Fundmastery Blog

Kurt Brouwer September 30th, 2009

Paul Volcker was the Federal Reserve chairman back in the early 1980s.  He had been appointed by President Jimmy Carter in 1979.  His task was to squelch inflation and that he did by sharply hiking short-term interest rates.  Unfortunately, the economy took a huge hit as a result of his inflation-fighting efforts, but he did kill off inflation for a generation.  That feat alone gives him enormous credibility in terms of our banking and monetary system.

Now, of course, Volcker is back in the news as an economic advisor to this administration.  However, they are apparently not taking his advice as this ABC News report suggests [emphasis added]:

White House adviser Paul Volcker today criticized the Obama administration’s sweeping financial regulatory reform proposals, specifically one that he warned could lead to future bailouts by designating certain firms as “too big to fail.”

In testimony prepared for a hearing Thursday morning before the House Financial Services committee, the former Federal Reserve chairman expressed doubts about the administration’s proposal to designate certain firms that pose a threat to financial stability, subject them to stricter supervision, and make them submit resolution plans in the event of failure.

“The clear implication of such designation whether officially acknowledged or not will be that such institutions, in whole or in part, will be sheltered by access to a Federal safety net in time of crisis; they will be broadly understood to be ‘too big to fail’,” Volcker said.

This designation, Volcker said, will only serve to encourage more risk-taking, thereby leading to even worse crises in the future.

“What all this amounts to is an unintended and unanticipated extension of the official ‘safety net,’ an arrangement designed decades ago to protect the stability of the commercial banking system,” Volcker stated. “The obvious danger is that with the passage of time, risk-taking will be encouraged and efforts at prudential restraint will be resisted…”

…The former Fed chief also expressed opposition to the administration’s proposal to remove responsibilities other than monetary policy from the central bank…

Chairman Volcker (a shorter version):

First, let’s make banking boring again.  No bank should be too big to fail.  And, second, don’t mess with the Federal Reserve.

What was it like back in the early 1980s?

To see what Chairman Volcker was up against, let’s head back to those days of yesteryear — the early 1980s — and compare some key indicators to the situation back then.  Here is a good chart showing key interest rates plus inflation and unemployment, then and now:

Source: Carpe Diem

I suspect you could win some bets with some of these statistics.  How many folks really remember that home mortgage rates hit 18% back then?  Or, that they never went below 12% from 1979 through 1985?

Double Digits in 1980-82: Inflation, Unemployment & Mortgage Rates

In the late 1970s and early 1980s we had sky-high inflation, unemployment and mortgages rates. At that time, Chairman Volcker, had to raise interest rates to unheard-of levels. These rate hikes led to a prolonged economic contraction that was the worst since the Great Depression of the 1930s. This description from Wikipedia gives a sense of how severe the reaction was [emphasis added]:

“…However, the change in policy contributed to the significant recession the U.S. economy experienced in the early 1980s, which included the highest unemployment levels since the Great Depression, and Volcker’s Fed also elicited the strongest political attacks and most wide-spread protests in the history of the Federal Reserve (unlike any protests experienced since 1922), due to the effects of the high interest rates on the construction and farming sectors, culminating in indebted farmers driving their tractors onto C Street and blockading the Eccles Building…”

The image of farmers blockading Washington D.C. with tractors is hard to imagine now, but those were tough times.  The reason Volcker raised interest rates so aggressively was that inflation went wild in the late 1970s. For example, inflation hit 11.3% in 1979, 13.5% in 1980 and 10.3% in 1981 before Volcker’s harsh medicine began to kick in and inflation moderated to 6.2% in 1982.

As inflation ratcheted higher, so did home mortgages rates. Thirty-year fixed rate mortgages went up to nearly 13% in November 1979 and did not fall under 12% again until November 1985. The peak rate for mortgages was 18.45% in October 1981. 18.45%!

