Broker Check

The Chronicles of Reflation (Part I)

April 20, 2012

Happy Spring!

"Break open a cherry tree and there are no flowers, but the spring breeze brings forth myriad blossoms."  - Ikkyu Sojun     

I sincerely hope that you and yours are enjoying the beauty of the season.  Thank you so much for your trust and for your business.  I have a great job and people like you make it possible.


We're going to cover this list of topics this go-'round:

1) Portfolio update

2) Reflation

  a) This recession is 'a different disease';

  b) Reflation timeline;

3) Q1 2012 compared to Q1 1998 (Reality Check);

4) Hyper-interest-rate-inflation is NOT looming (just bond spasms);

5) Money just sitting in banks - doesn't get into the real economy;

6) Analysis of recent "Fed-speak" about higher interest rates;

7) What if Jack is wrong?  What will my statement look like?;

8) Dudley speaks the truth about the real unemployment story;

9) Central banks HAVE to articulate exit strategy for us to project normal capital markets assumptions;

10) Politics to play a role in 2012.


1) Portfolio Update on our Three Strategies

Income Now

Remember, when I give a "yield", on a bond, it's a yield to worst.  This means, if the bonds are called before maturity and you receive cash for your bond investment.  In occassional stark contrast, when you see bond funds listed through 'google' or 'morningstar', or whatever - they list "SEC 7 day yield", that's mostly representative of a current yield and not necessarily representative of what your "true, net, net yield is".

Some of Q1 2012 activity in our portfolios included:

We invested in 9 year Gap (symbol:  GPS), bonds with a 6%+ yield.  Gap Stores, Old Navy, Banana Republic... 

We invested in 12 month Arcelormittal (symbol:  MT), bonds with a yankee-dollar-denominated 3%+ yield (no currency risk).  The Luxembourg steel production company...

We invested in 7 year Seacor (symbol:  CKH), bonds with a 6%+ yield.  The Fort Lauderdale, FL based offshore oil and gas operating company has great debt to asset, debt to equity and interest coverage ratios...

We invested in 7 year Jones Apparel (symbol:  JNY), bonds with a 7%+ yield.  Dockers, Anne Klein, Jones New York... (brands)...

We invested in 15 year step-up General Electric (symbol:  GE), bonds with a 5% yield.  The unique structure of this bond is that, for every 5-year time period that the bond is not called, the amount that GE pays the bondholder actually increases.  In either an increasing or decreasing interest rate environment, that's a good thing.

We added to our position of 7 year Alpha Natural Resources (symbol:  ANR), bonds with an 8%+ yield.  This is the Virginia-based coal company that sells metallurgical coal to steel companies and thermal coal to power plants.  They and other cyclical peers will most likely post losses in 2012.  Natural gas is kicking coal's butt YTD with respect to power plant consumption and the EPA is into promoting that, and therefore coal companies are going to have to change to survive - but the leaders, and the ones that own real mine assets, have lots of cash, nice cash flow, and are not too heavily-leveraged, will regain traction within a few years.

We invested in Suburban Propane (symbol:  SPH), bonds with a 6%+ yield.  The idea here is that MLPs' and REITS' dividend yields on their stocks are "IN", (popular), but I'd rather go up the capital structure and buy their senior debt than their stock.  The stocks of these types companies are 2X+ too high and their dividend payouts on their common stocks will be cut within 5 years and so I'd rather own the bonds.  Very nice, well-run company.

Warning!  Warning, Will Robinson...!...  "Income", is "IN", but not all Income is created equal...

"REITs are "IN"

In this environment when companies like Cooper Tires (we own their bonds (at 7-8%)),have the same amount of cash in their account that they have in total outstanding debt and their Debt to Asset ratio is 0.2that's a good thing for bondholders.  It means that since they're not too heavily leveraged and they're HOARDING cash, they should be able to sustain the next downturn just fine.  REITs can't hoard cash by definition - they have to distribute 95% of their income, so in the next downturn, guess what happens to many REITs...?...  (see below)... ouch...

