Editorial

The Cancer of Debt and Deficits; The Newgame of Investing for Income and Profits

August 9, 2012

If cheap money is good, then free money must be even better!

Real yields (after inflation) are already negative. The yield on the 10-year Treasury bond are well below 2% and three-month rates are 0%.

The yield on five-year TIPS is a negative 1.0%! How much lower can it get?

Heavens knows but the Fed is determined to push them lower because that seems to be the first, middle, and last page of the Central Banker training manual.

The Federal Open Market Committee of the Federal Reserve decided to extend Operation Twist through the end of this year and committed an additional $267 billion.

Operation Twist, which is where the Fed uses cash from the sale of short-dated Treasuries to buy longer-dated securities, in an effort to bring down long-term rates.

The hope is that it will lowering long-term interest rates and reduce the cost of loans for mortgages, cars, and business loans.

By the way, as much as I'd like to blame Bernanke for creating Operation Twist, the truth is that a different Dr. Frankenstein came up with it. The original Operation Twist was a program executed jointly by the Federal Reserve and the Kennedy Administration in the early 1960s, to keep short-term rates unchanged and lower long-term rates, effectively “twisting” the yield curve. Like today, the notion behind Operation Twist was that  lowering long-term rates would encourage housing and business investment.

If Operation Twist Phase Two doesn't work (Phase 1 didn't), the Fed is prepared to do even more.

"The Committee is prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.”

The further action would likely be a third round of Quantitative Easing or QE3. Given our sick, if not dying, economy it is only a matter of months before the Fed re-cranks up its printing press.

Even the Fed is concerned about the slowing US economy.

What didn't get a lot of media attention was that in addition to extending the Twist, the Fed also quietly revised its forecasts for the economy at the latest FOMC meeting.

At the April FOMC meeting, the Fed forecasted that the US economy would grow by 2.4% to 2.9% in 2012.

Now the Fed expects the US to grow by only 1.9% to 2.4% this year.

Expectations for 2013 were also revised lower. The Fed also reduced its GDP forecast from 2.7% to 3.1% to 2.2% to 2.8%.

 

Keeping Up With the Bernankes

Ben Bernanke isn't the only central banker that thinks cheap and/or free money is the solution to all the world's economic woes.

In July, the European Central Bank, the Peoples Bank of China, the Bank of Korea, and the Central Bank of Brazil all cut their key interest rates.

  • The ECB cut its key lending rate by a quarter of a percentage point to 0.75%, taking it below 1% for the first time in that central bank’s history, and cut its deposit rate that it pays on overnight funds from 0.25% to ZERO.
  • The PBOC chopped its one-year deposit rate by 25 basis points to 3% and its one-year lending rate by 0.31% to 6%.
  • Brazil's central bank first reduced its 2012 GDP growth forecast from 3.5% to 2.5% and then lowered its key lending rate from 8.5% to 8.0%, the lowest rate in Brazil's history.
  • The Bank of Korea did the opposite of Brazil. First it cuts its rates for the first time in three years by a quarter of a percent and then lowered its growth forecast from 3.5% to 3%.

Not wanting to feel left out from the global print-a-thon, the Bank of England increased the size of its Quantitative Easing program by 50 billion pounds ($78.1 billion), bringing the total commitment to £375 billion.

One by one, the countries of Europe are losing their ability to sell their bonds at an interest rate that is sustainable for their revenue bases without severe and socially disruptive restructuring.

The U.S. will soon be faced with that same problem. As the bond investors look at Europe and a soon-to-implode Japan, they will decide that the U.S. is only different in size and scale.

Our national debt surpassed our country's GDP last year. Think about that: our politicians have spent their way to the point that we owe more than the collective output of all our individuals and businesses in the entire United States.

And our debt problem is going to get worse.

 

The interest on our $16 TRILLION of national debt is rapidly becoming a huge part of the overall budget, and any rise in interest rates will put severe constraints on spending or force large tax increases or require the Federal Reserve to monetize the debt. None of those have positive outcomes.

Our ballooning deficit creates the very real risk of the bond market treating us just as it is treating Italy and any other country that gets to the point where its debt is unsustainable.

NO country can run deficits the size we are currently running, along with unfunded deficits over four times the size of the economy and a growing overall debt burden, without consequences.

At some not-too-distant point, investors in bonds will start to question the ability of the United States to service that debt and treat our government debt like a red-headed stepchild.

One has to go out beyond 5 years to get more than a 1% yield. Who is buying this stuff?

 

Don't Be a Yield Minnow; Be a Yield Shark!

Clearly, the world's central bankers are determined to push yields lower and keep them low until the global economy recovers.

That recovery will take a few years; perhaps longer. Under these new monetary rules, you must invest differently if you want to prosper.

What these central bankers are doing is defrauding a generation of hard-working savers.

The challenge is that low rates punish savers and leave them with less income and depresses final consumer demand; especially for retirees living off their investment income.

The chart, courtesy of my friend Dan Greenhaus of BTIG, shows that interest income has dropped like a rock as the Fed dropped, dropped, dropped interest rates.

 

My forecast is that you will see 2% yields on 30-year Treasuries and less than 1% on ten-year bonds within the next two or three years.

Better yields can be had with some serious research and homework but is isn't obvious or easy. 

It has been said that there is always a bull market somewhere.

For example, from 1970 to 1985, if you had invested $1 in the United States, you would have $2 by 1985. If you had invested that same $1 in Japan, you would have made $6 over the same period, and if you had invested in Hong Kong, you would have made more than $8.

Asian, Latin American, African markets will be the big winners of today's loose monetary policies around the world. Just as the Fed’s loose monetary policy after the internet bubble burst created the housing bubble in the U.S., the Fed’s money printing today will inflate emerging markets.

 

Additionally, there are pockets of opportunity hidden in Europe, primarily in Scandinavia and eastern Europe, where responsible governments have stayed within their means and run budget and/or trade surpluses.

I spend a lot of time traveling around the world and I have a Santa Claus list of the naughty and nice countries. The above map clearly shows who the spendthrifts countries who deserve a lump of financial coal as well as the countries that have financially behaved themselves in green.

Those are countries in which economies are expanding, people are plentiful, debt is under control, and corporate profits are growing. In short, those countries are incubators of rising stocks markets, growing earnings, safe dividends, and places that deserve your money.

Foreign investments have a profitable kicker. Since their revenues and profits are priced in non-dollar terms, you have the potential to earn an extra 5%, 10% or even more from the currency translation. A falling dollar actually boosts your profits on non-U.S. investments.

That is why the rules for successful income investing have changed. Why you will need to discard your old investment habits and adapt to a new way of investing for income. The Newgame of income investing.