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Treasury Yields Fall to Record Lows, But...

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
November 16, 2010

IN THIS ISSUE:

1.  Treasury Note Yields Fall to All-time Lows

2.  Bernanke Confirms That Inflation is Too Low

3.  More Reasons Why QE2 May Not Work

4.  New Fed Report on Tepid Small Business Lending

5.  Is the Bond Bull Market Nearing the End?

Introduction

On the day after Fed Chairman Bernanke announced the latest $600 billion in QE2, yields on Treasury Notes plunged – in particular the two-year, five-year and ten-year Treasury Notes.  The two-year and five-year fell to the lowest levels on record.  The yield on 30-year Treasury Bonds, however, went up since it appears the Fed will not be buying T-bonds in QE2.

Over the last few weeks, I have opined that the Fed Board of Governors is very concerned that the economy may be tipping toward deflation.  I even interpreted some of Fed Chairman Bernanke’s recent comments as his way of saying that inflation is too low.  In a rare editorial in the Washington Post recently, Bernanke confirmed what I wrote in spades – excerpts to follow.

While I have written about QE2 the last two weeks, a hot debate is developing between those who oppose it and those that think it should be even bigger.  We will briefly revisit those issues and some new reasons why QE2 may not work as hoped.

Next, we look at a new report from the New York Fed that sheds some new light on the problems with banks lending (or not lending) to small businesses.  While the report shows that banks have started to loosen their lending requirements, it also found that many small businesses still don’t qualify for loans.  Many others aren’t even bothering to apply.

Finally, we take a closer look at the US Treasury Bond market.  Bond prices have been falling  (yields rising) ever since Ben Bernanke leaked word about QE2 back in August.  This, of course, raises the question of whether the bond bull market is ending.  If you have bonds in your portfolio, you’ll definitely want to read this section.

Treasury Note Yields Fall to Record Lows, But…

Last week I wrote about the Federal Reserve’s announcement on November 3 that it will conduct another round of quantitative easing (this round referred to as “QE2”) between now and the middle of next year.  The Fed said it will buy up to $600 billion in medium-term Treasury Notes.  As a result, yields on two-year and five-year Treasury Notes fell to their lowest levels ever shortly after the announcement.

On November 4, the day after the official QE2 announcement, the yield on the 2-year Treasury Note fell to an all-time low of 0.31%.  The same day, the 5-year Treasury Note fell to a record low of 1.01%.  The benchmark 10-year Note fell to 2.53%.

[Imagine that, the United States government can sell Treasury Notes – still considered by many to be the safest securities on the planet – and pay record low yields at a time when we are running trillion-dollar budget deficits and exploding our national debt at an unprecedented rate.]

Interestingly, the Fed’s QE2 announcement did not suggest that the Fed will be purchasing any 30-year Treasury Bonds this time around, which came as somewhat of a surprise to the markets.  As a result, the 30-year T-bond yield actually rose to a four-month high of 4.12% shortly after the Fed’s statement.   This was a significant occurrence and could suggest that the bull market in bonds is coming to an end.  I will have more to say about bonds as we go along.

Bernanke Confirms That Inflation is Too Low

Over the last few weeks, I have opined that the Fed Board of Governors is very concerned that the economy may be tipping toward deflation.  I have also suggested that this concern about deflation is what has been driving the Fed toward another large round of QE.  In a rare editorial in the Washington Post on November 4, Fed Chairman Ben Bernanke confirmed what I wrote:

“Today, most measures of underlying inflation are running somewhat below 2 percent, or a bit lower than the rate most Fed policymakers see as being most consistent with healthy economic growth in the long run. Although low inflation is generally good, inflation that is too low can pose risks to the economy - especially when the economy is struggling. In the most extreme case, very low inflation can morph into deflation (falling prices and wages), which can contribute to long periods of economic stagnation.