For a sample of what I'm talking about, check out (below), Cousins Properties' stock(symbol:  CUZ) - it's a REIT - it used to be @ $40/share with a 6%+ dividend on their stock.  The stock is now at $7/share and pays a 2.7% dividend on the common stock.  That's what's in store for overvalued and over-paying REITs and MLPs.  I've charted it against a red-hot, popular, high price to sales REIT - HCP (symbol:  HCP).  HCP is in healthcare and obviously, healthcare is hot.  It is definitely a growth area.  The dividend payout ratio is well over 150% and their price to sales ratio is 10X.  So for folks buying this stock for the dividends expecting both the principal and the dividends to remain at such lofty and ever-increasing levels, they need only look to their "cousins" to see what's in store for them. 

 (Note:  Black is CUZ and Green is HCP)



We invested in 15 year Weyerhauser (symbol:  WY), bonds with a 6.17% yield.  This is the Washington State-based forest products company.

We invested in 10 year municipal, tax-free, South Georgia Development Authoritybonds with a 4%+ yield.

We invested in 13 year municipal, tax-free, Princeton University (NJ), bonds with a 3%+ yield.

Income Later

We added money to our private pensions (fixed indexed annuity chassis), under the premise that yields on these constructs will continue to drift lower - therefore lowering the amount of money during the retirement age income distribution period.  The sample attached illustrates a 48 year old investing $500,000 and deferring that investment through age 64.  Then we illustrate an age 65-95 distribution period.  The effect of lower rates on these constructs influences the total payout amount over 30 years by over $673,000!  That's a big deal... 

Capital Appreciation

We invested in a half position in Dover Corporation stock (symbol: DOV  (under the premise of a continuation of the strong resurgence of certain U.S. manufacturing exports)).  We are seeing solid numbers from manufacturing divisions within GE (we own half a position in GE), but if you look at their annual report, their division chiefs are planning on a severe downturn in Europe (interesting).

We invested in a half position in cyclical Alcoa stock (symbol:  AA (under the premise that the "hard landing" scenario for China, and deep recession in Europe, is already reflected in the price of the stock - with it down over 40% in the last 12 months)).

We invested in a full position in Kimberly Clark stock (symbol:  KMB), with a 4% dividend yield, reasonable price to sales ratio and with the ability to increase pricing to customers without cannibalizing sales in the process.

We invested in Baron Focused Growth Institutional Class stock mutual fund (under the premise that this money manager has demonstrated a unique ability to "capture", gains during periods of heightened stock market volatility.  (See November's Insights for information on this fund).

We invested in O'Shaughnessy's (stock fund) Enhanced Dividend Institutional Mutual Growth Fund  (under the premise that low price to sales ratios matter and dividend growth matters.  The fund's dividends are running ~6%).

We invested in Astrazeneca stock (symbol:  AZN), the pharmaceutical company that sports a AA- credit rating, nearly 7% dividend yield, with only a 36% payout ratio, and with an historically low Price to Sales Ratio.

Capital Appreciation strategy was up +12% net of fees in 2011.

I think that 2012 will look much like 2011 when you could broadly say, "Sell in May and go away", meaning that the peaks will be turned in in April because the data coming out of Germany and the U.K., supports the three-quarter lag thesis.  This means that the effects of the Eurozone recession will take a few quarters to be felt.  Additionally, with all of this historic stimulus coming from central banks (more on this in point # 9) down the pages)), stocks generally may continue to turn in decent results for the year.  I don't think that these low rates mean "get out of bonds and into stocks", like many are purporting, I think they're pointing to a clearly evident global slowdown.


2) What is "Reflation", and why should I care?

"What ails the truth is that it is mainly uncomfortable, and often dull.  The human mind seeks something more amusing, and more caressing." - H.L. Mencken

"How much better to get wisdom than gold, to get insight, rather than silver."  - Proverbs 16:16

Reflation:  (definition) - "A fiscal or monetary policy, designed to expand a country's output and curb the effects of deflation.  Reflation policies can include reducing taxes, changing the money supply and lowering interest rates."

The sad truth is that while monetary policy has been quite helpful at keeping the financial system alive and avoiding outright catastrophe, it is fairly ineffective at getting the economy growing at anywhere near normal trend.  You see, the Fed, and other monetary policy-setting groups around the globe can tinker and manipulate interest rates, but they cannot force consumers or businesses that have too much debt to borrow more.  As I've discussed in previous Insights, the three main consumers of debt are:  1) Government - and they don't want more debt; 2) Consumers - and they don't want more debt; 3) Businesses - and their behavior is mostly concentrated around refinancing, and mostly hoarding cash;though a bright spot is the historically low cost to borrow for strong balance sheet multinationals and there is a huge appetite for income even at very low yields.  Earnings can look very good due to, in many cases, a halving of the cost of interest expense on a company's debt YoY. 

