A lot of people are asking me what I think of Bernanke’s testimony before Congress this week. He has been explaining how he is going to deftly remove the 900% increase in bank reserves from the market before it turns into inflation. Here’s my answer.  I have started adding inflation-protected bonds to my portfolio.

When you buy inflation-protected bonds (we call them TIPS in the U.S.) you are basically shorting the central bank. I think that is a good idea today, especially for the U.S.. Here are some ideas how to do it.

For the U.S. you can own IPE and/or TIP. Both are bond portfolios and, therefore, negatively impacted by rising interest rates. The biggest difference is the duration (a measure of the sensitivity of its price to a change in interest rates; you can think of it as the weighted-average maturity.) The duration of IPE is 7.89, roughly double the 4.02 duration of the TIP. That means a one percentage point increase in the level of bond yields, say, from 4.0% to 5.0% will reduce the value of IPE by 7.89% but only reduce the value of TIP by 4.02%.

Another idea is WIP, the exchange traded fund that attempts to reproduce the performance of the non-U.S. inflation-indexed bond sector.  That is important today because the primary inflation risk in the world today is the Fed’s 900% increase in bank reserves since last September. That reserve increase won’t only push U.S. inflation up; it will push the dollar down against the Euro, the yen and other currencies. By owning WIP you own bonds that are protected against inflation in other countries and a drop in the dollar. The duration of WIP is 8.87, which means the bonds are of somewhat longer maturities than the U.S. portfolios above. It is made up of inflation-protected bonds from a number of countries. Its largest holdings are UK (20.4%), France (17.6%), Sweden (5.8%), Canada (5.3%), Italy (5.2%). These are all “museum economies”, places that have become calcified and stopped growing but are still great places to go on vacation to visit the museums.

I like the idea of keeping my equity bets in places that are groaing (China, Singapore, Korea, Brazil, Russia, India) and my (inflation-protected) bond bets in museums. I own all 3 of the stocks I  have discussed above.

Oh, and the Bernanke testimony. The Fed has no chance at all of pu;ing off the maneuvre he talked about this week and sucking nearly a trillion dollars of bank reserves out of the banking system without knocking something over. These are the same idiots who created this mess in the first place.

JR

Note: When I wrote this explanation of budget deficits and interest rates just a year ago as a chapter of my book, Lessons from a Road Warrior, we were in a different world where budgets mattered, at least a little. We argued about deficits of $100 billion or $200 billion, and never had to use trillion in polite conversation. Today, government spending is completely out of control. Since last fall, when Congress was railroaded into giving Treasury Secretary Paulson complete discretion over spending $700 billion for the TARP bailout plan all semblance of fiscal discipline has been destroyed. Obama’s team quickly used the financial crisis to add another $1.2 trillion of spending and has added or expanded countless spending programs in his first budget. As a result the deficit for Obama’s first full budget year is likely to approach an incredible $2 trillion–not including the cost of his proposed national healthcare program. Trillions more have been provided by the Federal Reserve, without congressional approval or oversight, by taking on the authority to add all sorts of assets to their once-pristine balance sheet.

I decided to leave the numbers and the charts unchanged from the original examples in part to highlight the difference between then and now. The analysis remains unchanged. Balance sheets are still huge compared with private saving and private and government borrowing. It still takes a huge amount of government borrowing to move the needle on interest rates. And the most important question for interest rates is still whether anything is going on to change people’s willingness to hold the securities that are already outstanding, not how many new ones the Treasury is selling. But today the numbers are big enough that people all around the world are taking notice and reevaluating whether they want to hold dollar assets. This is the most important economic question of our time.

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Textbooks have it all wrong when they teach students that interest rates are determined by the supply and demand for credit. For example, a leading finance textbook (Investments, by Bodie, Kane and Marcus) states:

Forecasting interest rates is one of the most notoriously difficult parts of applied macroeconomics Nonetheless, we do have a good understanding of the fundamental factors that determine the level of interest rates.

