Why Bet on Treasury Securities?

First Warren Buffet and now Bill Gross, of Pacific Investment Management Company, have publically stated that buying United States Treasury securities is not a good bet. (See http://www.bloomberg.com/news/2011-03-31/gross-echoes-buffett-saying-treasuries-have-little-value-on-debt-dollar.html.)

Gross wrote, in his most recent monthly investment outlook, that Treasuries “have very little value.”

One could couch this in other terms: “What is the probability that long term interest rates will go up over the next twelve months?”; and “What is the probability that long term interest rates will go down over the next twelve months?”.

How many people do you know that believe that the higher probability can be applied to the second of these two questions?

Most people I know and respect are arguing over whether the probability that long term interest rates will go up is 75% or 80% or higher.

The only significant argument I hear about falling interest rates on long term Treasury issues is that the Eurozone might collapse and there will be a “run to quality”, a run to United States government securities. Almost all other arguments go the other way.

The economic recovery, however weak, is continuing. The banking system (and the housing industry) is not going to collapse even though the banking industry is going to continue to grow smaller and smaller in terms of the number of commercial banks that are in the system while the biggest banks, including large foreign banks, are going to control more and more of the banking industry itself. The Federal Reserve will continue to keep money flowing into the banking industry so as to keep banks open while the FDIC makes sure that the banking industry shrinks in an orderly fashion.

Are we going to get QE3? Depends upon the rate at which insolvent banks can be closed without disrupting the financial system. The strength of the economic recovery is not the issue. The issue, to me, depends upon what the FDIC can achieve.

The federal government is going to continue to add more and more debt to the total already outstanding.

There just is no credibility in Washington, D. C. concerning the reduction in the cumulative deficits over the next ten years or so. I still believe that the government will add another $15 trillion or more to the federal debt outstanding over the next ten years.

The Libyan situation is a case in point. The federal government is so over-extended fiscally that other demands on its resources are just going to stretch budgets even further and keep the cumulative deficits at near-record levels. Then the government ends up doing two things, neither desirable: the government is limited in what it can do in very important situations; and even if the government cannot do much, whatever it does will increase the cumulative deficit.

Then there are other issues, like the boom in commodity prices worldwide, the acceleration of the merger and acquisition business in America, Europe, and the emerging countries, and currency speculation throughout the globe.

As a consequence, I see no reason to back off my earlier thoughts on the future of the interest rate on long term U. S. Government securities. See http://seekingalpha.com/article/250838-long-term-treasury-yields-and-inflationary-expectations. This post was written when the yield on the 10-year Treasury security was 3.48 percent, roughly two months ago at the beginning of February. Yesterday the 10-year Treasury closed at about 3.46 percent.

At that time I claimed that a forecast of 5.00 percent to 5.50 percent was not out of reason for a Treasury security of this maturity somewhere in the next 12 to 18 months.

The basic reasoning for this: my estimate of the expected long run “real” rate of interest is roughly 3.00 percent, (Similar, I found out, to the belief of the Wharton School’s Jeremy Siegel.)

I further believe that investors will come to build in a premium for inflationary expectations in longer term interest rates in the neighborhood of 2.00 percent to 2.50 percent.

How strongly do I feel about this prediction? I believe that the odds are in the neighborhood of 3- or 4-to one that rates will move into this range over the next 12 to 18 months.

Thus, I would have to agree with Bill Gross (and Warren Buffet) that Treasuries “have very little value” and are not a good “buy and hold” at this time.

Inflationary Expectations, the Dollar, and the 10-year Government Bond Yield

On Saturday, Allan Meltzer made the statement that “Inflation is coming.” Like the 1970s, we are in for another bout of high unemployment and inflation, which “flummoxed” the Federal Reserve’s policy committee and created a situation in which ”inflation and unemployment rose together throughout the decade.” (http://professional.wsj.com/article/SB10001424052748704709304576124033729197172.html?mod=ITP_opinion_0&mg=reno-wsj)

The market evidence for this?

“Commodity and some materials prices have increased dramatically in the past year. Countries everywhere face higher inflation. Despite the many problems in the euro area, the dollar has depreciated against the euro, a weak currency with many problems, suggesting that holders expect additional dollar weakness.”

The above chart shows that value of the United States dollar relative to the Euro. As the line rises the dollar weakens. In the early part of 2010, the Eurozone seemed to fall apart as the fiscal problems faced by sovereign governments created a financial collapse. The Euro declined against other currencies in the world.

By the summer of 2010, some quiet had returned to Europe and the Euro began to strengthen again against the dollar moderating late in the season around$1.27. However in late August 2010, Fed Chairman Ben Bernanke announced that QE2 was on the horizon and, as can be seen, the value of the dollar fell dramatically reaching the $1.40 neighborhood in November.

Although the value of the dollar rose again toward the end of the year, it again appears to be under siege as the dollar has fallen back into the $1.36-$1.37 range. So, in spite of its weakness, the value of the United States dollar seems to be losing ground relative to the Euro.

The key to this behavior Meltzer believes is the expectation of inflation. It is assumed by many that inflationary expectations get built into interest rates. I have just written on the current situation, the recent changes in inflationary expectations and the possible future movement in interest rates. See my post, “Long-Term Treasury Yields and Inflationary Expectations.” (http://seekingalpha.com/article/250838-long-term-treasury-yields-and-inflationary-expectations)

Here we have a chart the yield on 10-year Treasury securities. Note the decline in the yield that took place in the early part of 2010 to the fall. Many argue that this decline was due to a flight-to-quality as the investors left the sovereign debt of Eurozone countries and brought their money to invest in US Treasury securities.