It's the consumer's balance sheet that's acting as the deadweight.

"The essence of a balance sheet recession is that credit demand is weak.  It isn't exactly uncommon for even drastic liquidity injections to have little to no effect during balance sheet recessions."  Should the Fed Raise Rates? - Seeking Alpha - March 30, 2012


2a) A Different Disease

"We have never before gone this far into a U.S. recovery and not see one 4% or better quarterly growth rate for real GDP.  We are now into the eleventh quarter of this statistical recovery."  - David Rosenberg.  Please note that even though trailing reportable earnings look decent on a comparative YoY basis, corporate earnings growth momentum (JP Morgan's earnings from trading their account and several other exceptions notwithstanding), is showing strong signs of sputtering .

"While households want to spend and will raid their bank accounts to support that habit, unless income gains start improving, consumption will have to slow."  Joel Naroff, Chief Economist, Naroff Economic Advisors, Holland, Pennsylvania - March 30, 2012

I wrote in November that I thought that the next recession would be consumer-led.  I am still of that mindset.  Q1 2012 went down as the strongest quarterly performance for the US Stock market since 1998 - I've got a simple chart comparing several data points from Q1 1998 to Q1 2012.  It was a temporary period (and they do occur), when the stock market disconnected itself from the economic backdrop and earnings backdrop and experienced a liquidity-rally. 

The consumer is the ultimate hitch pin

Well, here we sit on April 16'th, 2012 with the yield on the 10 year US Treasury at 1.95%.  To repeat myself, when I first entered the business 15 years ago, that figure was 6.64%.  Whether or not we actually print $80 S&P earnings in calendar year 2012, is debatable.  Our government knows how the consumer is the ultimate hitch pin holding together this historically fragile and soft recovery.  That's why you're seeing legislation and deals around the themes of "mortgage balance reduction", and "student loan debt forgiveness" (next item up for bid - senator in Illinois is stirring the pot on this one - it'll rise to the surface very soon).  If the consumer is not "freed up", to spend more, in many ways our economy is up the creek without a paddle.

100 years later

"1913 wasn't a very good year.  1913 gave us the income tax, the 16'th Amendment and the IRS." - Ron Paul

Here we are 100 years after the 1913 laws and generally speaking (to repeat myself), in 2013, taxes are going up and benefits are going down.

Have a look at the "Fiscal Cliff ", many economists have dubbed 2013.  The economy is not fixed.  It is being held together by chewing gum and baling wire.  With respect to "leadership", in Washington - though we've got this "Fiscal Cliff", looming - does it seem to you that we've got a deep philosophical chasm politically with respect to gridlock?  How are these folks going to get stuff done...?...

Stay on target

I don't want to digress too much here with my points, but when we've got 50% of our working population with less than $10,000 in savings, and yet consumer spending figures are strong, you know we've got a broken system whereby consumption is rewarded and saving is discouraged.  We've got 40 million people on food stamps in the United States of America.  By the way, the numbers DO NOT add up - I'm not trying to be dramatic here, but 2012-2013 could very well be the 'year of the strategic default'.  The consumer numbers look good (broadly), due to many, and I mean MANY people not paying their mortgage / home equity line of credit payment.  It's going to take a few months/quarters for those figures to come through, but Gary Shilling's research/charts confirmed my hunch the other day on this one.  Also, banks are sitting on a huge number of homes and not allowing them to hit the market for fear of driving prices lower.  So, maybe the socialistic versus free-market capitalistic experiment will work, but I for one don't think it will.  Folks, when the music stops playing during this game of musical chairs, as an investor, you're going to want to make sure that you've got a chair to plop safely down in.  When people ask me about residential real estate as an investment - I tell them they should find the place where they want to live and live there and don't plan on investment results from that property.