Even absent such risks, low and falling inflation indicate that the economy has considerable spare capacity, implying that there is scope for monetary policy to support further gains in employment without risking economic overheating. The FOMC decided this week that, with unemployment high and inflation very low, further support to the economy is needed. With short-term interest rates already about as low as they can go, the FOMC agreed to deliver that support by purchasing additional longer-term securities, as it did in 2008 and 2009. The FOMC intends to buy an additional $600 billion of longer-term Treasury securities by mid-2011 and will continue to reinvest repayments of principal on its holdings of securities, as it has been doing since August.”  [Emphasis added.]

Bernanke admitted that Fed asset purchases such as QE1 and now QE2 are an “unfamiliar tool of monetary policy,” but he assured us that neither would lead to significant increases in inflation going forward.  So, on the one hand, he tells us that the current rate of inflation is too low, but on the other, QE won’t lead to a big increase in inflation.

More Reasons Why QE2, Like QE1, May Not Work

While I wrote about QE2 last week, a hot debate is developing between those who oppose it and those that think it should be even bigger.  So, let’s briefly revisit the issue this week.  You may remember that I suggested two weeks ago that QE2 may simply be the Fed’s way of showing it is doing “something,” whether or not it actually works.

Like President Obama’s $800+ billion stimulus package, there are many who believe that QE1 didn’t work, and QE2 may be no different.  After all, an estimated eight million jobs were lost after the huge stimulus bill was passed, and even as the $1.7 trillion QE1 was implemented.  Yet President Obama and Fed Chairman Bernanke would have us believe that things would be much worse today had neither of those actions taken place.

Yet there are reasons to believe that QE2 won’t work any more effectively than the stimulus or QE1.  There are those who believe that quantitative easing in any form simply does not address the fundamental problems the US economy faces.  At this point, reducing medium-term interest rates by 25 or even 50 basis points is almost certainly not going to lead to a significant increase in gross domestic product and a meaningful reduction in unemployment. 

As a reminder, here’s how QE2 is going to be implemented: The Fed will go to the major banks each month and buy apprx. $75 billion worth of T-Notes (mainly five and 10-year Notes) until the purchases total $600 billion in mid-2011.  This is in addition to the Treasury purchases being made with the income and maturing bonds from the first round of QE.  That increases the amount of buying this round to about $800 billion.  As I noted last week, the Fed has to “print” the money for the $600 billion in Treasury Notes it plans to purchase.

The Fed believes, apparently, that the large banks – with lots of new cash in the coffers from the Fed’s purchases of T-Notes – will be anxious to make more loans.  But while it does look as though bank lending has bottomed out finally, there is no reason to expect that bank lending will suddenly shoot higher.  For most of this year, we have been told that demand for credit, especially among small businesses, is still very weak, even if the banks were more willing to lend.  But a recent New York Fed report casts some doubt on supposedly weak demand for credit among small businesses – more on this below.

The same goes with the housing market.  Mortgage rates are the lowest in over 50 years.  What if rates fall another 25 basis points?  People don’t want to buy a house because they know that there is both a huge inventory of unsold houses today and another wave of “shadow” inventory coming in the future at lower prices as foreclosures continue.  The risk of housing prices going down further is more important than a mortgage that is 25 basis points cheaper.

On another front, we read that US corporations are sitting on $1.5-$2 trillion in cash.  A recent Duke University survey of CFOs showed that these firms are unwilling to deploy the cash because of: 1) uncertainty about the economy; and 2) they are afraid that their usual method of financing (through banks) might dry up in a possible second leg of the credit crisis.  QE2 does not address either of these problems. 

While some corporations are sitting on cash, there are many corporations that need financing for quality projects -- yet they cannot get this financing.  The Duke-CFO survey showed that for small and medium-sized businesses, credit conditions deteriorated for more than one third of them, as compared to 2009.  These firms have projects that they deem high quality that will help economic output and increase employment, yet they are refused financing.