Whereas the announcement of the coming of QE2 came in late August (and rates bounced up on the very next trading day after the Bernanke speech), the actual plan of action for QE2 was released in October and the Fed began conducting the QE2 in November. As can be seen in the above chart, the yield on 10-year treasuries has risen ever since. The last day in this chart is February 4. On February 8, the yield on the 10-year treasury security closed over 3.70 percent, a rise of 150 basis points since the late August date of Bernanke’s speech.

The argument can be made that participants in the financial markets are so sensitive to the possibility for future inflation that on the very next market trading day following the Bernanke statement, inflationary expectations began to build in the bond markets. And, the buildup of these inflationary expectations was also experienced in the market for the United States dollar and the dollar traded weaker even to the Euro even though the Eurozone was experiencing many fiscal and financial problems.
One can see this more clearly in tracing the value of the dollar indexed against major currencies. Here it is obvious that the dollar is trading at the lows reached over the past year and is even threatening the post- World War II lows reached in the summer of 2008.

It appears as if many investors in world financial markets agree with Allan Meltzer that, in fact, “Inflation is coming.” It is just the United States government that doesn’t see this.

Long-Term Yields, the Fed and QE2: The Weekly Fed Data

The 10-year United States Treasury issue backed off somewhat today. At 4:00 pm in New York the bond yielded about 3.43 percent, up from about 3.23 percent last week at this time. On Wednesday December 15, these bonds yielded around 3.55 percent, up from the previous Wednesday close of 3.30 percent.

Both Martin Wolf at the Financial Times and Jeremy Siegel, of the Finance Department at the Wharton School, in the Wall Street Journal attributed this rise in interest rates to the strengthening of the economy, which they both took as a good sign.


Although I hear their arguments, I am not quite convinced. This year, the yield on this 10-year security fell from a range of 3.80 percent to 4.00 percent in the March/April time frame. This fall in rates was attributed to the financial turmoil going on in Europe.

As can be seen in the chart, the rate feel almost constantly until late August. And, what happened in late August? Ben Bernanke spoke about QE2 at a Federal Reserve conference in Jackson Hole, Wyoming and guess what? The yield on the 10-year bond started up immediately and has continued to rise ever since. The timing of the rise was very specifically connected with the Bernanke speech and subsequent Fed releases. Where did the strength of the economy come into play? Wolf and Siegel just aren’t convincing.






So, the long term bond yield is rising. This isn’t what was supposed to happen. So the Federal Reserve got active. I reported this last Thursday evening as soon as the Fed statistics were released. (See http://seekingalpha.com/article/241050-fed-actions-aimed-at-long-term-interest-rates.)


Here is a part of what I said, “The Federal Reserve added over $32 billion in Treasury notes and bonds to its portfolio from Wednesday, Dec. 1, to Wednesday, Dec. 8. This move was not to replace mortgage backed securities as was the case over the past few weeks.
Also, this increase was not to replace reserves lost through operating transactions. Quite the contrary, deposits with Federal Reserve Banks other than reserve balances, which includes the General Account of the U.S. Treasury, fell by almost $8 billion, which also added reserves to the banking system.


All-in-all, over $50 billion was added to Reserve Balances with Federal Reserve Banks over the past week. Most if not all of this will show up in Excess Reserves at commercial banks.”


This week the Fed bought more United States Treasury securities, but this time the purchases were a substitution for the securities that were maturing in the Fed’s portfolio of mortgage backed securities. The Fed purchased outright $18 billion in United States Treasury securities. This went to offset a decline in the mortgage backs securities of almost $14 billion.


Net, the Fed supplied reserve funds in the amount of $3.5 billion. (The figures don’t match exactly because of other small changed that took place in the balance sheet.)


An interesting aberration took place in the data released at 4:30 PM today. The Fed statistics show that the “average” increase in the United States bond portfolio for the week was $23.6 billion and the decline in mortgage backed securities was $2.0 billion. These figures differ from those given above because the figures above relate to the Fed’s balance sheet as of the close of business on each Wednesday. The figures reported in this paragraph relate to the average of daily figures for the week ending each Wednesday. The only thing that can be said about the two sets of figures is that most of the purchases of Treasury securities for the week ending December 8 must have come on Monday, Tuesday, or Wednesday of the week so that the weekly average was closer to the portfolio held for the week ending December 2. That is why the numbers relating to the weekly average are so large relative to the end-of-week numbers.
Reserve balances with Federal Reserve Banks, a proxy for commercial bank excess reserves, fell by about $64 billion during the week. The primary cause of this was an increase in the general account of the Treasury held at the Federal Reserve. These Treasury deposits rose by $72 billion during the week as the Treasury sent out checks to the private sector and withdrew funds from the government Tax and Loan accounts held at commercial banks.


This movement between accounts was purely an “operational” transaction and should not be considered a part of the QE2 process.


So, the conclusion for the week is that Federal Reserve open market operations for the week were primarily a substitution of United States Treasury securities for maturing mortgage backed securities. Thus, it seems that very little effort was put into trying to keep interest rates from rising.


