to make a few bucks in the process.

The nearby chart shows quite clearly that prices of long-dated Treasury bonds (as represented by the iShares 20+ Treasury Bond ETF – NYSE: TLT) have been soaring, whiles the prices of TIPs (as represented by the iShares Treasury Inflation Protected ETF – NYSE: TIP) have been falling. Most long-dated TIPs have tumbled 15% in less than two months. Evidently, investors want nothing to do with inflation protection, but will stampede to obtain DE-flation protection.

But is deflation such an utter certainty that investors should be scooping up 10-year Treasury bonds that yield a near-record-low 3.11%? To rephrase the question, is inflation such impossibility that investors should be unloading 10-year TIPs (Treasury Inflation Protected) that currently yield 2.40%, but could produce a vastly greater return if inflation heats up?

We ask these questions, not because we believe a deflationary episode is unlikely, but rather, because we do not believe that an inflationary episode is impossible. Investors in long-dated Treasury securities seem to have convinced themselves that inflation has been “deep-sixed,” not just for the next two or three years, but for the next 10 to 20 years as well.

The cost of taking the other side of that trade has never been cheaper. But TIP-buyers beware!…The other side of the trade is not without risks. A potent deflationary trend would depress the value of TIPs, both in absolute terms and relative to conventional Treasuries. In such a circumstance, TIP prices could fall… a lot. At maturity, of course, the TIP-buyer would receive at least “par” for his bonds. But no investor wants to wait a decade or more to see the return of his capital.

[To better appreciate the virtues and vices of a TIP of security, consider the following brief primer: http://www.treasurydirect.gov/indiv/products/prod_tips_glance.htm]

As noted above, the conventional 10-year Treasury bond yields 3.11%, which is 71 basis points more than the 10-year TIP yield of 2.40%. The TIP-buyer accepts yield penalties like these in exchange for the comfort of inflation protection.

But comparing current yields is only one small part of the calculus that leads an investor to either buy or shun a TIP. The most important aspect of the comparative analysis is the “implied breakeven inflation rate.” In other words, what would the average inflation rate need to be during the life of a given TIP to make it a better buy than a conventional Treasury of the identical maturity?

During the last decade, the implied breakeven inflation rate for a 10-year TIP has fluctuated around 2% – meaning, if the inflation rate averaged less than 2% during the life of the TIP, a conventional 10-year Treasury bond would have been a better buy. On the other hand, if the inflation rate averaged more than 2% during the life of the TIP, the TIP would have been the better buy.

Lately, a very strange thing has happened in the TIP market: breakeven inflation rates have collapsed to all-time lows. The 10-year TIP, for example, is pricing in a razor-thin inflation rate of just 0.3% per year during the next 10 years. I.e, if the inflation rate averages more than 0.3% per year during the next 10 years, the buyer of a 10-year TIP at today’s prices would be better off than the buyer of a conventional 10-year Treasury bond. The inverse would also be true.

Let the reader decide, therefore, whether the average U.S. inflation rate will exceed 0.3% per year during the next decade. But before deciding, let the reader also do enough homework about the quirky world of TIP securities to avoid making unintended errors. One of the easiest – and costliest – errors a TIP-buyer could make would be to underestimate the capital-destroying potential of a severe deflation. If the Consumer Price Index were to decline sharply for a sustained period of time, the price of a long-dated TIP would also decline sharply. Furthermore, the current yield provided by the TIP would decline at the same time – a deflationary double-whammy.

Thus, the TIP buyer’s world is very simple: inflation = good; deflation = bad. But therein lies the appeal of these unique securities as well. Inflation is rarely a good thing for the value of a financial asset, but it is a good thing for a TIP.

When the central banks of the world flood the global monetary system with titanic quantities of credit and currency, an inflationary uptick does not usually trail far behind. And when the US Federal Reserve pours so many trillions of dollars into the US financial system that an $800 billion bailout seems like nothing at all, an inflationary uptick becomes increasingly likely.

TIPs are risky, but inflation is devastating.

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[Rude Endnote: “Many of us are surprised,” opines one Rude reader, “that you never commented about the enormous conflict of interest created by that fact that ex chairman Hank P. of Goldman Sachs is in charge of TARP and may other bailouts:

“1.He decided to let Lehman, the biggest competitor go belly up which only accelerated the devaluation of debt paper. 2. He only used TARP to buy shares in various banks but not to support the mortgage fiasco. 3.He bailed out AIG with a huge sum which most likely will get bigger and let its shareholders survive in the process. Most of the debt paper held by Goldman was insured illegally by AIG.

“There is also a problem with Bernanke. The idiots in Congress never asked him where he was going to find the 2 trillion for the expansion of his balance sheet. He had the gall to tell the politicians that he was not going to lose a penny from his investments. He told, Ron Paul, the only knowledgeable fellow in the Senate, that the currency was going to remain strong and he considered gold only as an object of sale by all Central Banks.

“Just some ideas for you ongoing analysis.”

Rude: Ideas indeed! Keep ‘em coming Rude readers. Part of this space is also yours… should you choose to use it. Forward your comments, ideas and complaints to the address below and keep a look out in future issues to see what’s rubbing your fellow readers the right and, perhaps more importantly, wrong way.

Until next time…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com