1. The supply of funds from savers, primarily households.
2. The demand for funds from businesses to be used to finance investments in plant, equipment, and inventories (real assets or capital formation).
3. The government’s net supply of or demand for funds as modified by the actions of the Fed.

These statements are wrong, wrong, wrong. Had you acted on them to structure your investments over the last 30 years you would have lost all your money. Interest rates are simply a calculation we make from asset prices, as I explained in a recent post. Asset prices are determined in asset markets by existing asset supplies and the demand to hold existing assets. In spite of what the textbooks tell you, throughout history, the correlation between interest rates and deficits is actually negative; i.e., higher deficits are associated with lower interest rates. The drawings below explain why.

Interest rates are not determined by savings rates and are not determined by the demand for credit. As a logical matter, it is debt, not deficits, along with people’s demand to hold different types of assets, that determine interest rates.

Budget deficits in the ranges we have historically seen them—a few hundred billion–don’t matter much for the economy. Not for interest rates. Not for growth. The multi-trillion dollar bond markets don’t care at all whether the government is a net seller or a net buyer of $100 billion in new Treasury securities in a given year. They care whether the people who own the old paper today are still going to want to own it tomorrow. And that will depend on whether something happens to change people’s minds about future after-tax returns on bonds relative to other assets–period. The rest is all rounding errors. Nothing else matters.

People's Total Assets

When the Treasury holds an auction to finance a deficit, they print and sell new T-bills or other Treasury IOUs (notes and bonds) to investors like Aunt Tilly. This isn’t the first time the government has borrowed money from private citizens. Aunt Tilly and other investors already own a huge stock of similar old T-bills—$5.1 trillion worth at the end of 2007—that we call the national debt. At the end of last year, there were $9.2 trillion of old T-bills outstanding—the government’s accumulated borrowing since the time of George Washington. Of those, $5.1 trillion, or 55%, was held by private investors like you, Aunt Tilly and me.

New treasury paper and old treasury paper are perfect substitutes to investors. Not almost perfect substitutes—perfect substitutes. In practice, they are indistinguishable in the market. T-bills, notes and bonds are also very good substitutes for many other securities owned by investors, including agency securities, corporate securities, municipal securities and securities issued by financial institutions. These, in turn, are substitutes to some degree for equities, foreign securities and tangible assets in the minds of investors. When you buy a bond, you shop for its issuer, its maturity date, its call provisions, its tax features, and its yield—not its model year. This means that new bonds and old bonds that are the same in every other way must sell at the same price. Arbitrageurs make sure they do.

It’s like the commercial where the dad asks his teenage son to drive to the local gas station to put gas in the family car. Hours later, the dad is still standing in the driveway when his son returns with the explanation, “But Dad, you didn’t want me to mix the new gas with the old gas, did you?”

Bond investors mix the new bonds with the old bonds all the time.

Flow-of-funds is a theory to explain the price of new bonds. Portfolio balance is a theory to explain the price of old bonds. But in the real world, there can only be one price for all bonds. Which theory wins? Portfolio balance, because almost all bonds are old bonds. The important question is not whether the government will borrow money this year. It is what price it will take to make Aunt Tilly—and all the other investors who owned T-bills yesterday—still want to own the stock of T-bills tomorrow.

But balance sheets do not sit still; they grow over time. The stock of tangible assets grows as a result of building houses, factories, shopping centers and new cars faster than they wear out. The stock of private financial assets grows as people issue mortgages to finance home purchases, and companies issue new stocks and bonds to finance capital spending, home construction and durable goods production—at a faster rate than the old ones mature. We create new government securities to finance the budget deficit, or we destroy them by using a budget surplus to buy back debt.

As our net worth grows, so does our appetite to hold all assets. This growth is represented by drawing a second pie chart showing the larger stock of stuff (tangible assets) and financial assets. Historically, U.S. balance sheets have grown at about 7% per year.

