2011May11 Shortage Drives U.S. T-bill Yields Down*With food and gas prices rising, fears of inflation have been resurrected in budget discussions across kitchen tables and in corporate board rooms while the mainstream media has largely avoided the subject. Gold and silver prices have risen in part from inflation fears and in part from fears of a U.S. monetary default and a collapse of the U.S. Dollar. Well, the Dollar has been falling for some time which has contributed to the rise in prices for food and energy. The Fed has indicated it will not activate a QE3 program when QE2 ends in June. Theoretically rising prices mean our economy is recovering enough that additional stimulus is not needed. However, there is a difference in inflation driven by demand and shortages and inflation created by monetary policy. The fear of inflation and typically rising interest rates, which are disastrous for bond portfolios, has resulted in a very unusual trade at PIMCO. The world’s largest bond fund manager, Bill Gross, has been very vocal about inflation risks and the U.S. Government’s credit risk. So much so that PIMCO Total Return Bond Fund sold 100% of its U.S. Treasuries.That is a manager with the conviction to “walk the talk.” Our government’s credit risk has been confirmed by Standard and Poor’s warning that delaying serious budgetary correction will likely result in a downgrade within two years.The Administration continues warning of a crisis if Congress does not raise the debt ceiling.Interestingly, interest rates have not risen since PIMCO’s decision, and bond values have increased which illustrates the confusion in today’s markets. Our headlined article from the Financial Times suggests the current anomaly is due to a shortage of Treasuries. Due to better than expected tax receipts and spending cuts, the Treasury Department announced it would be borrowing less money. Without QE3, supply won’t be expanding. That is half of the equation. What about demand – the other half of the equation? Demand for Treasuries continues in spite of the above mentioned fears and low yields. Fears are what they are and, perhaps, even more appropriate for traditional alternatives of municipal or junk bonds. Revenue problems at state and local government levels are very real. There is skepticism about the reliability of insurers of bonds. If the economy is not on a sustainable path of recovery, then concerns over the safety of high yielding bonds is justified. Treasuries still have the guaranty of payment by U.S. taxpayers. In spite of the rhetoric from bond vigilantes, the foundational issue is probably related to the private sector’s massive deleveraging commitment. Boomer’s in or nearing retirement are paying off debt. Businesses are downsizing space, inventory, staff and debt. Debt reduction shrinks the money supply faster than our government has expanded it. While it does not occur in all sectors simultaneously, deleveraging puts counteracting pressure on prices and inflation. In our opinion, we are in the early stages of protracted disinflation – or deflation – as occurred in Japan after 1989 economic peak. The U.S.A., unlike Japan, has demographic salvation in its future. The Millennial Generation is larger than the Boomers. They are just starting to enter the workforce. They will be entrepreneurial of necessity. They will generate innovation and increasing productivity. We just have to get through this decade to have enough of them in the economy to make a difference. |
