Saturday, January 2, 2010

Interest Rate Rally Portends Inflation in 2010

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

U.S. treasuries closed out 2009 with their biggest loss since 1978. It was the first loss since 1999 and only the fourth loss in 31 years. Interest rates at the long end of the curve are now almost double what they were at the height of the Credit Crisis. It was quite a turnaround from the end of 2008, when bonds managed to rally and survive the market slaughter that took down almost every asset class. 2009 witnessed a complete turnaround when treasuries went down and almost every other asset class went up. The rally in bonds in 2008 and the severe drop in interest rates was used as a key piece of evidence for those who argued the deflation would be a problem. They ignored that inflation-sensitive gold and farmland were the other two assets that had gone up in price that year (gold was up again in 2009 with a 25% gain - it's ninth straight annual gain; final figures for farmland are not yet available).

Very short-term interest rates are still close to zero in the U.S. As long as Fed Funds stay at that level, 3-month T-bills will not be much higher. Long-term rates themselves were kept down by the Fed purchasing 10-year treasuries as part of its quantitative easing program. This ended on October 31st. Once the Fed was no longer propping up the government bond market, December became one of the worst months for treasuries in a long time.  The case for deflation, although  questionable from the start, collapsed right along with treasury prices. Deflationary environments are characterized by low short-term rates and low long-term rates, as was the case in Japan starting in late 1990s and the U.S. during the 1930s Depression. The yield on the 10-year Japanese government bond fell below 1% in 2003, not far above the near zero rates on shorter dated paper. Rising long-term rates indicate inflation and the bigger the spread between them and short-term rates, the higher future inflation is likely to be. That spread is now already wide and widening even further in the U.S.

The problem isn't isolated to one side of the Atlantic either. Rates for 10-year gilts in the UK are already over 4% and are higher than government bond rates with the same maturity in Italy. The UK is engaging in major money printing and its policies are perhaps even more inflationary than those of the U.S. The yield on the 10-year U.S. treasury at the end of 2009 was 3.84%. The 30-year yield was 4.64%. This was not the high for 2009 though. That took place in June when the 10-year yield was around  4.00% and the 30-year yield around 5.00%. It was already clear by then that deflation was not going to happen. Nevertheless, the Federal Reserve, the Treasury and a number of prominent economists continued to maintain otherwise. The same thing happened in Weimar Germany, with the equivalent cast of characters claiming deflation was a problem - not inflation - right up to the point where prices exploded. There is no reason the script should be different this time. It rarely is.

Inflation is devastating for long-term bonds. Their prices have to drop substantially, so yields can go up enough to induce potential purchasers to buy them. These were some of the worst investments during the 1970s (until the final peak in interest rates in 1980, when they became excellent investments). Back then, the average investor's only option to deal with a dropping bond market was to stay away from it. Now we have the ETFs TBT and TMV, which have portfolios that represent leveraged shorts on long-term U.S. treasuries. Long-term treasuries are approaching resistance on the charts, so a pull back should be expected in early 2010. This could prove to be an excellent buying opportunity.

DISCLOSURE: Long gold, farmland, TBT and TMV.


Daryl Montgomery
Organizer,New York Investing meetup

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

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