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BOND MARKETS ARE BEGINNING TO FUNCTION IN A SMALL WAY

BOND MARKETS ARE BEGINNING TO FUNCTION IN A SMALL WAY

I AM WRITING THIS ON THE NORTHERN HEMISPHERE’S SHORTEST DAY OF THE YEAR

Personally, I am a lover of daylight, so I am hoping for more and more light as the solstice passes and days begin to lengthen.  Let us also hope for some enlightened behavior by banking functionaries and banking system users in coming months.  Our friends in the southern hemisphere are reaching mid summer, may you enjoy these pleasant times full of daylight.

NEW CAPITAL NEEDED BY WORLD BANKS

We have commented on this subject before.  The solution has not been found.  TARP and other government relief plans have done some of the job.  However, if all bad paper were marked to market, it would take trillions more in relief to provide enough capital for the world banking system to function properly.  How will this be accomplished?  Stock markets will need to recover.  We estimate that world markets have lost about $30 trillion in value in 2008.  The banks can raise money through equity offerings, but may have to wait until markets recover.  This can account for part of the recapitalization.

The government is now providing stop-gap capital, which can be replaced by new equity and debt capital if and when the crisis passes.  As we know, all industry and finance depends upon capital.  There is no question on this.

THE GOOD NEWS IS THAT BOND MARKETS ARE BEGINNING TO FUNCTION…IN SOME SMALL WAY.

Perhaps 5% of the natural functioning has returned, aided by the artificial liquidity from the Fed (providing commercial paper financing and other recently assumed government funding facilities).  5% is modest, but it is a start.

Let us hope that this modest start is going to snowball and create a good liquid banking system to replace the currently crippled and frozen system.

The Federal Reserve on December 16, 2008 took a major step (and it is a step that gives us direction for our investments for months to come).
1. The Fed cut the Fed Funds Rate to 0.25%, the lowest it has ever been.
2. More importantly they stated that it would “stay there for some time”.  This is a key announcement.
3. Another stunning announcement is that The Fed said they would increase their purchases of non U.S. treasury paper into more and more unfamiliar and speculative territory.  They will buy mortgage related securities, and possibly more Treasury securities in order to lower borrowing costs for borrowers of all stripes (mortgage and business borrowers especially).  This is in addition to previously announced purchases of the debt of Fannie Mae and Freddie Mac, the effectively nationalized mortgage agencies with the scandalous history of creating much of the mortgage crisis.

Our translation:  In our opinion, it means that the Fed sees inflation as a long term problem, and they will not worry about it now.

Currently, the Fed plans to work to re-liquefy the banking system and avert a deflationary psychology from taking hold.  Inflation rates are currently falling due to falling commodity prices.  Disinflation and possibly short term deflation may be experienced in the U.S. over the next few months.  This will be followed by inflation over the longer term.

The Fed knows that we must strengthen the banking system, and do it soon.  Before the lower commodity prices lead us to a deflationary national psychology where there is very little spending, a huge increase in saving, and fear of the future.  All of these variables will diminish risk taking, and the entrepreneurial spirit that causes the formation of new businesses.  It is well known to all economists that almost all employment growth in the U.S. in the last decade has come from small businesses.  Large business organizations have been laying people off for a decade or more.

IT SELDOM HAPPENS THAT YOU GET THIS CLEAR OF A SIGNAL FROM GOVERNMENTAL AUTHORITIES ABOUT THEIR PSYCHOLOGY

The above announcements have given such a signal.  The U.S. Government approach is to ignore inflation and quantitatively ease (substantially increase the amount of money and credit available).  Thus, the plan is to 1) create more money and credit, and 2) prop up prices or bonds by government purchase and keep the cost of bonds or borrowed money low.

Milton Friedman would argue that this will create inflation.  As he put it “Inflation is always and everywhere a monetary phenomenon.”

THESE EVENTS, AND THE VEHEMENT LANGUAGE THE FED USED IN MAKING THE ANNOUNCEMENT ARE SIGNIFICANT

“The Federal Reserve will employ all available tools…”(Quantitative Easing)“…to promote the resumption of sustainable economic growth and to preserve price stability.” To discuss price stability in this sentence is to engage in wishful thinking, in our opinion. Price stability will be gained in the short run.  A deflationary price spiral will not develop, and liquidity will be increased.  Longer term, it is our opinion that inflation will develop…and it will be politically difficult to tell the public that the low interest rate party is over.

Now comes the hard part.  Let us say that they are successful in their objectives, liquidity is pumped into the system, credit is created, many people benefit from lower mortgage rates, and lower borrowing costs.  Eventually, the economy of the U.S. begins to recover, but probably not before 2010.  The stock market begins to rally, perhaps sometime in 2009, primarily due to the fact that prices have been beaten down to attractive levels.

Mr. Obama’s voting record shows that he is at home with populist, socialist, redistribution of wealth thinking as exemplified by his pledge to create three million jobs within two years.

The chances for his infrastructure plans to even get organized within two years are uncertain.  How will he gainfully employ three million people doing this type of work within two years?  It is a pipe dream; a pleasant and hopeful one, but a dream nonetheless.  May I suggest that within two years Mr. Obama will be far behind on achieving his infrastructure goals and people will agree that they were unrealistic?

In our opinion, the following scenario may develop.  Mr. Obama will eventually be faced with the problem of rising inflation and a need for higher interest rates.  This will not be popular with his socialist minded constituency, which likes the government jobs and government social hand outs.  Interest rate increases will be delayed, because they are politically unpopular, and we will be back in a new inflationary environment.  Although we cannot guarantee that this will be the course of events, it appears to us to be the most likely outcome over the next few years.

AS HAS BEEN PROVEN BY NUMEROUS SOCIALIST EXPERIMENTS WORLDWIDE FOR THE LAST 80 YEARS…

Even well managed socialism can not, and does not provide the same rate of economic growth as free market capitalism.  If growth is important to rapidly achieving social goals, then slower growth will provide slower achievement of socialist goals.  This is well documented by hundreds of economic studies over the decades.

SUMMARY

The Fed’s actions have given a green light to a lower dollar, and a higher price for well managed foreign currencies.  Since many foreign currencies are not well managed and suffer from the very same problems as the U.S. dollar, many investors will choose gold to supplement their currency holdings.  A further support to foreign currencies will be the fact that the U.S. must float about $2 trillion in new bonds within a year or two, creating an excess supply of U.S. bonds.  As supply increases and demand stays the same, then the price must fall…these bonds are priced in dollars.

Thanks for listening.


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