The 20 to 25 basis point rise in the yields, seemingly, were not resisted by the Fed.

The Fed Acts!

Federal actions on QE2 have been relatively benign up to this week. (See my Monday post: http://seekingalpha.com/article/240375-federal-reserve-qe2-watch-part-1.)

Things were different this week as the United States Treasury issued a lot of bonds this week and longer terms interest rates rose to levels not seen since the middle of June 2010. The 10-year Treasury security got up to almost 3.30 percent on Wednesday, up by about 45 basis points over the past two weeks or so.

The Federal Reserve added over $32 billion in Treasury notes and bonds to its portfolio from Wednesday December 1 to Wednesday December 8. This move was not to replace mortgage backed securities as was the case over the past few weeks.

Also, this increase was not to replace reserves lost through operating transactions. Quite the contrary, deposits with Federal Reserve Banks other than reserve balances, which includes the General Account of the United States Treasury fell by almost $8 billion which also added reserves to the banking system.

All-in-all, over $50 billion was added to Reserve Balances with Federal Reserve Banks over the past week. Most, if not all of this will show up in Excess Reserves at commercial banks.

In August 2008, before the Fed started pumping reserves into the banking system, total reserves at all commercial banks totaled $46.4 billion!

The initial interpretation of this is that the Fed acted to keep long term interest rates from rising further. The ten-year bond rate was down slightly today, closing around 3.23 percent at 4:00 PM, New York time. This is what QE2 is supposedly all about!

Euro Solvency?

The financial markets hate uncertainty. It is the unknown that creates uncertainty and unexpected new information often creates uncertainty because investors must not only absorb the new information but must also translate what they have learned into action!

This is what I tried to emphasize in my post of April 28, 2010, “Greece: The ‘Surprise’ That Breaks The Camel’s Back” (http://seekingalpha.com/article/201382-greece-the-surprise-that-breaks-the-camel-s-back). Recently we were given knowledge that the budget deficit of the Greek government was much worse than we had been told, and, as a result of this news, the rating on Greek bonds was lowered. Immediately, investors began to sell off these bonds.

The financial market unrest continued. Then the European Union and the International Monetary Fund came up with its bailout package of €110 billion “to save the euro by providing Greece with enough cash to meet its financial obligations over the next twelve months or so.” (http://seekingalpha.com/article/202754-greece-and-insolvency-finding-a-way-out)

The problem is, as I pointed out in this last post, that the response was aimed at preventing a liquidity crisis and not a solvency crisis. These two types of financial crises are different and a failure to understand the difference and react in the appropriate way can just exacerbate a problem and not solve it.

The Federal Reserve under Ben Bernanke has been guilty of this very thing and, as a consequence, has contributed to the lingering solvency problem in the “less than mammoth” banks in the United States banking system today. (I have discussed this in many other posts.)

A liquidity crisis is a short run phenomenon related to the disclosure that the price of a certain financial asset should be different from what it had recently been trading at. The buy side of the market disappears and the price of the financial asset drops, sometimes precipitously. In the classical case, the central bank comes into the market and makes sure that there is sufficient liquidity in the market so that the price of the asset in question stabilizes and trading can resume.

The prices of other similar assets may be caught up in this uncertainty but the response of the central bank is enough to stabilize the market.

A solvency crisis is different. In a solvency crisis the value of the assets must be written down, but the concern is over the ability of the institutions that own the assets to cover the value write down with the equity capital they possess. Of course, the value of the assets may go up at some time in the future but in general these institutions must “work off” these assets over time in a way that does not exhaust their capital base.

Otherwise, if the effected institutions have to write off these “underwater” assets immediately they may have to be closed.

A solvency crisis takes a much longer time to get over than does a liquidity crisis. That is why so many small- to medium-sized banks are still having so much difficulty even with massive amounts of liquidity available in the banking system.

The problem with the current situation in the European Union is that the situation is not one of liquidity, but one of solvency. There is a very real concern in the market for sovereign debt about whether or not certain nations within the EU can maintain their solvency given the debt load their governments have assumed and given the very weak nature of their economies.

There is a question about the ability of certain governments to be able to pay-off their debts. And, if these debts cannot be re-paid, what will happen to the solvency of the banks and other institutions that now hold this sovereign debt. Special concern exists about commercial banks in Germany and France. Some think that the real reason for the Greek bailout is to keep several major banks in Germany and France from failing. (See the second post mentioned above.)

Just providing Greece the ability to be able to roll over its debt in the next twelve months or so is an attempt to make Greek debt “liquid”. The hopes are that this will buy time for the Greek government to “right its ship” so that it will be able to meet its financial obligations and then go bravely forward. The financial markets have responded by saying that the Greek situation is not a problem of market liquidity but a problem of government solvency: the government, as it appears now, cannot pay its bills.

The concern over solvency has spread. If Greece lied to its debtors, maybe other countries have been doing so as well. Maybe these other countries are not as well off as was thought. Hence, a need to check other “undisciplined” countries out.

The credit ratings of Spain and Portugal were lowered (with Portugal facing additional review concerning its credit rating). Isn’t this evidence enough. But, of course, other countries are on the radar screen: countries that have been particularly profligate like Great Britain where the Labour Government outspent the rate of inflation since 1997 by 41%! But also Italy and Ireland.

