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

The latest business loans numbers show that bank loans to businesses are still falling. As I have written in recent posts here and here, large banks have systematically shut down their lending to small businesses over the past 2 months, an unintended consequence of the hugely profitable government bailout programs. Basically, today if you can’t sell it to the government don’t bother making the loan.

Bank Loans to Businesses Still Falling

The chart above, from the Federal Reserve Bank of St. Louis, shows commercial and industrial loans from all banks. Banks have loaned approximately -$100 billion to U.S. companies since last fall. Tough to make payroll when you have to pay more to the bank than you get from the bank.

Bank C&I Loans Latest Data

The latest weekly figures, above, show that banks have reduced loans to businesses by $15.8 billion–roughly -$4,000,000,000 per week–in the past month alone. That does not mean there is less borrowing; it means there is negative borrowing. Banks have forced their business customers to actually pay down their loan balances by $4 billion per week. The only way to do that in a small business is to lay off a worker or sell some inventory or other assets at a deep discount.

Essentially all business loans are small business loans–big public companies get their working capital in the commercial paper market. This is a major reason why employment continues to fall.

This is not the end of the world. I wrote a few days ago, in a piece called Time to Think About the Next Story-Inflation, Rising Rates, Commodity Prices, Weak Dollar, that the tsunami of bank reserves released by the Fed over the past six months is hugely profitable for banks and will eventually force a reopening of the credit markets. This chart is just to remind you that it is going to take longer to show up in jobs numbers than it has in bank stock prices.

JR

One of the (many) problems with using big increases in federal government spending as an economic stimulus tool is timing. You can’t appropriate and spend it fast enough to matter much during the downturn. Spending it years later, after the economy has already begun to recover on it own, then becomes an inflation worry.

There is a new CBO study, Implementation Lags of Fiscal Policy, that details the path of the money this time around. In spite of all tyhe talk we have seen about shovel ready projects not much of the money has actually made its way into the economy yet. As you can see in the figure above, except for HHS and the Dept. of Labor, less than 2% of the money appropriated to all other departments (Education, Transportation, Energy, …) has been spent. The total spent so far is just $24.6 billion out of $379 billion.

Stimulus Spending is Too Slow-Less than 25% Will be Spent in 2009

This chart details how much of the $787 billion in stimulus money will hit the economy each year over the next three years. As you can see, only 11% of the $308 billion appropriated to discretionary spending like highways, mass transit, energy and education will be spent by the end of this year. Overall, less than a quarter of total funds will be spent in 2009.

Why is this s problem? Because there are early signs of recovery coming in now every day. By the end of this year the recovery will be undeniably underway. That means next year (2010) and the year after will be periods of rapid growth and rising inflationary worries. That’s why bond yields have increased by more than a full percentage point in recent weeks with more to come over the coming months. And that’s one of the reasons why commodity prices have been rising so fast.

Investors should be very careful to avoid long-term Treasury bonds today

JR

The credit crisis is all you hear about from officials in Washington and from talking heads on TV. Indeed, the credit shortage is still alive and well. Employment is still falling and small business owners–the only real source of new jobs–have an even tougher time getting working capital loans from banks than they did 2 months ago before bankers fell in love with the new government bailout plans. But it’s time for investors to move on to the next story.

Bank Reserves

The credit crisis is ending. The wall of money created by the Federal Reserve to extinguish the credit crunch and deflation that they, themselves, had created has rigged the deck so banks will make money. The banking system today is being run as a de facto monopoly bank by the Fed. The Fed is paying them interest on reserves, which at $990 billion are roughly ten times the level they were just eight months ago. Over the same period, bank depositors withdrew roughly $90 billion from their bank accounts to keep at home just in case their bank failed. As I pointed out in a post yesterday, there are signs people are beginning to exhale–currency holdings are no longer rising. When they once again feel safe they will put that $90 billion bank into their accounts, which will swell bank reserves by the same amount from 10x to 11x times last August levels.