Last but not least is the negative effect that QE2 has already had, and will continue to have, on the value of the US dollar.  The dollar has fallen over 8% since Bernanke first hinted at QE2 in late summer.  A lower dollar is good for exports, but the dollar has fallen a full 30% since the peak in 2001.  That makes foreign buyers of our record debt more than a little nervous.

New Fed Report on Tepid Small Business Lending

The bank lending debate over much of this year has hinged upon whether: 1) banks are unwilling to lend; or 2) small businesses have no interest in borrowing.  Multiple reports from various sources continue to confirm that bank lending is still in the dumps, although as noted above, lending has seemed to bottom out finally.

But what we have been led to believe from other reports is that there is very little loan demand from small businesses – those with 500 or fewer employees.  Yet a new report from the New York Fed suggests otherwise.  This report strongly suggests that there is plenty of loan demand from small businesses, but the banks are not cooperating.  Here are some excerpts:

“Small firms employ nearly half of all Americans, account for about 60 percent of gross job creation, and historically have created more jobs than larger firms at the start of economic recoveries. Yet recent contractions in business borrowing may be limiting the capacity of small businesses to play this critical role. More than three-quarters of small businesses that applied for a loan during the first half of 2010 received only ‘some’ or ‘none’ of the credit they desired, the report finds."

Of the 426 small business owners polled by the New York Fed between June and July of 2010, 59% applied for credit during that period. This suggests that there is still demand for credit among Main Street businesses – despite many banks’ claims that lending to small businesses is down because they haven't been asking for loans.

Federal Reserve Chairman Ben Bernanke said in a recent speech that there have been some “positive signs” in the credit conditions for small businesses.  In particular, he said, “Banks are no longer tightening lending standards and terms and are reportedly becoming more proactive in seeking out creditworthy borrowers.”

Banks may no longer be tightening their lending standards, but that's not saying much since they didn't have much further to squeeze anyway.  For three-and-a-half years straight, most banks said they were toughening their lending standards, according to a quarterly survey of senior bank loan officers by the Fed.

But according to the latest NY Fed report, the picture finally began to change in April of this year.  Since then, more banks are now loosening their lending standards to small firms than are tightening them.   

Even so, most banks continue to tell the Fed that many of the small business applicants are not creditworthy.  And indeed, the report from the NY Fed backs that up, finding “evidence of comparatively strong demand but weakened applicant quality and continued perceptions of restricted credit availability.”

It is worth noting that unmet demand for small business loans could be considerably higher than the numbers in the Fed’s latest report.  Why?  Because the report only counted small businesses that had actually applied for a bank loan in the first half of 2010.  The report notes that more than four out of ten small businesses did not apply for a loan during that timeframe.  They were too discouraged to bother applying.

Finally, as I discussed last week, there are many small businesses that are not applying for loans because of all the uncertainties about the economy, healthcare costs, increased government regulation, etc.  While the latest NY Fed report suggests that bank lending is improving, it could be 2012 before lending is even close to normal, if even then.

Is the Bond Bull Market Nearing the End?

Starting in late summer, I have had a continuing theme that the bull market in bonds will very likely come to an end before long.  There is actually a big debate ongoing as to whether today’s bond market is a “bubble” waiting to burst or not.  Whether it’s a bubble or not, millions of investors have shunned stocks and stock funds for bonds and bond funds over the last year.

According to the Investment Company Institute, which tracks mutual fund inflows and outflows, stock funds have experienced a net outflow of $68.9 billion in 2010, even though the S&P 500 is up around 8% this year.  But as the market has risen, more and more equity investors who were hurt in the bear market are getting out.

Bond funds, on the other hand, have seen their assets explode over the last year.  Bond mutual funds have seen net inflows of $268.3 billion just this year as of the end of October.  Investors have literally herded into bond funds at a time when interest rates are the lowest in decades.  The contrarian in me thinks this party is not going to end well.

The underlying question for the bond market is when will inflation start to rise.  Fed Chairman Bernanke assured us in his recent Washington Post column that there is enough slack in the economy to absorb the $600 billion without creating significantly higher inflation in the near-term. 

