The Federal Reserve recently announced that it would purchase up to $600 billion of US Treasury bonds in a program known as "quantitative easing", which is a fancy way of saying "printing money". This is actually the second bout of quantitative easing since the financial crisis, and thus this round has earned the nickname "QE2". The policy of printing money is a blunt economic instrument, with wide range of consequences, known and unknown. The announcement of the policy has attracted no shortage of critics, from World Bank President Robert Zoellick, to Sarah Palin, to the leaders of Germany, Japan, China and Brazil. All deride it as inflationary currency manipulation.

The Fed's ultimate goal is to prevent a Japan-like malaise of falling prices and shrinking consumption from infecting the United States. With short-term interest rates at zero, the Fed can't lower short-term rates any further. By printing money to buy longer-dated treasury bonds, the Fed accomplishes two things. First, by increasing the supply of money, it decreases the value of the dollar which helps create positive inflation. Second, by reducing interest rates of "risk-free" investments like cash and treasuries to below the rate of inflation, those investments become money-losers in inflation-adjusted terms. The goal is to bribe savers to shift investments from cash and treasuries into "risky" investments like corporate debt, equities and real estate and also into near term consumption of goods and services.

Pushing on a string in the US

There are three major problems with this policy. Americans are unlikely to increase their consumption markedly, given that they are determined to rebuild their savings after years of under-saving. In addition, real estate suffers from a massive debt overhang and isn't likely to truly recover for years. Businesses will gradually increase their investment, but generally act in their own interest and can't be forced into making investments they wouldn't otherwise make. For these reasons, the Fed's war on domestic savings will not likely be successful. In economics parlance, the Fed is "pushing on a string". Instead, we are seeing a shift of savings from investments that have a negative real rate of return (like cash and bonds) and into those that are considered inflation hedges like precious metals and commodities like oil, wheat and cotton.

Taking the fight to China

The second front in the Fed's war on savings is against the biggest saver in the world: the Chinese government. The Chinese government has systematically manipulated the world trade markets by recycling its export earnings into US dollar-denominated assets instead of into US-dollar imports. By mathematical equation, this results in a trade surplus in China and a trade deficit in the US. In the past decade, China has accumulated over $2 trillion of US-dollar reserves. By increasing the supply of US Treasuries and by holding interest rates below the rate of inflation, the US is essentially taxing Chinese savings. The weak dollar also pushes up the currencies of countries that compete with China, not only those of emerging market economies, but also currencies like the Japanese Yen and the Euro. China, Japan, Brazil, Korea, etc. have all been using export promotion policies like currency suppression to enrich themselves at the expense of exporters from the United States. The Fed is finally saying "Two can play at that game".

The current long-term trend of artificially-suppressed interest rates, a weaker dollar and higher commodities will play out until the world cries "uncle!". No one knows when this will happen, but when it does, the current trends will be reversed.

Economic growth ahead

The Fed has clearly learned the lessons of the Great Depression and of Japan. The TARP and the first round of quantitative easing were designed to prevent a second Great Depression, and were successful. QE2 is designed to prevent a repeat of the past two decades of deflationary malaise in Japan from occurring in the United States. If the Fed is determined to prevent deflation, they will. The downside, because there is no "free lunch" in economics, is a weaker currency on a relative basis (next to other paper currencies), and on an absolute basis (relative to precious metals and commodities). The decline in the dollar pushes up the prices of imported consumer goods and commodity products like food and gas, even while overall inflation may be tame. This hurts low-to-middle income Americans most of all.

Fixed Income

Looking at the interest rate complex, we can see that treasury rates are far below their equilibrium levels, with the exception of the 30-year treasury. Treasury Inflation-Protected Securities are showing negative yields right now, which is a sign that investors expect the Fed to be successful at maintaining positive inflation. The 30-year, which is the least manipulated issue on the curve, is expecting inflation to average 2.6% over the next 30 years, which is over the Fed's target range.

Source: Vanguard Funds, Bloomberg Treasury Rate Data, tylernewton.com

These rates are even lower than what prevailed at the time of my last post on July 11, 2010 (when I declared that there was not much more fun to be had in the fixed income markets…oh well).

So while the treasury complex is artificially over-priced, risk assets like corporate bonds, high yield bonds, muni bonds and equities are priced at above-equilibrium "spreads" over treasury rates, even if nominal yields are below equilibrium levels. If you are a long-only investor, it would be better to keep your fixed income investments in less-volatile shorter term maturities. If you are the type of investor that can short the appropriate treasury while going long on corporate, high yield and municipal bonds, you can enjoy better-than-equilibrium returns.

Equities

The rise in long-term inflation expectations explains the rise in the equity market since July.