What we seem to be seeing in the world is a realignment away from countries that have over-stayed their welcome in the credit markets. We see this especially in the currency markets. The value of the euro has plunged against the dollar and other major currencies. Today, May 6 it hit a 52-week low around 1.26. In other areas of the currency market the move seems to be away from the currencies of countries having “debt problems” to those that appear to be more secure.

The same thing has occurred in bond markets. The rush to United States Treasury bonds has been phenomenal over the past week. The two-year Treasury was yielding about 1.07% April 23 while the ten-year Treasury was yielding around 3.82%. These two yields have dropped to 0.79% and 3.39%, respectively, a major move!

When uncertainty increases, market volatility also increases. If we look at one index of market volatility, the CBOE’s VIX index, we see it peaking over 40 today, up from around 20 or so over the past week and in the 15-20 range before that. The market appears to be spooked and this means one might expect the volatility of the financial markets to remain high in the near future.

The major problem going forward is leadership: who can lead the eurozone and Great Britain out of this mess? The concern is captured in Landon Thomas’ article in the New York Times, “Bold Stroke May Be Beyond Europe’s Means,” (http://dealbook.blogs.nytimes.com/2010/05/06/bold-stroke-may-be-beyond-europes-means/?scp=5&sq=landon%20thomas%20jr.&st=cse). In the case of the eurozone, there is no leader. And, this has been a problem the detractors of this union have pointed to since before the euro was put into place. There is an economic union but no political union. It is like herding cats and given the cracks that are occurring in the structure, many are wondering if this economic union can last for more than two or three years more.

In Great Britain, there is going to be a “hung” Parliament. But, who really wants to rule in jolly ole England. Some are saying that if the new government (‘hung’ or not) really does what it needs to do with respect to the fiscal condition of the nation, these politicians will not be able to be re-elected for the next ten- to fifteen years because they will be so unpopular. Shades of Greece?

The bottom line: governments have lived beyond their means. Certain ‘brands of economics’ have argued that this is possible because people don’t really take into account future tax liabilities or future inflation. They are very ‘current minded.’ It just seems possible that this philosophy has run its course!

Future Long Term Treasury Rates

The ten year Treasury yield hit 4.00% yesterday, a level not hit since June 6, 2009. Then one has to go back to October 31, 2008 for the next time this yield hit the 4.00% level. The big question is, of course, where is the rate going to go from here?

Many experts claim that the outlook for longer term interest rates depends upon what is going to happen to inflationary expectations in the financial markets. With the Consumer Price Index for All Items hovering around the 2.0%-2.5% range, year-over-year, and the CPI less Food and Energy at the 1.0%-1.5% range, year-over-year, actual inflation is extremely low given the experience of the past 50 years or so.


So, what is the market anticipating in terms of inflationary expectations for the next ten years?


If one uses inflation-indexed government bonds as an estimate for the real rate of interest, then for a ten-year Treasury security the market seems to be estimating that the real rate of interest is now around 1.50%. If so, then with the nominal 10-year Treasury security around 4.00%, one could say that the market expects inflation, over the next ten year period to run about 2.5% or approximately at the upper end of the current range for the CPI for all items.


However, one could argue that the Treasury market has been the beneficiary over the past 15 months or so of two unusual forces, both connected with the financial collapse that began in the fall of 2008 and continue to this day. The first of these forces is the huge amount of funds that have flown to the United States and to Treasury securities connected with the “flight to quality” from the rest-of-the world. This “flight-to-quality” began in late 2008 and continued throughout most of 2009 with lapses here and there.


The second factor is the quantitative easing on the part of the Federal Reserve. This has helped to sustain very low market interest rates, long-term as well as short-term. The quantitative easing has also been accompanied by the Fed’s huge purchase program of mortgage-backed securities and Federal Agency securities that have provided a substantial amount of liquidity to the financial markets.


Both forces have resulted in Treasury yields that are substantially below what I would consider to be normal on a historical basis. And, these forces have impacted the inflation-indexed securities as well as the nominal-yield securities. Expected real rates of interest just do not drop to the level that the inflation-indexed securities have fallen to.


Historically, for the last fifty years, the estimate I have used for the real rate of interest tends to be around 3.0%. I won’t argue with 2.8% or with 3.2% because that is not the crucial issue. Before the 1960s, the real rate of interest seemed to be about 2.5% due to the slow growth period of the 1950s and this helps to account for nominal interest rates being so low throughout most of that period of time. Beginning in the sixties, however, the higher, 3.0% rate, seems to provide a relatively better estimate for the “expected” real rate of interest.


If one assumes that the “expected” real rate of interest for the next ten years is 3.0%, then one could argue that the current “realized” real rate of interest from the inflation-indexed securities resulting from the international “flight-to-quality” and the quantitative easing of the Federal Reserve is 150 basis points below what it otherwise would be.


Carrying this argument further, one could argue that the nominal 10-year Treasury security should be around 4.50% once the influence of the foreign “risk-averse” money and the Federal Reserve easing is accounted for. This would imply that the inflationary expectations built into the Treasury yield by the financial markets was about 1.5%, a figure that is at the high end of the current rate of inflation indicated by the CPI less food and energy costs.