Thumbnail on Europe

The ECB's LTRO (QE2'esque equivalent), created an injection of liquidity and a perception of "stability" for the Eurobean banking system.  It bought time - that's all.  Nine of the largest financial institutions on the planet are in Europe and with the exception of the communist bank of China, do you know who finances most of the emerging market growth?  European banks.  I can't see how they can avoid a Lehman'esque failure in Europe.  That's what the LTRO was intended to do and you know, I could be wrong - it might work, but I don't think it will. 

Will the Euro survive?

To me, the questions are NOT:  1) Can the Euro survive the next several months by floating gargantuan amounts of 1% loans to try to keep the large banks from failing?  And:  2) Can the Euro survive the Spanish-ECB negotiations?

To me, the questions ARE:  1) Can the Euro survive the French and German negotiations?  Because it will come to that (the Germans bailing out the French);  And, 2) Will the Euro be around in 10 years?

"You can print as much money as you like without causing inflation [interest-rate-inflation] unless the borrowing is enough to restore full employment." - Paul Krugman - Princeton Economist - December 19, 2011

You see, no matter how much money the Fed prints, the Fed can't create demand for debt.  If borrowers don't want it, or not enough can get it, and if many, many people who already have it, want much, much less, and so they're actually in a secular trend of getting out of debt instead of getting into more, interest rates go nowhere.  Nowhere.  Now, let's get real - I don't mean completely flatlined.  I've said it before - rates will be in a trading range.  Let's call our 10 year US Treasury yield low of 1% and the high of 4%.  That's a significant range, butI'm talking 7-10 years like that.  Due to deleveraging, the soft credit demand trend is secular, not cyclical.  If you couple that truth with the truth that if the interest rate on our nation's debt were to increase by only 1%, that would add $440 Billion to the interest expense alone on the Federal debt, you see that you've got quite a bit of headwind in front of the "higher interest rates", story.

Most people are underestimating how big of a deal a balance sheet recession is.  You see, the U.S., household mortgage was a credit bubble and it began to deflate in 2007.  We had a serious contraction in GDP in the U.S., and the Fed and other monetary groups would rather print money than to deal with the structural issues facing them.  Monetary policy makers around the globe do not want a repeat of what we just went through... Trouble is, they may help buy time and cushion the blow, but can they really keep natural business cycle contractions from occurring...?...  We'll see...but make NO mistake about it, we are in experimental territory here with all of this coordinated global monetary policy stuff.  Experimental treatment on a known disease.  That's okay, it's just that if you're the patient, you need to know that information, right?  Seem reasonable?  Personally, due to the hyper-global-market-connectivity now, and lack of non-correlation, I don't think that a global contraction to GDP is avoidable (see chart below)...

The Magic 8 ball prediction...

You know, there's an art and a science to forecasting...and then there's always the Magic 8 ball...Remember this thing...?...  : )

What's the Magic 8 ball say about 2012-2013 global GDP...?...


  “This is actually a different disease. This is not an ordinary recession...” Richard Koo – Chief Economist Nomura Securities – January 7, 2012

Balance Sheet Recession (revisited)


Where are we in this "Deleveraging" cycle?  Our pal, David Rosenberg recently shed some light on this:  "We've done $1 Trillion of deleveraging, and if we're talking pre-bubble norms (reverting to the mean), you've got another $3 Trillion of deleveraging left to go." - David Rosenberg - March 2012


2b) Reflation timeline

Let's look at the timelines for the stock market and the bond market with the latest injections of "QE"

a) "Loudness" of the Stock market (QE Timeline); I call it "loudness", because the media airplay emphasizes the stock market instead of yields on safe income at a reasonable price.


The media loudness of "QE3"

QE 3 (the Fed is unlikely to call it that) - Remember "Twist"?  Maybe the newest QE variant will be dubbed, "Shout".  Who knows?  The reflation tonic is inevitable, in my mind - I thought that it would be before the summer of this year, but we didn't have the LTRO (sounds like R2D2 from Star Wars), deal out of Europe at that time, and so it may have pushed the timeline back a few months, we'll see - I think it will be attempted in an election year.  For the simple reason of what I say, "When there is a leadership vaccuum, someone will step in and fill the hole."  Whether or not we get it is an academic forecasting discussion that you can argue doesn't impact where you live (how you invest).  What you need to know is that everyone is wrong about hyper-inflation with respect to interest rates.  Until there are major structural changes made here and around the globe now, it's NOT going to happen.

