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Obama Giveth but Bonds May Taketh Away |
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FORECASTS & TRENDS E-LETTER IN THIS ISSUE:
1. How Things Were Supposed to Work 3. Bonds May be the Fly in the Ointment 4. What Will be the Next Asset Bubble? 5. You Heard It Here First & Often 6. A Bond Strategy for Both Up and Down Markets Introduction With President Obama’s decision to let all of the Bush tax cuts continue for two more years, even for those in the top two brackets, most economists and analysts have increased their forecasts for growth in 2011, at least modestly. It’s as if they had based their prior projections on the idea that all of the Bush tax cuts were going to expire at year-end. I never thought they would expire, except perhaps for those in the top two brackets. So, I am not at all convinced that we should raise our expectations for economic growth next year, certainly not significantly. Then there are those who believe that the Fed’s latest proposed QE2 spending of an additional $600 billion over the next 6-7 months will boost the economy, but as I have discussed recently, I’m not convinced that will do much for us either. President Obama’s QE1and stimulus spending of over $2 trillion has accomplished very little, other than ballooning the national debt, so why should we expect another $600 billion of Treasury purchases by the Fed to do the trick? Most importantly, a new phenomenon has emerged over the last few months: medium and long- term interest rates have quietly risen significantly. Ten-year Treasury Notes have risen from 2.4% to above 3.2%. Thirty-year Treasury Bonds have jumped from 3.5% to near 4.5% since September. At the end of the day, the question now is: Will interest rates continue to rise, and thereby negate the potentially positive effects of income taxes not going up for two more years and the Fed spending another $600 billion in QE2? Few are talking seriously about this significant move up in medium and long-term interest rates, since the short-term Fed Funds rate remains near zero and one-year CD rates are still around 1%. Yet I have been warning about a selloff in the bond market since August. It has been a continuing theme in this E-Letter for several months. In this week’s E-Letter, we will focus on whether or not the increase in interest rates will serve to blunt the effects of more Fed and government stimulus. Expect this topic to get a lot more attention once the news of Obama’s compromise to extend the Bush tax cuts for everyone wears off. How Things Were Supposed to Work Obama and Democrats in general backed the extension of the Bush tax cuts for lower and middle-income taxpayers, based on the belief that raising taxes would jeopardize the fragile economy. The last thing Obama wants to happen on his watch is for the US economy to slow down further, or worse, lapse into a double-dip recession. Keeping the income tax status-quo on all but the wealthiest taxpayers, plus putting additional money in workers’ pockets through a reduction in payroll taxes and an extension of unemployment benefits would have helped to maintain or even increase spending at a time when it is needed most. However, a funny thing happened on the way to a Lame Duck rubber stamp of Obama’s tax policy to keep the Bush tax cuts for all but the “rich.” This Democratic plan failed – twice – to pass in the Senate even though the Democrats had control. Political realities set in and Obama figured that it would be better to compromise with the Republicans and extend the tax cuts for everyone for two years rather than preside over the largest tax increase in history. Rather than fall on his sword, he’d live to fight another day. While Obama has remained unapologetic in his opposition to the extension of tax cuts for the wealthy, allowing all the tax cuts to expire and ending emergency unemployment benefits presented an unacceptable economic risk. In his speech announcing the compromise, Obama said, in part: “…I'm not willing to let working families across this country become collateral damage for political warfare here in Washington. And I'm not willing to let our economy slip backwards just as we're pulling ourselves out of this devastating recession…Make no mistake: Allowing taxes to go up on all Americans would have raised taxes by $3,000 for a typical American family. And that could cost our economy well over a million jobs.” However, increasing taxes is only one of the two arch enemies of the fragile economic recovery. The other comes in the form of higher interest rates. Increasing the cost of borrowing could have just as much of a negative effect on economic growth as higher taxes, if not more so. Therefore, even before the deal was made on tax cuts, the Fed had already announced that it was going to buy another $600 billion of Treasury securities. And not just any Treasuries, the longer-term maturities would be targeted. By attempting to slay the deflation dragon, Bernanke is injecting hundreds of billions of new dollars into the economy. However, the hoped for increase in borrowing and lending isn’t happening because corporations are wary of the future in an economy where unemployment remains at almost 10% and is expected to remain high for a long time. By all accounts, companies are sitting on top of a record supply of cash, so funding capital improvements isn’t the problem. It’s justifying new investment, spending and hiring in a very uncertain economic situation and with interest rates on the rise that’s the tricky part. While the official line on the Treasury purchases was that they were necessary to fight deflationary forces in the economy and inject money into the banking system so lending could resume, the real target was to keep long-term interest rates low. Economist Peter Schiff had the following comment on QE2 back in November: “At the end of the day, all the deflation talk is a red herring. As global demand for dollar-denominated debt falls, the Fed is looking for an excuse to pick up the slack. The true purpose of QE2 is to disguise the decreasing ability of the Treasury to finance its debts.” Red herring, indeed. As I noted in my November 30 E-Letter, there are already plenty of signs of inflation in the US economy. All you have to do is go to the store, gas station or pay your utility bill and you’ll see plenty of evidence of it. Bernanke’s bid to promote inflation when it’s already here can only lead to worse inflation in the future, in my opinion. That means higher interest rates and lower