But, you could go further than this. The Fed and Ben Bernanke have stated that the “informal” inflation target of the Federal Reserve is about 2.0%. If it is assumed that the Fed is able to contain inflation at this 2.0% level for the next decade, then one would assume that the 10-year Treasury yield should be around 5.0% to reflect an expectation of inflation of about 2.0%.
If the market believes that in the long run, the costs of food and energy should be accounted for in inflation, then, assuming that the upper bound of the current rate of CPI inflation for All Items, 2.5% is achieved over the next 10-years, then inflationary expectations should be at this level and the nominal 10-year Treasury yield should be around 5.5%


Of course, there is another body of thought that looks at the $1.1 trillion of excess reserves in the United States banking system and contends that there is no way the Fed will be able to remove these excess reserves from the banking system before bank loans expand excessively, money stock growth becomes extremely rapid, and inflation becomes a major problem again. To these investors, the assumption of inflationary expectations of 2.5% is ridiculous. Consequently, even a 5.5% 10-year bond rate seems excessively low.


One can argue that, as in the decade of the 2000s, many foreign countries have helped to finance the United States deficit and, as a consequence, and this has also kept United States interest rates lower than perhaps they would have been otherwise. Some analysts believe that this will continue. One can argue from many different sides of this argument for a specific level of interest rates relative to expected real rates plus inflationary expectations. I don’t really find this “supply of funds” argument convincing.


I believe that long term interest rates are headed up. How far they will go depends upon a lot of things, some of which I have tried to present in this post. If the economy continues to strengthen, I feel that the 10-year yield on Treasury securities should, over the next two years, be closer to the 6.00% level than the 4.5% level. There, I am on the record.

Long Term Treasury Yields and the U. S. Dollar

I still feel that the yields on long term Treasury issues and the value of the United States dollar are tied together. I have believed for some time now that long term interest rates will trend upwards over the next 12 months and that the value of the dollar will decline during the same time period. The strong rise in the 10-year Treasury and strong drop in the value of the dollar on August 3 just reinforce this belief.

In looking back at the 2002-2004 period there are too many similarities to feel comfortable. The Federal government is presenting us with large and growing deficits. Monetary policy is ridiculously easy. And, the dollar is under pressure.

What about long term Treasury yields? Well, in that earlier period the United States had the Chinese to pick up large amounts of the exploding Treasury debt so that long term interest rates did not have to rise significantly and the Federal Reserve did not have to monetize the debt.

The reason for the Federal Reserve behavior at that time? Chairman Greenspan was concerned that we might experience a period of deflation!

There are two theories why long term interest rates have not risen further than they have this year. First, there is still a concern among major investors about investment risk and as long as this concern lingers, funds from these investors will remain in long term Treasuries.

Now, there is a second reason given for long term interest rates remaining low and that is the enormous amount of liquidity in the commercial banking system. In recent weeks, commercial banks have started to expand their holdings of U. S. Government securities and this has put funds into the Treasury market with some of it spilling over into the longer end.

Why are commercial banks expanding their holdings of U. S. Government securities? Because the Federal Reserve has given out signals that it may keep short term interest rates low for an extended period of time: even into 2011. If this is to occur, then the reserves that the Fed has put into the banking system will have to stay for a while. That is, there will be no quick exit on the part of the Fed. Since the banks don’t want to lend to businesses or consumers they might as well get a higher yield than they do on reserves at the Fed by investing in market issues.

The reason for the Federal Reserve behavior at this time? Chairman Bernanke is concerned that we might experience a period of deflation!

As a consequence of the specific conditions of the present time, long term Treasury interest rates may not rise appreciably in the near term. However, I still believe that they will show a significant rise in the next 12 months.

I feel more certain about the decline in the value of the United States dollar. Participants in international markets are very reluctant to stick with the currency of a country that runs huge deficits with the strong likelihood that these large deficits will not go away for a long time.

Can you imagine a $2.0 trillion deficit this fiscal year and a Federal deficit of around $1.0 trillion a year for up to ten years! This is unsustainable, even for the United States.

And, what is going to fuel the further decline in the value of the United States dollar?

Oil prices. And, copper prices. And, gold prices. And, stock prices, And, housing prices. All these are rising now. As these asset prices continue to show strength, the value of the dollar will continue to decline. On August 2 I wrote a post called “Looking for Signs of a Recovery” (see http://maseportfolio.blogspot.com/). In that post I laid out some things to look for in determining whether or not the economic recovery is taking place. Rising asset prices is an important factor.

The trouble with rising asset prices at this time is that these increases are being underwritten by the extremely loose monetary policy. It is entirely possible that these asset prices may continue to rise while real economic growth remains dismal at best. And, in such a situation, consumer prices may not rise appreciably. Again, this is consistent with what we saw in the 2002-2004 period—asset bubbles and only moderate consumer price inflation.

Of course, a scenario that contains a continuing decline in the value of the United States dollar is not a good one for the Obama administration. It raises serious questions about the ability of the Federal government to finance such huge deficits as the ones that are forecast and still maintain relatively low long term interest rates without a major monetization of the debt. This whole scene seems like a replay of the first term of the Bush administration. There is just too much debt in existence. And, like the Bush administration, the Obama administration is experiencing a reduction in any “good” policy options that are available to it.

Known Unknowns

It is still too early to think that we are near or past the bottom of this economic downturn. However, in my mind, we are in the “working out” stage of the downturn, especially in the current economic restructuring we are going through, and we cannot expect this stage to be a short one.