Same time-period for bond yields and safe investments...hmm...(this very quietly occurs though, there's not much "loud" media airplay about this one)...



3) But, "Mr. Q1 2012, you're no Q1 1998." 

Comparison Organic Economic Backdrop - 2012 vs. 1998 (Reality Check)


4) Hyper-interest-rate-inflation is NOT looming (just bond spasms)

"I'm kind of comfortable with getting older because it's better than the other option, which is being dead.  So I'll take getting older."  - George Clooney

When you're age 48-60 (or so), and you've got 0% allocation in bonds when you can buy them and receive 7% per year, and you wake up a few years later and you want more safety from your portfolio and you decide to allocate, say, 50% of your portfolio in bonds, and because you've paid more attention to the "loud" than the quiet, if you look to bond funds, and not to our 6-and-3-handle-strategy, you pick up 2%.   That stinks.  

 That's a rough deal.  It's going to get worse and stay bad before it gets better, too...We've now entered a phase where it's not so much that the yields are going dramatically lower, it's just that NOW it's a SCARCITY issue.  There's way too much demand for the good bonds with yield and not enough supply.           Have you noticed how so many strategists have been screaming about hyper-inflation (with respect to interest rates), for quite a while now?  As I've been saying for years now - It's not going to happen in the current environment.  Many structural changes would have to occur before we would enter a substantial interest rate rising cycle

20 years of LOW rates...?...

Hmm...look at what happened for 20 years following the Great Depression...I'm not saying that the time period we are about to enter (or are already in), is completely analogous, but it's a compelling comparison to consider...

I don't mean that the Fed might bump rates from 0 to 0.50%-0.75%.  What I mean, is for us to be in a place where we're talking about the Fed embarking on a 0%-4% process - not happening - not any time soon.  Why would I say that?  I'm not nearly as smart as many of the guys (investment strategists, bank trust officers and financial advisers), I met with late last year in Manhattan who thought (late last year), that we were going to be looking at 5% US Treasury yields by now.  This was the consensus three years ago as well.  Only now are some embracing a really, low-rate environment.  Almost all advisors are going to miss this because they're presuming historically normative capital markets projections - but as Richard Koo explained in the Balance Sheet Recession piece - this is not an ordinary recession.  Like it or not, we're in experimental territory...

Recent Spasms and swings in bond prices challenging my ultra-low interest rate for years thesis

By the way, let me just say that I use charts of the 10 year treasury yields to convey directional points and to really understand many things about bond markets and stock markets. 

Big spasm 2008...then 8 more...

In 2008, the 10 year yield sank from 4.04% to 2.25%, and there were exactly EIGHT periods of yield hiccups of at least 30 basis points (the average being 40 bps).

These trading spasms are part of the deal. These selloffs last 21 days on average and on average take the 10 year T-note yield up 54 basis points, so we'll most likely see more of them.  

(Figure below:  Period of benchmark US rate going from 4.75%-6.5% (~June 99-~January 01); I include this to illustrate more of my "what if I'm wrong", point - the economy was in a very different state during this time period highlighted (~June 99-~January 01), but I'm showing it anyways.


 6 Handles and 3 Handles

Look closely at that 10 year US Treasury yield chart (2 charts above).  It ends in March of this year and it appears to be carving out a bottom, doesn't it?  It could be.  Does that mean that it's going to take off and head straight up or even push forward with an upwards trajectory?  When we had the yield on the 10 year US Treasury go from 2% to 2.4% quickly, I took notice.  You took notice when you heard Warren Buffett and others say that the "worst investment is bonds".    He and others who say that are not referring to what we're doing here - at all.  Please note that I never have recommended to anyone that they buy a 10 year US Treasury at 2% and hold it for ten years til maturity.  That is not a good deal.  You'd pay half of your yield in taxes and my fee would also come out of that, and that's horrible.  But if you can score what the bond traders and credit analysts I work with call "6 handles and 3 handles", that's nice.  That means you earn 6% a year on your taxable corporate bonds and 3% per year on your municipal tax-free bonds.  That's reasonable, right?  To repeat, the continual references I make to the 10 year US Treasury and other 10 year bonds around the globe are made to emphasize directions in the economy, interest rates and so on.  