bond prices, as I have been saying for months. The Bush Tax Cuts Extension Reality As this is written, the extension of the Bush tax cuts is still not a done deal, but I expect it to pass before the Christmas break in Congress. Most Democrats who are expressing outrage at Obama’s giving in to the GOP know this and are really waiting to see what kind of pet projects they can finagle into the final bill. Lest we forget the outright bribes that accompanied the Obamacare legislative process, don’t think that those Democrats who are holding out on support of the tax cut compromise are doing so out of a pure heart. More likely, they’re waiting to see what they can get in the way of pork barrel projects inserted into the bill. Because the tax cut extension and related spending measures do not need to have offsetting spending cuts, all financial consequences will simply increase the deficit over the next couple of years. This helps to explain why some Democrats are holding out. They know that their votes are needed and that they can negotiate for special projects (earmarks) that benefit their constituents and therefore their own popularity. Since no spending cuts are required, it’s all gain and no pain (for them). I can just imagine what must be going on in closed-door negotiations right now. All of this horse trading over the tax cut extension goes to show that most Democrats learned absolutely nothing from the GOP landslide in the mid-term elections. These politicians are once again holding the economy hostage without any regard for how their pet projects will affect the deficit and growing national debt. Assuming that the tax cuts are extended for all, it is likely that the economic recovery will continue. While there’s always the fear of a contagion from the European sovereign debt problems or a crisis in the value of the dollar, the economy should continue to chug along, albeit slowly. Yet there are many analysts who are now increasing their expectations for GDP growth in 2011, some to 4% or more. The explanation is that the tax cut compromise means that there will be no tax increase in 2011, so economic activity will continue to grow. I don’t believe for a minute that any reputable economic forecaster assumed that all of the Bush tax cuts would expire. At worst, some probably factored in losing tax cuts for the “rich,” but not a total expiration. Thus, I think that some of the new projections for growth next year are painting a rosier picture than might be justified. With unemployment remaining at almost 10%, with businesses still hesitant to fund capital improvements and with the housing market still in a funk, I think it’s still going to be a struggle next year. While the odds of a double-dip recession have declined significantly, there are still plenty of storm clouds on the horizon that merit close watching. One of these storm clouds is in the form of increasing long-term interest rates, as I will discuss below. Bonds May Be the Fly in the Ointment As I have previously noted, the recent decision by the Fed to purchase another $600 billion of medium and long-term Treasury Bonds was supposed to put downward pressure on interest rates. However, since Bernanke leaked that QE2 was coming back in late August, long-term interest rates have been creeping steadily higher, as I have been suggesting. As you can see in the chart below, 30-year Treasury Bond yields began to trend higher back in early September to the surprise of most analysts.
But as you can also see above, T-bond yields turned lower once again in mid-November. However, in late November, as it became likely that President Obama was going to compromise on extending all of the Bush tax cuts, you can see that bond yields reversed abruptly higher, moving to a new recent high near 4.50%. Bond investors interpret the tax cut extension and the cut in the payroll tax rate as leading to continued economic growth, even higher budget deficits and eventually, higher inflation. These factors, in turn, lead to higher bond yields and lower bond prices. Thus, the key question is, will interest rates continue to climb and choke off the positive aspects of the tax cut extensions and the decrease in the payroll tax? Another interesting question is whether or not interest rates will rise to the point that they derail the ongoing bull market in stocks. Yet another interesting question is whether or not interest rates will rise enough to make already hard to get business loans and home mortgages even more scarce. Obviously, these are all questions for which no one knows the answers for certain. Most of the sources I respect agree that the short-term Fed Funds rate will remain near zero for some time to come. With regard to medium-term and long-term rates, most believe we are in a rather broad trading range. However, antennae went up all around the world with the latest move to new recent highs in the 10-year Note and the 30-year Bond. In the near-term, the trading range forecast may continue to be accurate. At last Thursday’s Treasury auction, for example, there was strong institutional demand for 30-year T-bonds. Rates on 30-year Treasuries settled in at a 4.41% yield, slightly below the recent high. After the auction, bond yields fell even further to 4.36% and were at 4.4% as of the close yesterday. Still, it remains to be seen if the uptrend in bond yields that began back in September will continue from here, or remain in a trading range. Just keep in mind that debt levels around the world are at record levels, and it could just mean that investors who buy that debt are demanding higher returns on their money. Also, keep in mind that trading ranges are trading ranges only until they are broken out of. What Will be the Next Asset Bubble? Of course, there’s also a chance that the huge amount of liquidity being pumped into the economy could fuel yet another asset bubble. There are various candidates for this bubble ranging from gold to emerging market securities, but it’s possible we could also see another asset bubble in the stock market. I have previously noted that increasing yields would take a toll on all of the investors who have fled like lemmings into the bond market over the last year. With higher yields now evident, the inflows into bond mutual funds have slowed to a trickle, and will likely soon reverse. All of this money that may come out of bonds and bond mutual funds will have to go somewhere, and since the stock market has done well this year, bond outflows could end up going there. Another interesting option is that the