The problem with many analysts and policy makers is that they continue to see our economic problems in Keynesian terms and think that the difficulties being experienced in banking and financial markets as a liquidity issue. Hence the search for evidence pointing to “green shoots” and for an “easing of credit.” Every day we hear when new statistics are released that the numbers just presented are “less bad” than before and this indicates that the economy is getting worse at a slower pace. An obvious sign that we are near the bottom!

In my mind, the two major issues facing the United States (and the world) are the structural problems in industry and finance and the debt problem. I have said all along that the basic cause of the financial collapse and the following economic dislocations comes more from the supply side of the economy than from the demand side as assumed by the Keynesians. And, because our problems are primarily supply side problems, governmental stimulus plans and deficit financing are not the incentives needed for restructuring the economy and putting people back to work.

In fact, demand side stimulus can even exacerbate the problems and slow down the changes that need to be made. Furthermore, treating the debt problem as a liquidity problem, as the Federal Reserve and the Treasury seem to be doing, can do the very same thing.

The “good news” is that most organizations and institutions have identified the major problems they will be facing in the near future. However, the “bad news” is that no one knows the depth or breath of the problems. The difficulty facing these organizations and institutions going forward is that these problems must be “worked through” and “worked out”. This “working through” and “working out” will take time and, since the problems are related and interconnected, the outcomes will be dependent on just how systemic and cumulative they are.

For example, greater unemployment due to structural reductions in the workforce who were employed making cars, producing parts, or selling cars will lead to more foreclosures on “prime” loans. (See “Job Losses Force Safer Mortgages to Foreclosure” in New York Times, http://www.nytimes.com/2009/05/25/business/economy/25foreclose.html?_r=1&em.) This will have further ramifications for the financial sector, housing construction and so on. The repercussions will continue on throughout the economy.

In the area of foreign trade, declining incomes lead to reductions in imports, but these imports are the exports of other countries. Countries that have built their economic growth and prosperity on their export trade face worsening times because of the decline in their exports. And, with the slowdown in these countries world trade declines. (See “Trade and Hard Times” in the New York Times, http://www.nytimes.com/2009/05/26/opinion/26tue1.html?ref=opinion.) There are more and more calls to prevent, if possible, further reductions in foreign trade in the world, especially relate to tariffs and other means of protectionism.

These are just two examples of situations where problems exist but where there is no real understanding of how far the cumulative interactions will take us. Many more situations like these exist at the present time. They are not problems that will be resolved through fiscal stimulus and the creation of government debt. There are three major problems with this response.

First, fiscal stimulus does not eliminate structural dislocations in the economy. The government (or no one else for that matter) does not know what the future structure of the economy will look like. Existing organizations, including financial institutions, can “re-tool” themselves, but this takes time and the exploration of different models for companies to find what works best. In terms of innovation, governmental funds can be made available for the next generation of energy sources and transportation systems and so forth, but no one knows exactly how these sources and systems should be put together. Restructuring and creative innovation take time and experimentation. One cannot “will” the right structure or the best innovation.

Furthermore, who wants to invest in something the government is the driving force in? Current events attest to emerging problems related to governance, decision making, and “the rule of law” when the government gets involved with a company or an industry.

Second, when the solvency problem is treated as a liquidity problem, the issue of solvency does not go away. The “toxic asset” program (P-PIP) developed by the Treasury and the efforts by the Federal Reserve to shore up various segments of the financial markets is just a “round-about” way of allowing the federal government to pay for the bad debts that are on the balance sheets of financial institutions. That is, the programs just allow the financial system to transfer financial losses to the government so that the tax payer will eventually end up with the bill for any insolvency that exists. Still, the question of the solvency does not go away.

Third, the government assumption that both problems, those related to economic restructuring and the amount of debt outstanding, can be solved by creating more and more debt is laughable if it were not so potentially tragic. International financial markets understand that in one way or another and at some time in the future, excessive amounts of government debt will end up being monetized. How this monetization works out in each particular case cannot be foretold. History has shown, over and over again, that at some time this connection between large amounts of debt and money creation becomes a reality. It cannot be avoided; it is just the timing that is uncertain.

The conclusions that can be drawn from this analysis are very straight forward. First, economic growth, even when it becomes positive again, will stay low for an extended period of time. My reading of the 1930s has lead me to believe that this decade was a time of industrial and financial restructuring (not helped very much by the government) and technological change. It was not a time that demand-side stimulus could help very much. The restructuring had to take place and World War II did not contribute to the recovery because of the added spending but because of the re-focus and restructuring of industry it forced on the nation. I believe that, like the 1930s, we may be facing an extended period of time in which we need to re-focus and restructure industry. One hopes that we do not need a world war in order to finally achieve this re-structuring.

Second, the continued creation of debt is not going to help. The government debt is going to be monetized at some time. The realization of this, I believe, has become a reality to the bond markets and the foreign exchange markets. To me, the yield on long term U. S. Treasury securities will continue to trend upwards in the foreseeable future and the value of the U. S. dollar will continue to trend downwards. The trends will continue unless some financial “miracle” takes place that eliminates the projected upcoming deficits in the government budget—perhaps an amazing recovering in tax receipts or massive savings discovered in the health care industry.

Third, whereas paper assets from the United States will not be that desirable internationally, physical assets will. For much of the two years or so ending in August 2008, the weak dollar allowed foreign countries and investors to buy U. S. companies at a record pace. With the rising strength of China, India, and Brazil, I believe that with the continued slide in the United States dollar, more and more U. S. companies and their physical assets will come into foreign hands. That is, until the U. S. Congress bans such transactions.