But, even though high interest rates began knocking down inflation, soaring rates also led to sharply higher unemployment. The unemployment rate peaked at 10.8% in December 1982. However, it had been soaring for years and it remained at 8% or higher until January of 1984. Given all this, it is not surprising that investors and consumers were very negative in that time period 1980-82.

As you can see from the chart above, there is a huge disparity between interest rates, inflation and unemployment today versus the early 1980s.  It is true, that government statistics on inflation and unemployment have changed since then.  Nonetheless, interest rates and inflation were much higher back then.  Unemployment was probably about the same although some would argue it is higher now due to changes in the methodology of calculating unemployment.  

In that period, the Federal Reserve had to fight pervasive inflation and the only means available was to raise interest rates.  As a result of higher interest rates, bond yields soared and bond values plummeted.  Higher interest rates hurt the real estate market and values fell.  Higher rates also hurt the stock market.

Inflation is not a huge problem now as it was throughout the 1970s and early 1980s.  For example, inflation averaged nearly 8% per year for the entire decade of the 1970s.  And, it began accelerating into double digits for the period 1979-81.  Clearly, that was a huge threat.

Is deflation underway?

Today, we have two competing issues:  current deflationary trends and likely future inflation influences (see Pimco Warns of Deflation To Come).

Right now, the government is more concerned with deflation than inflation as this report from the Congressional Budget Office indicates.  The CBO made this statement in the summary section of its recent report on the President’s Budget [emphasis added]:

…For the next two years, CBO anticipates that economic output will average about 7 percent below its potential-the output that would be produced if the economy’s resources were fully employed. That shortfall is comparable with the one that occurred during the recession of 1981 and 1982 and will persist for significantly longer-making the current recession the most severe since World War II. In CBO’s forecast, the unemployment rate peaks at 9.4 percent in late 2009 and early 2010 and remains above 7.0 percent through the end of 2011. With a large and sustained output gap, inflation is expected to be very low during the next several years…

The CBO estimates that inflation will be very low for ‘the next several years’ due to the output gap mentioned in the quotation above. That is, if global GDP is 7% below potential then there should not be a lot of pressure on pricing until the output gap is closed.

Will Paul Volcker’s voice be heeded?

However, even though inflation is not a pressing problem today, there are plenty of serious concerns we have about the integrity of the banking system and many other factors. Paul Volcker’s wisdom and experience are badly needed now and I hope the administration heeds it.

Unfortunately, I’m afraid that — so far — his recommendations are not getting the hearing they deserve.

• Business , Economy , Investing , Money , inflation
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Kurt Brouwer September 29th, 2009

Though inflation fears are popping up all over the place — particularly in ads for inflation-hedging investments such as gold — Pimco’s Bill Gross still believes economic activity is weak and he is warning of deflation ahead, not inflation.  This Bloomberg pieces gives his thoughts [emphasis added]. Be wary though of the headline because I believe it is incorrect as I point out below:

Pimco’s Gross Buys Treasuries Amid Deflation Concern (Bloomberg, September 29, 2020, Thomas R. Keene and Susanne Walker)

Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., said he’s been buying longer maturity Treasuries in recent weeks as protection against deflation.

“There has been significant flattening on the long end of the [yield] curve,” Gross said in an interview from Newport Beach, California, with Bloomberg Radio. “This reflects the re-emergence of deflationary fears. The U.S. is at the center of de-levering as opposed to accelerating growth.”

...He boosted the $177.5 billion Total Return Fund’s investment in government-related bonds to 44 percent of assets, the most since August 2004, from 25 percent in July, according data released earlier this month on Pimco’s Web site. The fund cut mortgage debt to 38 percent from 47 percent…

This piece is a good example of why you should be wary of headlines and media reports in general.  The reporters were probably correct that Pimco bought a modest amount of Treasury securities opportunistically when rates hit an attractive level, but they gave the impression that a major move into Treasuries was underway.  And, the headline writer added to that erroneous (I believe) impression.