Next Year's Total Asset Growth

Higher net worth gives investors like Aunt Tilly an appetite to own more T-Bills too, as illustrated in the drawing. You can think of this appetite as thousands of Aunt Tillys standing in line in front of the Treasury building, waiting to place orders for the new T-bills that the government will sell next year (to add to the ones they already own).

That appetite is larger than most people think. If net worth grows 7% next year, as it has done historically, investors will want to increase their holdings of T-bills by $357 billion, from $5.1 trillion to just under $5.5 trillion.

If the Treasury issues just enough new T-bills to satisfy Aunt Tilly’s appetite, then everyone will go away happy. There will be just enough T-bills to go around. Prices will remain the same as they were last year. Interest rates will remain unchanged.

But what would happen if the treasury issued too few or too many T-bills to satisfy investors’ appetites? That’s easy. There would be a scuffle. If they were too few T-Bills for sale due to a smaller government deficit, then Aunt Tilly would wrestle with the other investors for the limited supply. This would drive T-Bill prices up and interest rates down.

Too Few New T-Bills

If the government ran up the deficit and there were too many T-Bills for sale, then the Treasury would be forced to lower their asking price to sell their inventory. T-Bill prices would fall and interest rates would rise.

Too Many New T-Bills

It is only to the extent that budget deficits exceed Aunt Tilly’s appetite for new securities that they can be said to push interest rates up at all. In our example, we can think of the $357 billion from the previous example as the interest rate neutral budget deficit—one that will put no pressure on interest rates. The balanced budget that we all wish for would actually exert downward pressure on interest rates every year. Over time, government debt would gradually become extinct like the dodo bird; it would be irrelevant for investors.

This does not mean that I love budget deficits. It does not mean that deficits are good or bad. And it does not blunt the fact that higher government spending uses tons of resources and creates all sorts of incentive and resource allocation problems. It just means that budget deficits are unlikely to be a factor in determining interest rates in the range in which we have historically seen them.

If deficits don’t determine interest rates, then what does? The answer is any factor that could drive a wedge between the relative returns on different assets. Higher inflation does that by increasing the return on tangible assets (i.e., the gain on owning a home raises its return) relative to returns on securities. That makes people sell securities to increase their holdings of real assets, like we saw during the 1970s, which drives interest rates higher. Lower income tax rates increase the after-tax returns on taxable securities relative to real assets, for example, because people are forced to report all income from securities on their tax forms but are not required to report the value of living in their home as taxable income. This will drive interest rates lower. Rising productivity growth can quicken net worth growth, which will increase Aunt Tilly’s appetite for all assets and drive interest rates lower. And the Fed can influence the rate of net worth growth by making it easier or more difficult to finance investments.

JR

Yesterday I posted a piece about inflation and interest rates arguing that although recent inflation numbers have been very tame, the tsunami of bank reserves (=800%) released by the Fed is beginning to show up in inflation expectations, which is why long Treasury yields are rising. I ended with a warning that long-term bonds, not stocks, are the riskiest assets in our portfolios today.

A good friend asked me to review some of the logic in more detail. I will do so below:

1) The link between rising interest rates is not just a theory that might or might not be true. It is the definition of an interest rate, or yield. 

For example, In the chart below, if you pay pay $95.24 to buy a bond (really just an IOU) that promises to pay you $100 in one year then we would calculate its yield as r = ($100-$95.24)/$95.24 = $4.76/$95.24 = 5.0%.

If something changes in the marketplace and people lose interest in owning bonds so that their price falls to $90.91 then we would calculate their yield to be r = ($100-$90.91)/$90.91 = $9.09/$90.91 = 10.0%.

SO, SAYING THAT INTEREST RATES GO UP FROM 5% TO 10% IS THE SAME EXACT STATEMENT AS SAYING THAT BOND PRICES ARE FALLING.

2) the interest rate, or yield, (which is just a calculation we make by dividing a contractual interest payment by the price we pay for the security) on all sorts of securities rises and falls with inflation (actually expected inflation. Bet way to understand this is to think of the inflation rate as the “interest” you receive from owning a tangible asset like a house or a bar of gold. If you buy it for $100 this year and its prices goes up to $110 in one year (10% inflation) then the “yield” on the asset is $10/$100 = 10% (the increase in value divided by what you paid.) 

