Del Boca Vista

October 17, 2010

Regrettably, I'm leaving Bend soon to return to the land of the dying and infirm and experienced some insominia. Rather than count sheep, I pondered the complex issue of what's next for interest rates.

Certainly, conventional wisdom dictates that interest rates will surely rise. Our Federal Reserve, in contrast to the actions of Paul Volker, has a mission to defeat deflation, the inverse of which is to create inflation. Printing noncollateralized $ and flooding our monetary base is the mechanism of QE2. How can this not be inflationary?

Historically, it doesn't pay to bet against the Fed. Markets are taking note: the price of gold is through the roof, commodities climb higher, the TIPS are climbing and the 30/10 spreads are rising. Since the prices of food and energy are rising, the average American is experiencing a measure of inflation. Seems like a slamdunk but hold on. Remember that the Fed controls M1 but not M2 or M3. To say that it cannot affect the velocity of money in essance means that it cannot force banks to loan or people to borrow.

Contrast the enormous fall in mortgage rates engineered by the buying of 1.25 trillion $ of these securities with the current state of our housing market. Deflation is a real threat. The folks at the Federal Reserve are justifiably worried about this issue. Look at a chart of the core CPI over the past few years; much more descent leaves us around zero. Simplistically, inflation is too much $ chasing too few goods and deflation is too much debt chasing too little cash flow. Following a two decade debt binge, I think the latter scenario most accurately describes our current plight. So the question becomes, will more $ printing reverse this trend. I doubt it. To date, money has recirculated back to the Fed in the form of bank reserves and abroad where growth opportunities exist. Large corporations are flush with cash but they're not spending. This experiment has been tried before in Japan and the inflation rate has become mired at a negative 1% and the ten year JGB yields about 1%.

I know that we're not Japan, but people have been alleging that for the past 5 years despite the progression of the similarities. The critical difference between Japan and the US is that they have savings and a capital surplus that allows them to fund their burgeoning debt. We're dependant on the kindness of strangers. What to make of these opposing forces? I think that the key, independant variable is the $. The last default of US sovereign debt was created by FDR in 1933 when he halved the value of the $ relative to gold. Our government is determined to undermine the value of our currency. The obvious salubrious effects will be an edge to our exports, raising nominal wealth in the financial markets, a perception of inflation. This policy could have untoward effects, however in igniting an allout currency war and an abrupt rather than gradual fall in the value of the $. Once again, the US defaults on its debt via a significant devaluation of the value of its debts.

At some point, the strangers who fund our debt will no longer be friendly. I have maintained for some time that the US Treasury market is the greatest bubble in human history and the issue is not if but when it deflates. Therefore, I am awaiting the appearance of the 2013 options of TBT. In the interim, I am investing in issues which should hold up in a rising interest rate environment: floaters, junk, converts Canadian oil trusts and pipelines.

-Guga