Prices Continue to Rise

"The Labor Department reported that prices received by producers of finished goods rose 0.3 percent last month, further blunting the prospect that the economy was veering into a vicious cycle of lower prices and lower wages known as deflation.” (See http://www.nytimes.com/2009/05/15/business/economy/15econ.html?hp.) Analysts continue to be amazed that we have not yet moved into a deflationary spiral, given the weakness in the economy.

The amazement is due to the fact that most analysts still perceive the decline in the United States economy as one of a collapse in aggregate demand.

The amazement would disappear if these analysts considered that maybe the decline in economic activity was, at least, partially caused by a reduction in aggregate supply. However, most economists are still locked in their retreat to a fundamental Keynesian interpretation.

The banking industry has shrunk. The automobile industry has shrunk. Many retail chains have fallen by the wayside. The housing industry has suffered a massive decline in activity. And, there are many other structural shifts taking place in output and production. These are supply side shifts that are resulting in a major reconstruction of American commerce.

Yes, demand has fallen as the collapse in these industries has resulted in layoffs, firings, and reductions in force. However, the reductions in demand coming from the consumer have been the result of the structural shift in how the United States produces goods and services. Aggregate demand has fallen, but it has followed the decline in aggregate supply and not led it.

The consequence of this? A double whammy! Employment and output have declined due to the shift in both aggregate supply and aggregate demand, yet price increases have not declined as might have been predicted if the reduced output were just a result of a fall in aggregate demand as in the Keynesian case.

What evidence do we have to support this shift? First, there is the massive drop in capacity utilization. Since the start of the recession in December 2007, capacity utilization in the United States has dropped from about 80% to about 65%, a huge decline. Of course, capacity is defined in terms of the current industrial structure and does not take into account that a goodly portion of this capacity is redundant given the changes that are going on in the economy. This is why the auto industry is closing plants.

Furthermore, capacity utilization always lags the recovery of the economy, but in this case the response will be just that much slower because of the structural shift that needs to take place in how we produce and deliver goods and services.

Second, industrial production has nose-dived since the recession began. This is another indication of the structural shift that has taken place in the economy, a shift that will not be recovered just because aggregate demand increases. There has not been a decrease like this in Post World War II history, even in the 1981-1982 period. The year-over-year rate of change in industrial production has dropped from about a 2% rate of increase in December 2007 to a 13% rate of decrease in March 2009 with no let up expected.

Third, civilian unemployed has increased tremendously and the rate of increase of those unemployed has not yet slowed down on a year-over-year basis. This too is a reflection of the structural shifts that have taken place in employment patterns. Furthermore, these numbers include those that are discouraged from the work force and those that are partially employed but would like to be fully employed. Year-over-year, the civilian population that is unemployed has increased from around 10% in December 2007 to about 80% in March 2009. We have not seen such an increase in the Post World War II period!



So, the United States economy has been seeing a tremendous shift in its productive base. Yet, inflationary pressures seem to have remained relatively steady. This is captured in the year-over-year rate of increase in the consumer price index, when energy costs are excluded, which is increasing at a 2.2% rate in March 2009 which is down only slightly from a 2.8% rate of increase in December 2007. In terms of a broader measure of inflation, that recorded by the year-over-year rate of increase in the deflator of real GDP, inflation was at 2.1% in the first quarter of 2009, down modestly from 2.5% in the fourth quarter of 2007.

The use of resources, that is the use of capital and the use of labor, has declined in a major way since December 2007 reflecting not only the weakening economy but also the structural shifts taking place in the production of goods and services. Inflation has decreased only modestly. The combination of these two facts cannot indicate that the changes in the economy have only resulted from a shift in aggregate demand.

There are several reasons why we need to get a consistent interpretation of what is happening to the United States economy. The first is to understand that any stimulus that increases aggregate demand will have a minimal impact on the growth of economic output. The reason for this is that the restructuring of the economy is underway and jobs will just not be forced back into the previous employment patterns. Ironic as it sounds, demand stimulus will have more effect in keeping inflation where it is rather than increasing output. That is what happens when there has been a shift in aggregate supply.

This is, of course, difficult on the consumer because employment and incomes are falling, yet prices are staying constant or increasing, which reduces real incomes.

In addition, this interpretation can also help us to explain why the long term Treasury yields remain high. Everyone agrees that Treasury rates dropped dramatically last fall due to the international rush to quality. As the desire for low risk investments resides, the fact that inflation is not dropping off is being transmitted back into the bond market and Treasury yields are rising once again. In addition, with the massive federal deficits that are now on the horizon, the fear that this new debt will be monetized becomes more and more real to participants in the bond markets.

Furthermore, as Treasury rates rise, upward pressure is also asserted on mortgage rates, which is not helpful to a sagging housing market, and on corporate rates, which will not help stimulate business activity or support corporations in their attempt to restructure their balance sheets.

Finally, as the concern over quality declines, the value of the United States dollar will decline. It seems as if the structural shift in United States economic activity is more supply side than in other parts of the world. Thus, the behavior in prices appears to be different than that in other countries. That is, the price in goods outside the United States will fall relative to the price of goods in the United States. This will put downward pressure on the value of the United States dollar over time, even though interest rates in the United States may stay high relative to those in the rest of the world. This paradox exists because of the change in the relationship between price levels in the various countries.