The piece got it right in the final paragraph above when it pointed out that Pimco is putting more emphasis on government-backed securities (such as Fannie Mae bonds or other government agency bonds) and interest rate swaps and other similar instruments tied to government-backed securities. Government agency bonds are guaranteed by the Treasury, but they are very different from Treasury bonds or notes.

Getting back to the main theme, like Gross, I too wonder and worry about deflation.  It’s not that I do not see a threat from inflation in the future because I do see inflation ahead.  But, inflation is not much of a factor right now whereas deflationary forces are still quite strong.  With the potential for deflation, we also have a higher likelihood of lower interest rates.  Whereas, in an inflationary environment, we would typically have higher interest rates for most fixed income securities.

What is inflation and what is deflation?

Inflation means that we are experiencing a general increase in the price of goods we buy.  Deflation is the opposite, that is, a general decline in the prices of various assets and the goods we buy. Inflation is very common in most developed countries, but deflation is rare.  The last time we had protracted deflation was in the Great Depression of the 1930s.  Now, the slumping economy has weakened demand enough that, at least, most goods and services are under some pricing pressure. Overall, the cost of living (Consumer Price Index) is still up a bit, but that is primarily due to recent increases in the cost of energy.

Why is general deflation so scary to our government?

Falling consumer prices are a good thing, but there are concerns about generalized falling prices, i.e. deflation.  A generalized state of deflation is viewed with fear and loathing by the government because it can be very disruptive.  Falling prices for goods and services mean companies struggle financially and are forced to cut spending and employment.  Falling prices for assets such as real estate means that homeowners see their equity vanish and that leads to lower levels of consumer spending.  As real estate prices fall, banks and mortgage holders also suffer.  This leads to a hoarding of capital and decreased lending activity.  And, as economic activity under a deflationary environment falls, more unemployment results, thus leading to yet further reductions in consumer spending.

In short, deflation can become a downward spiral and our government will use every tool it has to quickly root out deflation and prevent it from taking hold because, to paraphrase Sun Tzu from The Art of War:

If the deflation is protracted, the resources of the State will not bear the strain.

As Gross pointed out in his September Investment Outlook,

As of now, PIMCO observes that the highest probabilities favor the following strategic conclusions:

1. Global policy rates will remain low for extended periods of time.
2. The extent and duration of quantitative easing, term financing and fiscal stimulation efforts are keys to future investment returns across a multitude of asset categories, both domestically and globally.
3. Investors should continue to anticipate and, if necessary, shake hands with government policies, utilizing leverage and/or guarantees to their benefit.
4. Asia and Asian-connected economies (Australia, Brazil) will dominate future global growth.
5. The dollar is vulnerable on a long-term basis.

The Feds are fighting deflation very hard for the reasons noted above, but the deflationary pressures are such that we are not likely to see inflation for some time.  That’s good. Unfortunately, deflationary pressures also mean that we will probably have a modest, rather than robust, economic recovery in 2010.

See also:

Burgeoning Bond Funds

Economy Turning — slow growth ahead

Full Disclosure:  Kurt Brouwer owns Pimco Total Return (pttrx)

• Economy , Geopolitics , Investing , Mutual Funds , debt , deficit , inflation
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Kurt Brouwer September 28th, 2009

During this recession, Americans are paying down their mortgages, paying off car and truck loans and moving back to old fashioned thrift.  And, Yet, despite all the cutbacks on the part of Americans, the country’s debt load has gone up due primarily to government borrowing.  Yet, even with all the new government debt, the country’s headlong race into indebtedness has slowed considerably:

Source: New York Times

The rate of growth in new national debt, is down to 3.7%, which is low by historical standards.  This piece by Floyd Norris from the New York Times gives some detail [emphasis added]:

THE United States government is borrowing money like never before. The national debt rose by more than a third over a one-year period, far more than it ever did at any time since World War II.