Implied market returns

7/11/10

11/8/10

The implied long term return on equities is 2.4 percentage points higher than the yield on the 30-year treasury, versus an equilibrium spread of 2.3 percentage points. (This equilibrium spread is based on an after-tax equilibrium spread of 4.5 percentage points above the after-tax return on the 30-year treasury. Because equities are more tax efficient than treasury debt, the nominal equilibrium spread shrinks to 2.4 percentage points.) Note that I use a lower spread than the 6% or so often used in valuation textbooks.

Equities are a decent buy at this point if you believe that the Federal Reserve's policy of quantitative easing will be successful at increasing long term inflation expectations, weakening the dollar and supporting economic growth. So far the price of the 30-year treasury bond and equities are telling you that the market thinks that quantitative easing will be successful.

The Dollar

The value of the dollar also shows that the market believes that quantitative easing will be successful.

Major Currencies Index (nominal)

Broad Currencies Index (real)

Source: economy.com

Both measures of the dollar index are trading at the bottom of their long term ranges, which means that further upside in foreign currency trades may be limited.

Gold and commodities

Source: economy.com

Both gold and commodities reflect the effects of quantitative easing.

On a relative basis, oil and other commodities are cheap relative to gold.

Source: economy.com, calculations by tylernewton.com

Conclusion: A crowded trade?

In the past week (November 8-12), the QE2 trade has been reversing itself. Treasury yields and the dollar have been rising and gold and stocks have been falling, reflecting a classic "buy the rumor, sell the news" situation. The QE2 rally reflected a liquidity-driven rally, where everything except the dollar (stocks, bonds, commodities, and foreign currencies) goes up, and since November 8, we've had a classic withdrawal of liquidity trade, with everything except the dollar going down. This is different from a crisis trade, during which treasury bonds would also rally.

Possible reasons for the break in the markets this week:

European debt – In the past week, we've had the glimmerings of a renewal of the European debt crisis, as the yields on bonds of Ireland, Greece, Spain, etc. have returned to records relative to German bonds. If a renewed sense of fear regarding Europe were driving the markets, then we would see treasuries rallying, which we are not.
China slowdown – Another possibility is fear that QE2-induced inflation in emerging markets, particularly China, is forcing them to take unpredictable actions to slow their economies, fight inflation and/or erect capital controls. This is a distinct possibility, although I would expect such a scenario to lead to a decline in the dollar, which we are not seeing.
QE2 letdown – The markets may have been disappointed with the size of the QE2 program ("only $600 billion versus $1 trillion or more). This could be true, which would also support the following scenario.
Just taking a breather – The markets are just taking a breather after a good run.

The balance of risks tells me that the markets are likely transitioning from a liquidity-driven phase to a phase that will discount moderate-to-strengthening economic growth. Such a scenario would favor equities and commodities and support the spreads of risk assets over treasuries. The valuation level of domestic equities is relatively high, however.

QE2 will continue to drive investors into emerging markets, which will likely to blow a bubble in emerging markets stocks and commodities. I don't think emerging markets stocks are cheap, but the "story" will likely stay favorable for some time.

Action plan

As the current market pullback runs its course, I will likely trim a few of my precious metals (gold and silver) positions and add other commodities (a net neutral change in the commodity weighting for the whole portfolio). I will trim a bit of my foreign bond positions (which I added last quarter) and add foreign stocks. I remain neutral/underweight domestic equities at levels above $1,000 on the S&P 500. I remain neutral on bond duration in the US.

Waiting for "regime change"

I suspect we are in the last phase of "casino capitalism" in the international capital markets. While the leaders of the G-20 couldn't agree to anything last week, it is only a matter of time before the international currency and trade system slams into a wall of nationalism. At that point, international regulation of currencies, trade flows, bank leverage and hedge funds will become widely accepted to save the real economy from the whims of the financial economy. The financial system is meant to serve the real economy, not the other way around. The transition to the new system will be messy, so stay on guard in the meantime. Be conservative in your investment decisions, don't be afraid to hold cash and don't be a hero. I still have a strong suspicion that the best investment opportunity still lies ahead.

I am not a financial advisor, and write these columns for personal enjoyment only. Please consult your own investment advisor before acting on any recommendations you find on the internet.

Dad-Folio – The Essential Financial and Legal Tools Every Dad Must Own

November 11, 2010 tylerdynamistLeave a comment

As a dad, you’ve got a lot on your plate. From picking insurance to paying for your children’s education, you have some serious decisions to make. If you’re looking for some answers to those important questions, take a look at my Dad-Folio. I included financial and legal tools that can make great additions to any dad’s tool kit.

This article by Tyler Newton can be found at the site "Man of the House" HERE.