Lower rates

Last Insights, I referenced how there's no way that Italy and others were going to refinance big chunks of debt at 8%; they can barely afford the math at 1%, much less 8%.  Here's an update on where Germany's yields are:

April 12, 2012 yield on 10 year German bunde:  1.67%


India just announced a 50 bps rate cut, and Brazil just announced a 75 bps rate cut... 

Australia's on the way next... 

By the way, these are some of the remaining "higher than average", rates left on the planet.  What's with all of the ultra-low interest rates...?...  If we're seeing a recovery, why all of the rate cut announcements...?...  Global recession is on its way.  Now this doesn't mean I'm a "perma-bear", or that I'm "anti-stock", it's just a definite waving of the yellow flag by the bond markets signaling trouble ahead.  There are many opportunities.

You can really miss the big picture, I believe, if you don't know how all of this stuff is interconnected.

 "Truing up"

One of my mentors for several years in this business recently wrote that he believes that investors need to "true up", their asset allocation towards more equities.  I just mean to be clinical and observational in mentioning this - not critical - I remember him saying the same thing in 2007 as well.  You see when you are myopically a bottom's up analyst looking at the reportable EPS for individual companies but you don't see the macro, there are times when you can have the stool literally kicked out from underneath you.  You've got to have a fairly good grasp of both the micro and the macro, I believe.  Corporate earnings momentum is clearly slowing down and slowing down hard and in a "risk on", and "risk off", environment, that is usually very dangerous.

"Sometimes the conductor has to respectfully turn his back to the audience" - Max Lucado

That advice, of 'truing up' into equities and out of bonds, I believe, is, for most pre-retirees, and retirees who are close to having their peak earnings years behind them, DEAD WRONG.  See the picture below of our bond sharp-shooter - [safe income at a reasonable price].  At the right time, and frankly as things begin to crack and look ugly a little bit, it becomes opportunistic, and I start to get excited about putting cash to work [from my lens].  In other words, bond prices will most likely begin to go lower with stock prices as the Euro crisis worsens, China's growth slippage and property crisis comes into focus, and the US consumer cracks and it will hopefully mean really nice yields on good quality bonds.  It will, most assuredly, mean cheaper prices for stocks and so when stocks are cheaper, ifwe've got your 'income now' and 'income later' needs met, we can take advantage of opportunities

"The Chinese have two separate characters for the word "crisis".  One represents danger and the other represents opportunity."  John F. Kennedy



5) Money just sits in the banks - it doesn't get into the real economy 

Money is just sitting in U.S., Banks' bank accounts (see chart below), and lending IS NOT GROWING - except for Student Loans - we've got $1Trillion of THAT (Student loans) stuff...


Money just sat there in Japan as well (see chart below).  Corporations did not want any more debt.  For 15 years (from 1990-2005), corporations (like US households today), paid down debt in record numbers and credit decreased.


The only strong growth in consumer debt that we're seeing is in the form of student loans.  This is definitely concerning.  With the mortgage balance forgiveness plans in motion, there is currently a movement afoot trying to make student loans forgiveable in a personal bankruptcy...just like I never wanted any Fannie Mae or Freddie Mac corporate (non-government guaranteed), bonds (even at nice yields), I don't want any Sallie Mae corporate bonds (the Fannie Mae/Freddie Mac publically traded company equivalent that deals with student loans).



6) Analysis of recent "Fed-speak" about higher interest rates

I have noticed, as you may have, that there have been a few dissident Fed voices lately.  Plosser and Lacker jawing about higher rates.  I analyzed what they actually said recently and if you look carefully, they're optimistic, yes - but they're not disagreeing with my thesis at all.

"If higher interest rates come about, it will be because of a stronger recovery." - Richmond Fed President Lacker - could it be that they're all working on their public speaking skills because Bernanke's term expires at the end of 2014 and they might like a crack at the job?  Lacker wouldn't give an exact number or any numeric guidance at all - Plosser did say that even if we saw 75 bps...  we're still ultra-accomodative" - yes, that's true.

Recent CNBC interview with Richmond Fed President, Lacker - March 2012:

"I don't think the demand for bank lending is there", said Lacker - "When you talk with bankers and ask them what's restraining lending, they say it's the supply of credit-worthy borrowers".