…This week, the Federal Reserve published its quarterly report on debt levels in the economy. While Uncle Sam borrowed more, others borrowed less. The accompanying chart shows that total domestic debt — the amounts owed by individuals, governments and businesses — climbed just 3.7 percent from the second quarter of 2008 through the second quarter of this year. That is the smallest increase since the Fed started these calculations in the early 1950s.

Moreover, domestic debt declined in the second quarter, falling 0.3 percent to $50.8 trillion. The figures are not seasonally adjusted, making quarter-to-quarter comparisons risky, but it was the first such decline since the first quarter of 1954, when total debt was less than $500 billion.

…Until this recession, the idea that American individuals would ever cut their overall debt levels seemed as likely as an August snowfall in Miami. But that was before the bottom fell out of the housing market, something that Florida condo developers had considered to be equally unlikely.

Over the year, total household debt fell by 1.7 percent, and mortgage debt — the largest component of household debt — fell a bit more, at a 1.8 percent pace. This is the 10th recession since the Fed began collecting the numbers, but the first in which the amount of home mortgage debt fell. Some of that decline, of course, came from foreclosures that canceled debt and left lenders with big losses…

Without the huge slug of debt put on by the government, our overall indebtedness would be falling.  Some economists and pundits think government borrowing is the only thing between us and disaster.  That may or may not be, but in my opinion it is disaster deferred not disaster avoided.

Even though households are cutting back, the U.S. Treasury just reached a new — albeit dubious — record:

The U.S. Treasury issued a new record of $7 trillion in bonds for the fiscal year that will end next week:

U.S. issues $7 trillion debt, supply to stabilize  (Reuters, September 23, 2020, Burton Frierson)

The U.S. government will have issued $7 trillion in bonds by the time the current fiscal year ends next week, but it expects the debt deluge to stabilize by mid 2010, a Treasury official said on Wednesday.

…However, this expansion may take place in an environment where investors consider leaving the safe-haven Treasury market for riskier assets, and debt issuance is likely to level off mid next year, said Treasury Acting Assistant Secretary for Financial Markets Karthik Ramanathan.

“In fiscal year 2009, which ends next week, Treasury will have issued $7 trillion in gross issuance — that’s in a 12-month period,” Ramanathan told a financial markets conference in New York…

A trillion here and a trillion there.  After a while, it adds up.  Not all of these bonds were brand new.  In fact, most of the bonds issued replaced bonds that were maturing.  Nonetheless, the new debt issuance is huge.  Reuters continues:

“This issuance was necessary to meet nearly $1.7 trillion in net marketable borrowing needs, nearly $1 trillion more than what we raised last year,” he added.

That’s sizeable.  $1.7 trillion in net new borrowing.

Finally, the headline of this piece cracks me up.  ‘U.S. issues $7 trillion debt, supply to stabilize.’  Since the Treasury determines what the supply is, I guess that’s like saying, “We’re borrowing scads of money now, but we plan to borrow less in the future.”  OK, that’s nice, but we’ll believe it when we see it.

Ordinary Americans have proved they can cut back, but it remains to be seen what happens when the recession ends and the recovery begins.  The reverse is true of government borrowing.

• Business , Economy , Money , Personal Finance , debt , deficit , inflation
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Kurt Brouwer September 24th, 2009

Money market fund yields approaching zero have grabbed the attention of millions of investors who are now making the move into bonds funds.

Jason Zweig, at the Wall Street Journal, notes the trend and provides a bit of caution for those seeking yields [emphasis added below].

If you have not read him before, Zweig is an excellent and prolific writer for Money and other publications such as the Wall Street Journal.  He also has written or edited several books, his most recent being Your Money and Your Brain (Simon & Schuster, 2007).

Don’t Trip in Search for Bond Yields  (Wall Street Journal, September 18, 2020, Jason Zweig)

The Federal Reserve’s policy of driving interest rates down toward zero may have kept the financial system alive. But it is killing savers, and driving them to do desperate things.