US Politics – The Middle Class is Still Up For Grabs

October 31, 2010 tylerdynamist1 Comment

On Tuesday, the Democrats face a major shellacking. Looking at online betting site Intrade, the GOP has a greater than 90% chance of taking control of the House of Representatives where it is favored to pick up 55-60 seats. The Republicans also look likely to pick up 8-10 Senate seats (it needs 10 to take control of the Senate). The GOP appears to be a lock to pick up currently democratic seats in Arkansas, Colorado, Illinois, Indiana, Nevada, North Dakota, Pennsylvania, and Wisconsin. Washington and West Virginia are within reach for the GOP, but are favored to remain in Democratic hands. The GOP appears to also have a lock on open GOP-held Senate seats in Alaska, Kentucky, Florida, Missouri, New Hampshire and Ohio. Considering that the Senate seats up for election this year were last elected in the strong Republican year of 2004, gaining this many seats would be quite a feat. In the next two cycles, the Democrats will be defending the wave of seats they won in 2006 and 2008, many of which are in conservative states.

Such an outcome would pretty much bury my theory, posited here and here, that the 2008 election was a "realigning election", ushering in a new era of Democratic dominance. It seemed like a good theory at the time. Obama had a robust agenda and Congressional majorities to back him up while the GOP was generally befuddled, with weak leadership and unclear agenda. The turnaround in the GOP's fortunes has been remarkable, but is explainable. The problem is that neither party has a platform that truly appeals to the middle class. Middle class voters are seeing that the Obama administration has ramped up spending on programs that haven't benefitted them in any way outside of the most abstract sense. In addition, the Tea Party has allowed the GOP to rebrand themselves as fiscal conservatives after years of fiscal laxity under the Bush administration. Obama's problem isn't his inability to promote his platform or irrational rage on the part of the pesky electorate. Obama is suffering from the same structural flaw that has hindered Democratic politics for the past thirty years: failing to present a positive agenda for the middle class.

How to build a successful political coalition

The American electorate can be divided into four groups, two elite groups and two populist (Jacksonian) groups. Right-leaning elites, known as Hamiltonians, tend to vote on fiscal or business issues. Left-leaning elites, known as Jeffersonians, tend to vote on social issues. Jacksonians tend to be economically populist and socially conservative. Right-leaning Jacksonians tend to be suspicious of big government and big business, and are fiercely independent. The Tea Party voters are examples of right-leaning Jacksonians, many of whom were likely Ross Perot voters in the early 1990s. Left-leaning Jacksonians tend to be more communitarian than their right-leaning counterparts, and are often the classic union or machine-politics voters from the urban ethnic North.

Lasting political coalitions tend to marry one of the elite groups with one of the Jacksonian groups and then use wedge issues to peel off a chunk of the opposite elite and Jacksonian group. The wedge issues have to pit subsets of the opposition coalition against one another. Obama the (Jeffersonian) candidate did a good job of winning over a good chunk of Hamiltonians, particularly those in the technology and manufacturing industries and those that would benefit from his clean energy agenda. Obama and the Democrats courted the financial industry, even though it was clear that they were going to implement strong financial regulations. He co-opted many elements of the normally Republican-leaning health care industry into supporting his health reform. In other instances, he has used regulations to hobble Republican industries like for-profit education and energy extraction. His stimulus was geared toward supporting his base in public-sector unions, as well as by spending on clean energy and health care technology. If the electorate consisted of no one but elites and public sector employees, it was a pretty clever strategy. Unfortunately for president Obama, the Democrats have done virtually nothing to fire up the Jacksonian base.

The Democrats' political misfire

One of the great conceits of the Democratic Party is that middle class voters that vote Republican are voting against their own economic interest. The basic subtext is that middle class voters are so dumb, or racist, or homophobic, or jingoistic, or angry or afraid that they are repeatedly tricked by the billionaires that back the "Republican attack machine" from embracing the party that has their best interests at heart. (Obama himself continues to blame the voters for their own ignorance.) There never seems to be the introspection that calling the voters stupid may not be politically astute. Or that maybe there is something wrong with the Democratic agenda in the first place.

The Democrats used to be a positive force for the middle class, implementing programs like Social Security, the GI Bill, support for housing finance, and Medicare. Since the late 1960s, however, the agenda has been much more tilted to serve rich liberals and the poor.