money that may be fleeing from bonds might not go anywhere, at least not into any securities market. A recent study by Spectrem Group indicated that the households classified as “mass affluent” are more likely to invest in CASH over the next 12 months than in any other type of security. Spectrem defines mass affluent as households with net worths from $100,000 to $1 million, excluding their primary residence. Based on a survey of the financial decision makers in over 1,500 households, Spectrem found that 40% of mass affluent investors are likely to invest in cash equivalents (CDs, money markets, etc.) over the next 12 months, as compared to only 23% who said they would likely buy stocks, 17% to buy fixed income investments, 12% international investments and 6% are likely to invest in real estate. Overall, 55% of respondents indicated that it is more important to protect principal than to grow their investments. Imagine that: After two major bear markets in less than a decade, it appears that most Americans are finally realizing that the return OF principal is more important than the return ON principal. How novel! That’s a concept I have been arguing for over 20 years. That is precisely why I have been promoting actively managed investment strategies that seek to move to the sidelines during bear markets, and why I don’t recommend Wall Street’s “buy-and-hold” mantra. You Heard It Here First & Often Since early August, I have maintained one continuing theme: that the US Treasury Bond market was ripe for a selloff. Millions of investors have shunned stocks and loaded up on bonds and bond mutual funds over the last year or so. Meanwhile, commodity prices have been going through the roof as I detailed in my November 30 E-Letter. My concern has been that many of my readers may have been among those millions of investors who bought bonds and bond funds this year and would be harmed if bond yields started to rise. As we discuss below, not only have bond yields started to rise, they have risen significantly since early September. As noted above, investors in bonds and bond funds are now starting to feel the pain. My advice over the last several months has been to lighten up on bonds by at least taking your profits off the table. I hope my readers that were overweight in bonds took that advice, because as the chart above illustrates, the yield on 30-year Treasury Bonds has spiked from near 3.5% to over 4.4% since September. Now it could be that the recent selloff in bonds is just a temporary phenomenon – a “correction,” if you will. It may be that bond yields have had their correction and will move lower again in the next few months. The idea that the recent upswing in bond yields is only a correction, and that yields will move sideways to lower going forward is the prevailing view right now. I’m not here to say that this view is wrong. What I am here to say is twofold. First, most forecasters have no idea why medium and long-term interest rates have risen significantly over the last several months. So how do they profess to know why rates will decline again going forward? They don’t know. Second, commodity prices are soaring higher, much higher than anyone expected, as I pointed out in my November 30 E-Letter. I maintain that this is primarily why bond yields turned significantly higher back in September. Soaring commodity prices always lead to higher inflation. The only question is, how much higher? Finally, one last point: The US bond market is the largest single market in the world by far, and as such, it has a mind of its own; it frequently moves higher or lower than just about anyone expects. The point is, there is no way to know if the recent rise in interest rates is just a correction, or if rates will continue to rise over the next year or longer. The bottom line is, if you are over-invested in bonds – as millions of Americans are – you may need a different strategy than buy-and-hold (or buy-and-hope, as I call it). A Bond Strategy for Both Up and Down Markets In my August 3 E-Letter I discussed one of our recommended money managers that specializes in trading Treasury Bond funds, Hg Capital Advisors. Hg invests in the Rydex Government Bond Fund (1.2X Strategy) when bond rates are trending lower. But if bond yields begin to trend higher, Hg can invest in the Rydex Inverse Government Bond Fund, which makes money when bond yields go up. In effect, they can “short” the bond market. Hg had their best year ever in 2009 as interest rates fell, and they’re having another strong year in 2010. Whenever bond yields do turn higher, I expect they will go up more than most people would expect. Hopefully, Hg will catch that trend when the time comes. As always, past performance is no guarantee of future results. Best of all, Hg’s minimum investment is only $25,000. To learn more about Hg Capital Advisors, click on the link above to see my last report on Hg. Or you can:
I know the holiday season is fast approaching, but there is still plenty of time to adjust your investment allocations before the end of the year and reposition your holdings for 2011, if need be. At Halbert Wealth Management, we are happy to consult with you on most any questions you may have. My knowledgeable Investment Consultants are happy to visit with you about your investments. They are salaried professionals (non-commission), so there is never any pressure to do anything. Don’t hesitate to contact us. Wishing you Happy Holidays,
Gary D. Halbert SPECIAL ARTICLES
2011 May Whack Bonds & Boost Stocks
Say goodbye to the bond bull market?
Senate Passage of Compromise Tax Bill considered likely |
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Forecasts & Trends E-Letter is published by Halbert Wealth Management, Inc., a Registered Investment Adviser under the Investment Advisers Act of 1940. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of the named author and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific advice. Readers are urged to check with their financial counselors before making any decisions. This does not constitute an offer of sale of any securities. Halbert Wealth Management, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have their own money in markets or programs mentioned herein. Past results are not necessarily indicative of future results. All investments have a risk of loss. Be sure to read all offering materials and disclosures before making a decision to invest. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent. |
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