The logic is; inflation goes up => “yield” on real goods goes up => that makes the yield on real goods high compared with the yield on bonds and other securities => that makes people sell bonds to buy more houses and other hard assets => that pushes hard asset prices up and bond prices down => Falling bond prices increases the yield. => SO YOU DON’T WANT TO OWN BONDS WHEN THEIR PRICES ARE FALLING.

3) Over long periods the price level will be roughly proportional to the money supply. The money supply is roughly proportional to bank reserves. The Fed has increased bank reserves by +800% since last September. Together these mean that there is a big increase in the price level, hence inflation, baked into the recent Fed policy. When the economy starts to look a little more normal again (it is starting to do this already) people are going to worry about inflation unless the Fed does something to reverse their actions over the past 6 months.

Moral of the story–you don’t want to own bonds when people start worrying that inflation, hence interest rates, will go up.

JR

Last week we had reports on both producer prices (PPI) and consumer prices (CPI) for April. The headlines were about flat and falling prices. So why are interest rates going up?

April PPI showed finished goods up 0.3%, 0.1% ex food and energy and -3.7% from 12 months ago. Intermediate goods ex food and energy were -0.9% for the month of April and -10.5% over the last 12 months. Crude goods were -0.6% in April and a stunning -40% from a year earlier.

Consumer goods in April were flat (0.0%), and -0.7% from 12 months earlier. Energy costs were -8.5% over the past 3 months, and -25.2% from year earlier. 

So then why are interest rates going up? Not at the short end where the Fed is keeping fed funds and T-bill rates low, but at the long end as shown in the above chart of the 10 year Treasury yield. Rates have popped up by roughly one percentage point in recent weeks.

You can see the same bump in the 30 year Treasury yield above. Looking at the 30 year yield has fallen out of fashion due to the interruption in supply and thinness of the market compared with the ten year. But I think it is especially important because its duration is much closer to the duration of the stock market, roughly 25-30 years at today’s rate levels. In rough terms that means a one percentage point increase in the long Treasury yield (currently 3.17% for the 10 year and 4.18% for the 30 year) will reduce the intrinsic value (the expected value of free cash flow) of the S&P 500 by 25-30%.

So why are rates rising? Because bond market investors can see the end of the financial crisis that still dominates the headlines and the talk in Washington. They are looking beyond the credit crunch at the inflation implications of the Fed’s unprecedented tsunami increase in bank reserves (roughly +800%) since last September. They are right to do so.

I don’t think many economists would argue with the statement that an 800% increase in bank reserves, if allowed to remain in the market permanently, would increase the price level by about 800% over a few years. To clarify, that means the price of a quart of milk would go from $2 to $16! I don’t think that is going to happen because I believe the Fed and the political system would not allow it to happen. But it does mean that the Fed is going to have to start taking steps very soon to clean up their mess before it hits prices in a big way.

Here is the catch. The guys who are going to be in charge of cleaning up the mess by vacuuming up the 800% bank reserve increase (and an additional $90 billion that will come back onto reserves when consumers finally unclench their buttocks and re-deposit the $90 billion worth of $20 and $100 bills they have taken out of their bank accounts over the last year) are the same guys (the Federal Open Market Committee) that created the mess in the first place by first under-printing reserves in the year before last September, then over-printing reserves since then. The odds that they will handle this mopping up exercise with grace and agility are approximately equal to zero.

I’m not smart enough at this point to write the story of what happens when they try to do so. But I do believe we will see further increases in long rates as we approach the Fed hoover exercise, which could start to take place as early as the end of the year.

This has two implications to me: First, long-term bonds are the riskiest component of people’s portfolios in spite of what all the textbooks say. Second, the strong gains in the stock market caused by the Fed tsunami are real but temporary. There is no surer way to kill a long-term stock market that to increase bond yields.

JR