Long Term Bond Yields and the Fed

The Federal Reserve is trying to hold down long term interest rates. The reason? To stimulate economic activity and encourage credit flow and especially mortgage lending. But, we have a problem. The Financial Times puts out headlines stating that “Rising bond yields present fresh challenge for the Fed.”

Long term bond rates have been rising lately. Yesterday, the 10-year Treasury hit 3.096%, a territory not breached since November 24, 2008. Last time I looked today, this yield was at 3.134%. The same was true for 20-year Treasuries topping 4.00% yesterday and today.

The Fed has been engaged in an effort to purchase longer term United States Treasury issues on a continuous basis as well as Federal Agency issues and mortgage-backed securities. It has made purchases in sizable amounts weekly. Now, the Fed seems to be losing its grip on yields in the long term end of the market.

The rationale given for this slippage? The record amounts of debt the United States government has to sell.

It is true that there are and will continue to be record amounts of debt issued by the United States government coming to the market now and for as far as we can see in the future. The supply issue may have some effect in the short run, but let me provide another possibility for the rise in rates in the longer term end of the yield curve.

The argument about whether or not the central bank can significantly impact yields in the longer term end of the yield curve has been going on for almost the entire length of my professional career. First, people think that the central bank can, and should, conduct open market operations so as to lower long term interest rates in order to spur on the economy. Then, research is produced that indicates that the Fed cannot achieve a significant reduction in long term yields through open market operations. A little later, some others think that it would be a good idea for the central bank to conduct open market operations to reduce long term interest rates. This is followed by another round of research indicating that the central bank cannot achieve this goal. Now, we are back at the point where policy makers believe that the Fed should attempt to keep long term interest rates low.

My reading of history is that the Federal Reserve cannot control, for any length of time, yields on long-term Treasury issues!

My reading of history also causes me to believe that the supply of Treasury securities cannot impact, for any length of time, the yields on long-term Treasury issues!

I am one that believes that long-term Treasury yields are determined by the appropriate expected real rate of interest and the expected rate of inflation. Since the expected real rate of interest does not change over short periods of time, the general movement in longer-terms interest rates will be determined by changes in expected inflation. And, expected inflation is dependent upon what the financial markets believe the Federal Reserve will be doing with respect to the monetization of the federal debt.

This, of course, has been a big fear in the financial markets. With all of the projected government debt coming down the road, many market participants believe that the Federal Reserve will have no choice but to monetize large portions of this debt. As more and more of the debt is monetized the probability that inflation will rise increases. And, this expectation gets built into long term interest rates.

If this is true, then the central bank faces a real dilemma. When the Federal Reserve attempts to keep long term interest rates low, it can cause a rise in inflationary expectations and this will create upward pressure on long term interest rates. If the Fed monetizes more of the debt to keep interest rates at the lower level, inflationary expectations will become even greater, putting even more upward pressure on long term interest rates. And, as long as the central bank continues to keep these long term yields below where the market wants them, the more damaging will be the consequences in the future.

In all my experience, I have not seen the Federal Reserve succeed in keeping long term interest rates below where the market wants them to be. I don’t expect them to succeed in their present efforts.

And, what about inflationary expectations? I believe that we can provide evidence from other markets that confirm this recent sensitivity to the increasing pressure on the monetary authorities to monetize the government debt. I am not concerned with the absolute levels of expected inflation, just the direction in which the spread has moved.

The spread between the 10-year government bond yield and the rate on 10-year inflation indexed government bonds is often used as an indicator of movements in inflationary expectations. The spread remained relatively constant from January 2009 through March. However, in April the spread has increased by 2 ½ times the January figure. This spread now is at a level we have not seen since early October 2008, right after the fall crisis hit. Market participants seem to be increasingly worried about what the Fed is going to have to do.

Furthermore, every time we see this spread increasing we tend to see a decline in the value of the United States dollar against the Euro and against other major currencies. Relative currency valuations are highly dependent upon changes in what central banks are expected to do because their actions can affect relative rates of inflation. If investors believe that the central bank in your country is going to monetize its government’s debt more rapidly than that of another country, the value of your currency will decline relative to that of the other country.

In this respect, the value of the United States dollar has declined over the past two days and tends to drop every time there is a rise in yields on longer term Treasury bonds. This would indicate that some of the same things affecting the yields on long term bonds are also affecting the value of the currency.

A final piece of evidence in support of this idea is that the market also responded to the minutes released yesterday by the Federal Reserve’s Open Market Committee. In those minutes the Fed stated that “the economic outlook has improved modestly since the March meeting…” It also noted that household spending “has shown signs of stabilizing while businesses have cut inventories, investments and staffing” implying that if consumer spending does stabilize or even increase, businesses will have to restock their shelves in order to support this spending which would be positive for economic recovery. Both of these statements foresee a stronger economy in the future, reinforcing the earlier fears of the market.

Long term Treasury yields were low because there was a flight to quality and because inflationary expectations were low. Unless there is another major shock to the system, I believe that the flight to quality is over and is in the process of being reversed. In addition, I believe that the Fed will continue to monetize the debt in increasing amounts for the Fed also emphasized in the minutes released yesterday that they will “stay the course” in the fight against an economic collapse. For both of these reasons, I feel that pressure will continue for long term Treasury yields to rise and for the value of the dollar to fall.