The cost of money is so low that no matter what view an investor may have, there is enough money around to be right over the short term.
Players that are deploying a defensive investment strategy either by buying deflation related trades like bonds or inflation related trades like gold are winning. I argued, last week, that gold is due for a 20% price reduction. By the same token, treasury yields are subject to a similar upward correction.
As of November 27, 2009 ten year US treasuries were yielding 3.25%. A decomposition of this rate reveals that the US economy is not likely to increase much more than 1.25% per year on the long term with an inflationary factor of 2.00%. As an historical rule, US treasury yields have for most part averaged 80% of the growth of nominal GDP. It’s interesting to note that nominal GDP should decrease 1.55% in 2009 and increase by as much as 4.00% and 4.25% respectively in 2010 and 2011. Accordingly, actual treasury yields are bang on with fundamental, equilibrium and fair value.
However, investors are receiving absolutely no compensation for any fiscal risks. The Treasury market is priced for perfection believing that the ‘sweet spot’ created by the quantitative and near zero monetary policies of the central bank plus the collapse of credit demand by the private sector and benign inflation will last for a long time. Like gold, there is a huge disconnect here.
Forward-looking bond participants are not considering the possibility that strong headwinds of large debt burden, huge deficit financing and un-relented currency depreciation could bring about responsive money management and/or earlier rate hike by the FRB. Investors cannot hope on huge household savings, albeit much better than it has been for years, to bail out the government.
Based on the recent performance of leading indicators, a 5.00% increase in nominal GDP is not out of the question. A circumstance that would certainly stop QE, raise bank credit demand and increase target rates a few notches forcing yields on ten year treasury notes toward 4.25%. Defensive plays like the purchase of treasuries are good insurances against deflation, but current premiums are expansive for they are not automatically "risk free’. The FED may not believe that an exit strategy is yet warranted. Nevertheless, investors should have one because it may come sooner than expected and it would then be too late to smartly react.
We will always hold bonds for insurance in all of our funds but a lot less than we used to own. Keep a close watch on the weekly ECRI Leading index. It increased to 128.8 for the week ended November 20 for an annualized growth rate of 24.1%. A significant improvement since the bottoming out of last March. The Great Recession ended in late July.
Hubert Marleau, Chief Investment Officer, Palos Management Inc.
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