He may be correct, but he also fired a shot across the bond market’s bow when he said that inflation is now too low.  In fact, the bond market has been going down ever since August when Bernanke first said the Fed was considering another round of QE.  When bond prices go down, the yield goes up (and vice-versa).

  30-yr T-Bond Nearest Futures  

There are those who argue that bond yields can’t rise significantly with the Fed holding the rates on 5-year and 10-year Treasury Notes to record or near-record levels by buying $75 billion of these securities a month through mid-2011.  While there may be some truth to that argument, keep in mind that bonds are indeed a forward-looking market.

I obviously can’t say that the bond market topped out in August.  No one knows for sure.  What I would predict, however, is that if the next bond rally fails in the 135-136 resistance area shown above, a rather nasty selloff could follow.

The bottom line is: If I were an investor in a medium to long-term bond fund today, I would at least know where the exit lights are.  More likely, I would be taking some profits off the table.  Think about it.

Bonds are a commodity, and commodities are very unforgiving, especially to investors who herd in late to the party.  That is what has happened over the last year or so.

A Strategy to Make Money When Bonds Go Down

In my August 3 E-Letter I discussed one of our recommended money managers that specializes in trading Treasury Bonds, Hg Capital Advisors.  Hg invests in the Rydex Government Bond Fund (1.2X Strategy) when bond rates are trending lower.  But if bond rates 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 as of October 31, they’re having another good 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:

Debt Commission Preliminary Report

Before hitting the “Send” button, I thought I’d mention the preliminary report issued by the Co-Chairs of President Obama’s National Commission on Fiscal Responsibility.  It has been reported that the 18 members of the so-called “Debt Commission” are dead-locked and so Co-Chairs Erskine Bowles and Alan Simpson decided it was time to make public a draft to the recommendations they prefer.  Yet they cautioned that they have no idea if they will get the required 14 of 18 votes to make it official.

The proposals in the preliminary report would supposedly trim $4 trillion from the deficit over the next decade.  While the mainstream press has mostly concentrated only on the highlights of the report, the devil, as they say, is in the details.  It’s actually a pretty good read IF you are one committed to enduring the pain necessary to cut federal spending.

In regard to spending reductions, the preliminary report could also be called a list of sacred cows, in that there are many proposed cuts aimed at such untouchable spending as Social Security, Medicare, defense, government employee pay and even workforce reductions.  The report also takes on one of the favorite ways for legislators to pad the budget with pork by calling for an end to “earmarks.”  Yes, you read that right.

Some have said that the Debt Commission’s final report might provide the political cover needed for Congress to take drastic action necessary to reduce spending and/or restructure the tax code.  Others (myself included) feel that there’s little chance of these proposals getting the 14 votes required from the bipartisan appointees to this Commission, no matter how across-the-board they may appear.

Perhaps that’s why the Co-Chairs released this preliminary report, to at least get some of these issues out in the open where they can be discussed.  Only time will tell whether they opened a door to fiscal health or Pandora’s Box. 

I have included a summary of the draft report in SPECIAL ARTICLES below.  You should also read the second article below if you really want to understand what’s wrong with the Debt Commission’s findings, and why President Obama wanted it that way.

Very best regards,,

Gary D. Halbert

 

SPECIAL ARTICLES

Highlights of the Debt Commission’s preliminary report
http://news.yahoo.com/s/ap/20101110/ap_on_bi_ge/us_cutting_deficits

Obama’s Debt Commission Won’t Help Fiscal Crisis
http://www.newsmax.com/Limbaugh/Obama-Deficit-Commission-Obamacare/2010/11/12/id/376861


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Forecasts & Trends E-Letter is published by Halbert Wealth Management, Inc. Gary D. Halbert is the president and CEO of Halbert Wealth Management, Inc. and is the editor of this publication. 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 Gary D. Halbert (or another 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 investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, Halbert Wealth Management, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. 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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