The first sentence of this piece suggests that investors were doing desperate things by going into bond funds.  No doubt that is true in some cases, but it is also true that getting a yield of zero is unrewarding.  In fact, if you are getting a yield approaching zero from a money market fund — while inflation is running about 1-2% — well then you are losing purchasing power every year.

So, making a move into bond funds makes sense provided you do so wisely (see Purchasing Power for more on inflation and purchasing power).

Nearly 78% of taxable money-market funds, the traditional parking place for savings, are offering 0.1% or less in annualized yield, according to Crane Data LLC, a research firm. On a $10,000 balance, that will earn you a maximum of 83 cents — yes, $0.83 — in monthly interest income. All told, these funds hold $1.3 trillion that will generate a return of just about zilch for the people who worked so hard to save it.

Bear in mind this number in bold above, $1.3 trillion, is just the amount held by so-called retail investors.  The amount held by institutions of various sorts is actually higher, well north of $2 trillion.  The Investment Company Institute reports total money market fund assets of $3.48 trillion as of September 24th. Then, if you add in bank deposits, Treasury Bills and so on, the number gets even bigger.  In other words, there’s lots of money out there in very low-yielding investments.

Choose carefully and conservatively

The type of bond fund you choose is very important.  Fortunately, there are plenty of conservative taxable bond funds from which to choose that have yields of 3-5%.   And, there are many solid tax-exempt or municipal bond funds with attractive tax-free yields.

On the other hand, if investors are going from very low-risk money market mutual funds to high risk bond funds, then that is a problem.  Higher risk bond funds would be those with longer average maturities or those that hold high yield or junk bonds.

The Wall Street Journal continues:

Last month, investors put twice as much money into intermediate-term and junk-bond funds as into short-term bond portfolios. As a result, they have exposed themselves to much greater risk from rising rates or falling credit quality. When interest rates go up, as in 1994, investors in longer-term bonds can get slaughtered.

…Bonds are safer than stocks. But, at today’s high prices and low yields, bonds are riskier than they were a few months ago. The easiest way to tell is by looking at duration: the change in a bond’s market value when interest rates go up or down by one percentage point. If, for example, you own a bond with a duration of four, then its value will go up about 4% if interest rates fall by a percentage point; the bond will lose about 4% if rates rise by one point…

So, be careful out there.  And, please don’t shop for the highest yield because that will lead you to long-term bond funds and/or junk bond funds.  There is nothing wrong with putting some of your fixed income money into junk bond funds, for example, but do it only if you are diversified and also if you understand how volatile long-term bond funds and junk bond funds can be.  For example, a long-term bond fund has roughly the same volatility as a diversified stock fund.

And, what exactly is duration, anyway?

Zweig mentioned a bit of financial jargon that is worth a moment of your time.  Duration attempts to marry two separate aspects of a bond or a bond fund: first, the average maturity of all the bonds in the portfolio and, second, the average yield or interest income coming in to the portfolio.

The article is correct that we use duration as a rule of thumb to estimate portfolio volatility in the event of a quick spike in interest rates.  However, it’s just a rule of thumb, not exact.  It’s also not the only the only factor that determines volatility.  Imagine the dismay felt by someone last year who had invested in a fund with low duration, but a high commitment to mortgage bonds or junk bonds?

What to do now?

If you have money in a money market fund that is destined for use in the near future such as paying taxes or next year’s tuition for your daughter or son, then I would keep it in a money market fund or maybe a bank certificate of deposit.  Or, you could consider a very short-term bond fund.

On the other hand, if you were keeping the money in cash just due to uncertainty of where to invest for the long haul, then a solid portfolio of bond funds could be excellent as part of your overall portfolio.  Or, if you are purely an income investor, then a diversified portfolio of bond funds could be fine.

My favorite bond fund (see The Biggest Bond Fund) is Pimco Total Return (pttrx).  It has a current (SEC) yield of about 4.93% and a duration of 4.4 years.  Pimco has a similar fund with a shorter duration, Pimco Limited Maturity (ptldx), which has a current yield of 3.44% and a duration of 2.1 years.