Know what that means?  People's homes that are too heavily levered are underwater.  Theycan't borrow more.  And for the ones that can afford to borrow - those folks don't want to borrow more

He went on to say, "For the most part, banks are falling over themselves looking for credit-worthy borrowers to make some yield off of."  That's a balance sheet recession - defined, folks.

Plosser talked about "coming off of zero interest rate policy."  He said that even if "we went up to 75 bps [0.75%], we'd still be ultra-accomodative by historic measures."  I agree.  And I think that's the risk to my thesis is that sort of interest-rate cycle rise.  Very smooth, very low-banded - not "hyper", or sharp rise at all.

Bernanke said 0% rates through 2014 - why?

Why 2014 for the end of the ultra-low rate cycle? The vast majority have agreed (minutes from voting Fed members), with Bernanke that it'd take at least that long to fix things. Also, Bernanke's term is up then.  He seems to be grooming Bill Dudley or Janet Yellen.  They both agree with him and will most likely keep rates in that 0%-2% range through 2020.


7) What if Jack is wrong? What will my statement look like?


"Fortunes are made, and disappear, over the lifetime of a single generation.  Today, a person in essence takes his wealth from society just for the duration of his or her lifetime.  The next generation has to create it anew." - Mikhail Khodorkovsky

Low yields, and I mean, LOW yields will be here for safe investments for YEARS...I really don't know how many; but most likely several more years...

Bond market definition of Duration:

"A measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates."


What if Jack is WR-R-R-WR-RRR (Fonzie from Happy Days TV show) (WRONG)

What if I'm wrong, though?  The answer is - let's "stress-test", the bonds that we've been buying lately under certain assumptions and test them to see how their prices hold up under a hypothetical rising interest rate environment (sounds nerdy enough, eh?)...

(More on Modified Duration Calculations (and "stress-tests"), in the next Insights)...

So, as I've said before - I don't get it - this seems clear as water to me - why doesn't anybody else see this?  But, you know, if you're not careful and you embrace a certain way of thinking for too long, you can miss things - so I've spent an incredible amount of time lately "stress-testing", the recent bond transactions we've made.  I've asked me credit analysts and my bond traders that I work with to help me perform several modified duration calculations so that hopefully, you, as a client, can be forewarned, and I, as an advisor, can know what to expect in interim portfolio performance if I'm wrong at rates go on an extended, steep, directional increase.

Let's consider Fed President Plosser's comments in March 2012 and use his 75 bps comment as a guide and let's also use history as a guide.  I've analyzed the Recent spasms in the 10 year U.S. Treasury  and have found that the most significant spasm in recent history is one of ~147 bps.  So let's use round figures and give the other team the benefit of the doubt andstress-test at 200 bps or say that rates go up 2% from here.

Here's what would happen to a recent (Q1 2012), bond purchase:

(Now remember, your bond prices would be affected on an unrealized basis, so assuming you hold your bonds to maturity, you're not realizing a loss less than what your yield to worst is (typically a 6 or 3 handle with some outliers and exceptions on the high-side and the low-side)...

One of the most aggressive with respect to duration:

Weyerhauser BBB- 2027 (non-callable)

$1076.625 per bond <<(price)|(yield)>>6.178% per year

With a 200 bps rise in interest rates, that price goes down to: $900 per bond.  You're still getting your 6.178% each year you hold the bond.  Remember, this is one of the most aggressive bonds in our portfolio from a duration point of view.

"Perhaps the biggest practical reason against monetary tightening now is that this would make the dollar rise in the currency markets, worsening American competitiveness and widening an already large trade deficit.  This could even snuff out much of the recovery".  - Should the Fed Raise Rates?  - Seeking Alpha - March 30, 2012

Remember, with the Weyerhauser example, you're still getting your 6.178% each year you hold the bond.  Lastly, by the way, NO voting member or non-voting member of the Fed is jawing about anything but 0.50%-0.75% rates; not 2% or 200 bps (our stress-test figure).


From the trading desk...

I've had to spend SO much time recently with my traders and credit analysts finding SIRP bonds.  They are around and very recently we've been buying a ton of them.  But the list is certainly not as long as it was back when I first started my street-preaching campaign about moving into safe, income-producing investments because of the forthcoming interest-rate deflation.

This historic reflation is experimental.  We've never had central banks around the globe expand their balance sheets like they are currently.  Remember I said in November that "everyone's doing it"?  Well, the five large central banks are - it started with Japan, went to US now it's the rest of the world in a collaborated effort.  Again, this is an experiment people (more on this by Jim Bianco (former UBS strategist), below)).