Health care is a prime example. Most middle class voters have health insurance, but feel that it is too costly and too complicated. Obama's health reform was more focused on extending coverage to the working poor. To pay for that extension, the bill cut Medicare (a middle class benefit), reduced the tax deduction for "Cadillac" plans (often a union benefit), and raised fees and regulations on small businesses. It was wildly expensive, yet the Obama administration used blatant slight-of-hand to pretend that it paid for itself. The average voter can correctly assume that their health care costs will now accelerate and eat into their wages. In exchange they receive not-so-exciting benefits like being able to keep your kids on your insurance until they turn 26. Universal health care is to the Democrats as the white whale is to Captain Ahab. Even though the economy and housing markets faced, and continue to face, huge problems, the Democrats instead chased the ideological white whale.

The stimulus is another example. The $700 billion price tag delivered no tangible benefits to the average voter. Even though it probably did prevent things from getting worse, it was probably spent in the least politically advantageous way possible. It transferred money to irresponsible state governments to keep their bloated payrolls afloat, which felt like a political payoff for the Democrats' public union supporters. The rest was spent on behind-the-scenes technology investments like green energy projects, electronic medical records and vanity projects like high-speed rail that won't be built for years. I actually think most of these items are decent things to spend money on, but they appeal mostly to eggheads like me. The rest of the country was left scratching their heads at what exactly we spent $700 billion on. To make matters worse, even the tax cuts in the bill somehow escaped the notice of the electorate.

The TARP, of course, was the most egregious self-inflicted wound by the political class. While I can defend the TARP intellectually, the politicians absolutely should not have let it seem like a scot-free bailout for the bankers in charge. While the Bush Administration implemented the first part of the TARP program, the GOP in Congress largely voted against it. They can thus credibly take credit for rejecting TARP with the voters, who view the TARP as an un-American bailout of the politically connected. The voters are basically right about this. The Democratic Party has been courting the financial industry for decades and didn't want to cross the bankers by reining in their pay or power. In fact, the largest banks became even bigger and more powerful during the crisis, while small banks (and small business lending) were left to suffer.

So we have more than $2 trillion spent on the TARP, the stimulus and the health care bill with very little tangible benefit for the middle class. The TARP and the stimulus have undoubtedly helped the economy, but the average voter can credibly wonder if that $1.5 trillion could have been better spent. To make matters worse, the political class got sidetracked on a health care reform that has more downside than upside for middle class voters.

Voting for divided government

The voters are not necessarily looking to put the GOP back in charge. They still mostly blame the Bush Administration for the financial crisis. They just look at the Democrats' agenda and think it needs to be reined in. By taking away the Democrats' control of congress, they put an end to an unsuccessful bout of one-party rule and replace it with divided government. Divided government is better for cutting the deficit and forcing more moderate compromise. It doesn't matter what the Republicans did when they were in charge. The voters are forward-looking. Obama is still president, so we aren't returning to one-party Republican rule. The Republicans don't have a positive economic agenda for the middle-class either. The future is wide open for both parties.

The American electorate as a whole is actually very smart. They have historically made the right choices between the choices that they have had. Obama needs to be reined in, so they will vote Republican in the mid-terms. How 2012 turns out will depend on how the parties act in the next two years. 2010 isn't necessarily a Republican victory any more than it is a Democratic defeat. The middle class is still looking for its long-lost champion.

Get Rich, Slowly

October 28, 2010 tylerdynamistLeave a comment

Slow and steady wins the race in investing. For every successful get-rich-quick hare, there are a thousand that end up road kill. Emulate the tortoise instead. Follow these five rules for slow and steady wealth-building:

This article by Tyler Newton can be found at the site "Man of the House" HERE.

Financial Planning with Purpose

October 15, 2010 tylerdynamist1 Comment

Set goals and achieve them. You have probably heard this your whole life, but when it comes to financial planning, setting goals and a vision is imperative to your success. By balancing the four pillars in your life – career, family, hobbies and community – your goals are clearer and become something to work toward. Once you set a long-term life plan, your financial goals become a lot easier to obtain.

This article by Tyler Newton can be found at the site "Man of the House" HERE.

The Return of the US Consumer

September 2, 2010 tylerdynamistLeave a comment

The following post is the second in my "United States of Debt" series that analyzes how the different sectors of the US economy will handle their high debt loads. The first installment can be found here.

During the housing bubble, American consumers loaded up on debt. Since the bursting of the bubble, Americans have adjusted by increasing their savings and paying down debt. This adjustment resulted in a slight decrease in consumer spending and a large decrease in residential investment. My analysis shows that the bulk of the adjustment in consumer spending is complete. The level of personal savings is driven by household net worth. As a percent of GDP, both household net worth and savings have returned to normal levels. Therefore if asset values can remain elevated, consumer spending can at least keep pace with normal levels of GDP growth for the foreseeable future.

As has been discussed previously in the Dynamist, a big secular trend over the past forty years has been the rise in consumer spending and residential investment as a percent of GDP.

Figure 1