This tsunami of reserves since last September translates into bank profits at no risk. The Fed pays the same 0.25% interest on bank reserves whether the bank lends the money to customers or not. How much? One quarter percent of the $1 trillion reserve increase equals $2.75 billion per year in incremental bank earnings. The spread between deposit rates–effectively zero–and lending rates, including fees is huge. And the FASB accounting rule change at the end of the first quarter that allowed boards of directors the leeway to value assets based upon their expected cash flow rather than firm quotes from dealers was a huge boost to bank balance sheets. That’s why bank stocks have knocked the lights out since then. And those reasons are why bank stocks have been the biggest bet in my portfolio this quarter with returns 17% over the market so far this year.

Now it’s time to change the bet gain. I still have big bets on bank and financial stocks but have been increasing my exposure to two other bets, China and inflation. Both bets have been working nicely.

My visits with Chinese leaders and Asian CEOs at the BOAO Forum in April convinced me that we were going to see a long string of positive growth surprises from China and its main suppliers around the Pacific Rim–Singapore, Hong Kong, Australia and Indonesia.

The inflation bet is still early. But the recent run of commodity prices and weakness of the dollar suggest it is not too early. Once the credit crunch and recession are off the front page people are going to focus more and more on two factors. First, the Fed tsunami of bank reserves will sooner or later translate into rising price levels. If the Fed allowed the reserves it has already created to remain in the market after the crisis is over the U.S. price level would rise to about 9x its current level over a small number of years, i.e., the $3 vanilla latte you bought at Starbucks today is going to cost you $30–you better start saving your money. Of course, the U.S. political system will not allow a nine-fold increase in the price level so sooner or later the Fed is going to have to take steps to reduce bank reserves. Hint: the same guys who brought you the current disaster are going to be the ones who will be in charge of shrinking reserves. This is not going to be elegant.

The other reason, of course, is that government spending is completely out of control. Ever since last fall when Treas. Secretary Paulson convinced Congress to give him $700 billion to spend however the hell he wanted with no controls or oversight the barn door has been open. Obama’s team has pushed trillions of dollars of new spending through that door in the space of a few months. The result is the $3.5 trillion budget Obama proudly presented to Congress. That budget projects budget shortfalls of roughly $1 trillion per year for the next decade. And that does not even include the added cost of his new national healthcare system.

Those huge spending numbers, of course, mean that Congress will soon increase every tax rate in the book including taxes on ordinary income, dividend income and capital gains as well as higher corporate taxes. We can also expect increased excise taxes on tobacco, liquor, and energy of a forms. Last week the White House also floated the idea of adding a national sales tax–they call it a value added tax–that would be a huge increase on working families. The problem is these tax rate increases are not going to generate much revenue–they never do–because people can easily avoid them by either using tax shelters or by simply deferring or avoiding the realization of income. Over the past 6 decades tax rates have varied all over the map but tax revenues, the amount people actually pay, has been 19% of GDP +/= one percent.

If spending is out of control and the government can’t raise more tax revenue we are going to have massive budget , or budget deficits, shortfalls every year. The Treasury is going to have to sell truckloads of new Tbills and bonds into the market every year as well as roll over the ones already out there. That is the scenario that is now beginning to spook the bond and currency markets. Big bank reserve growth, big spending increases and big budget deficits mean the market is being floods with dollar assets, which has to drive down the value of all assets denominated in dollars. That’s why the long Treasury bond yield has increased by more than 100 basis points, or one full percentage point, in recent weeks. And the dollar is posting new lows against both the Euro and the pound. And that’s why the vice Premier of China asked me last month if there was a way China could protect its $2 trillion Tbill portfolio against inflation and a falling dollar.

Faster growth in China and higher inflation point you in the same direction–commodity stocks. I have been increasing my exposure to oil (STO), coal (BHP) and copper and metals (FCX). I expect to add more to these positions next week.

It has been a long time since we needed to worry about the impact of budget deficits on interest rates. But now we do. The best analysis I have done on the topic is Chapter 4 of my book Lessons from a Road Warrior. Over the next few days I will write a series of blogs to help readers think through the issue.

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