Not much "Product"

What is not charted here is the yield on Safe Income at a Reasonable Price.  Guess what?  It's WAY down.  Remember in past Insights, how I've mentioned Alcoa and Internatational Paper Senior Bonds?  Among others?  Remember how I've stated, some of you clients know, because you owned/own them and you were/are privy to those higher yields because you bought them back before the crowds starting clamoring over them.  You see, at this point,SIRP bonds face a serious scarcity issue.  Baby Boomers are retiring by the hundreds of thousands.  And you know what the smart ones know?  They know that they need income for retirement.  And they also know that their peak earnings years are behind them.


8) Dudley speaks the truth about the real unemployment story 

From my lens, you may have heard me say this to you - I see many $300k / year jobs going away (broadly), and being replaced (broadly), with $30k / year service jobs.  So, though, the statistical numbers are the quantitative truth, there's a qualitative truth that is untold in the numbers.

Based on their comments, Bernanke and Dudley are not believers in the labor reports, either.

The ways that the unemployment figures are presented are very, very confusing...

Unemployment truth examples:

The U-3 number is the "official" unemployment rate.  It is 8.3%.  HOWEVER...

 - There is a U-5 number that includes discouraged or other marginally attached workers.  Then the unemployment rate climbs to 9.9%;

 - Then there is a U-6 number that includes people unemployed for less than 365 days but are currently not looking for work but are ready, willing and able to work.  If we use that number the unemployment rate rises to 15.1%.

 - If we include the people unemployed longer than 365 days and unable to find work the number rises to 22.5% unemployment.

 - If we discuss minorities and young people under 30 years old; their combined unemployment rate is over 30%!


See why Vice Chairman of the Fed Bill Dudley said (in April), what he said about unemployment?

Dudley - “It is far too soon to conclude that we are out of the woods.”

 "About half the drop in unemployment since September was due to a declining labor force participation rate,” said Dudley.  "Had participation not decreased from around 66 percent in mid-2008 to under 64 percent in February, the unemployment rate would still be over 10 percent.”


9) Central banks HAVE to articulate exit strategy for us to project normal capital markets assumptions

"Everybody's doing it" (expanded from November 2011 Insights)

Jim Bianco, former market strategist for UBS, has expanded on the thesis that I wrote about in November of last year about how all central banks were going to very soon embark on their own QE (Reflation), path.  Have a look at a few of the charts that Jim has produced to give weight to this thesis.  Remember, "Reflation", of this magnitude and of this global breadth is completely without precedent and is experimental...

"If the basic definition of quantitative easing (QE) is a significant increase in a central bank’s balance sheet via increasing banking reserves, then all of these central banks are engaged in QE."  - Jim Bianco - January 27, 2012 


"Until a worldwide exit strategy can be articulated and understood, risk markets will rise and fall based on the perceptions and realities of central bank balance sheets.  As long as this is perceived to be a good thing, like perpetually rising home prices were perceived to be a good thing, risk markets will rise.

When/If these central banks go too far, as was eventually the case with home prices, expanding balance sheets will no longer be looked upon in a positive light.  Instead they will be viewed in the same light as CDOs backed by sub-prime mortgages were when home prices were falling.  The heads of these central banks will no longer be put on a pedestal but looked upon as eight Alan Greenspans that caused a financial crisis.

The tipping point between balance sheet expansion being bullish for risk assets versus bearish is impossible to know.  Given the growth rate of central bank balance sheets around the world over the past few years, we might not have to wait too long to find out.  Enjoy it while it is still bullish." - Jim Bianco - January 27, 2012


10) Politics to play a role in 2012 

Politics going to play a role in 2012-2013

Again, thank you so much for your business and for your interest in how our company can help you.  My team and I are here to help you, your family, your friends, and your colleagues.  We have great jobs and people like you make it possible.

Have a great day!  Talk with you / see you soon.



PS - Enjoy one of the latest KAL (The Economist), cartoons (CLICK HERE) on the forthcoming Global Recession

- The next Insights edition (Part II of The Chronicles of Reflation), will be published at the end of February 2013 -  And then again in late January 2014 (on an annual basis).