Thursday, February 25, 2010

Inflation Risks Remain Tilted Upward in the Ice Age

As was widely reported, Bernanke Says ‘Nascent’ Recovery Requires Low Rates.

This is of course so wrong as to virtually be a lie.

If less money is paid to lenders, their lost income is equal and opposite to the interest savings that accrue to borrowers.

If one wants to prevent malinvestment, such as occurred in housing several years ago, in commercial real estate, and in many other settings such as unsound corporate takeovers, borrowing costs should be higher rather than lower.

Preventing malinvestment means preventing bubbles. No more bubbles!

The current benefit of record-low short-term borrowing rates is to the U. S. Government and other allegedly high-quality borrowers, and to financial companies that report high current income from borrowing short and lending long (such as by financing the Federal debt by buying a 10-year Treasury with leverage gained from borrowing at the Fed funds rate).

Why did the Fed create massive "reserves" that banks can't do anything with?

Of course it was to "print" "money".

We are seeing the results of the money-printing seep into the economy.

As this occurs, we will see price increases, and the longer the Fed stays "easy", the difference between actual and reported inflation will grow. In the last cycle, the result was massive speculation.

Blaming the speculators is not really fair. What is the owner of capital to do when the "safety" of cash is that even pre-tax, there is a guaranteed return below the rate of price increases?

Now, with industrial and labor slack, what in prior eras would have been outright deflation has been prevented.

If economic hard times remain and the up-cycle is brief and/or restrained enough, the much-maligned Phillips curve may keep actual price increases limited and perhaps allow the 10-year Treasury rate to hit David Rosenberg's target of under 3%, perhaps if and when the economy goes south again.

There have been many times in the 20th century when the 10-year bond yielded less than current inflation, sometimes much less.

Nonetheless, the Fed and the Feds want price increases to "grow" out of the bubble.

Gold but not gold stocks is a long-term hedge against the official desire for inflation. With more volatility, so is silver and definitely not silver stocks.

The price of gold is hanging in well above the average 2009 gold price. This in and of itself tilts the short-term risk to the downside. However, the amazing amount of money-printing and governmental deficits argue that at least so far as the U. S. is concerned, this is a new era.

Just as the Internet did in fact represent a new era and was associated with 20-30% yearly gains in the NASDAQ beginning in 1995 until it doubled in 1999, the "bull" case for gold is built on the new reality that the U. S. Government is not really a AAA borrower anymore. If it were, it wouldn't have had the Fed buy so much of its debt and its more-or-less obligations of Fannie/Freddie mortgage-backed securities.

Investors must keep in mind that the truly extraordinary near-zero return on cash is a reflection of extreme economic weakness and extreme government money-printing to benefit itself and its banking allies, which purchase and resell the government's debt. Traditional stock and bond metrics do not apply now, just as some usual laws of physics and chemistry do not always apply near temperatures of absolute zero.

The economy is in an Ice Age and despite that, prices are rising. A strong economy could easily be associated with 5% inflation and much higher interest rates. Thus, opposite from the situation in 1950, when stocks were cheap and dividend yields were much higher than even the long Treasury bond yield, stocks could be unexciting investments (or worse) if the economy starts doing well.

Strange times in the investment world.

Copyright (C) Long Lake LLC 2010

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