Vanguard also has a number of excellent taxable funds and tax-exempt funds. In the tax-free arena, I like Vanguard Intermediate Term Tax-Exempt (vwiux), which has a Federal tax-free yield of 3.20% and a duration of 5.9 years.  Also, Vanguard Limited Term Tax-Exempt is good.  It has a tax-free yield of 1.67% and a duration of 2.4 years.

My advice is to move slowly and deliberately if you are considering a change from money market funds into bond funds.  The rewards are tangible, but make sure you understand the risks.

• ETF , Geopolitics , Investing , Mutual Funds , Personal Finance , debt , deficit
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Kurt Brouwer September 23rd, 2009

I really never thought we would be tossing around the term trillion right and left, but we are.  Or, rather Congress is. But, I don’t think they really know how much money — or rather debt — we are incurring with each new trillion dollar commitment.

So, just how much is a trillion? The late Illinois Senator, Everett Dirksen once said,

“A billion here and a billion there.  After a while, it adds up to real money.”

Dirksen was referring sarcastically to the aplomb with which Congressional leaders of that day spent taxpayers’ money in round lots of billion dollars.

Now, in less than a year, we have moved on from budget deficits in the billions to trillion dollar plus deficits.  So, I wondered, what comes next?  This Associated Press report gives us the answer [emphasis added]:

A New Hampshire man says he swiped his debit card at a gas station to buy a pack of cigarettes and was charged over 23 quadrillion dollars.

Josh Muszynski (Moo-SIN’-ski) checked his account online a few hours later and saw the 17-digit number — a stunning $23,148,855,308,184,500 (twenty-three quadrillion, one hundred forty-eight trillion, eight hundred fifty-five billion, three hundred eight million, one hundred eighty-four thousand, five hundred dollars).

Muszynski says he spent two hours on the phone with Bank of America trying to sort out the string of numbers and the $15 overdraft fee…

If a guy in New Hampshire can spend quadrillions on gas, just think what the Congress could do?

Seriously though.  Take a look at this news item from a previous post about a new world’s record of $7 trillion in bonds for the fiscal year that will end next week:

U.S. issues $7 trillion debt, supply to stabilize  (Reuters, September 23, 2020, Burton Frierson)

The U.S. government will have issued $7 trillion in bonds by the time the current fiscal year ends next week, but it expects the debt deluge to stabilize by mid 2010, a Treasury official said on Wednesday.

…However, this expansion may take place in an environment where investors consider leaving the safe-haven Treasury market for riskier assets, and debt issuance is likely to level off mid next year, said Treasury Acting Assistant Secretary for Financial Markets Karthik Ramanathan.

“In fiscal year 2009, which ends next week, Treasury will have issued $7 trillion in gross issuance — that’s in a 12-month period,” Ramanathan told a financial markets conference in New York…

A trillion here and a trillion there.  After a while, it adds up.  Not all of these bonds were brand new.  In fact, most of the bonds issued replaced bonds that were maturing.  Nonetheless, the new debt issuance is huge.  Reuters continues:

“This issuance was necessary to meet nearly $1.7 trillion in net marketable borrowing needs, nearly $1 trillion more than what we raised last year,” he added.

That’s sizeable.  $1.7 trillion in net new borrowing.

Finally, the headline of this piece cracks me up.  ‘U.S. issues $7 trillion debt, supply to stabilize.’  Since the Treasury determines what the supply is, I guess that’s like saying, “We’re borrowing scads of money now, but we plan to borrow less in the future.”  OK, that’s nice, but we’ll believe it when we see it.

After seeing how quickly Congress made the leap from spending billions to trillions, I am hoping that no one tells them what comes next.  If they figure it out, we’ll soon be seeing quadrillion dollar deficits.

• Economy , Geopolitics , Investing , debt , deficit
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