Saturday, June 13, 2009

When Lehman Brothers was allowed to fail for fear of moral hazard, investors far and wide sold everything from Apple to municipal bonds


"ETF Briefing
No Doomsday Message From Treasury Yields
Herb Morgan 06.12.09, 4:00 PM ET

What does the rise in Treasury yields really tell us? There is a fair amount of histrionics surrounding the rise in the yield on the 10-year Treasury note from a low near 2% to recent highs up near 4%. Financial press and cocktail talk seems to focus on imminent inflation of herculean proportions. If recent money supply increases meet improved confidence, then I suspect raising one's inflation expectations is realistic, but let's keep in mind that the regressed calculation that culminates in the 10-year yield at any moment is comprised of more than one variable.

1. Fear Reduction. When Lehman Brothers was allowed to fail for fear of moral hazard, investors far and wide sold everything from Apple to municipal bonds. There was a rapid, forced and deflationary deleveraging that would have shortened the investment time horizon of even Rip Van Winkle. The shortest duration Treasury securities actually traded at a negative yield. During this period the 10-year yield touched 2.04%. The rise up to 4% must have a healthy component of fear reduction assigned. We simply can't ignore the precipitous decline in the CBOE Volatility Index from above 80 to below 30. See the I-Shares SP500 VIX Short-Term ETN (VXX). The iShares 20+ Year Treasury Bond ETF has dropped from over $120 to below $90, back to its pre-crisis levels.

2. Inflationary Expectations. There is no doubt that Treasury yields are highly reliable indicators of the collective expectations about inflation. Just a couple of quarters ago, we were in the midst of a very real and dangerous deflationary threat. The recent rise in yields represents a significant waning of that threat up to this point. Further increases in yield may well suggest expectations for higher inflation. It's just too soon in my view. With no upward pressure on wages, and real estate prices barely stabilizing, it's hard to say that consumer and producer prices are going higher imminently.

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3. Over-Supply and Lack of Buyers. The need of the U.S. government to borrow during recession and the mounting debt as a percentage of GDP has likely exerted minimal impact on rates. But the suggestion that the U.S. is anything less than the one place on the planet that offers complete political security to its sovereign debt holders is a great exaggeration.

Nobody who invests money in U.S. Treasury securities is worried about fiat currency devaluation or authoritarian confiscation. Of course, if inflationary expectations rise significantly from here relative to that of other stable regimes, then foreign buyers could go on strike.

Keep in mind, of course, that our trade deficit means these overseas buyers are sitting on dollars, and U.S. Treasuries are a pretty nice place to put your dollars. My guess is that the economy is headed into recovery sooner rather than later.

Job losses will remain a lagging indicator, keeping inflation at bay in the near term. Looking out a few years, it's hard to imagine the unprecedented fiscal and monetary stimulus being removed at precisely the proper moment so as not to ignite inflation.

The recession that began in December of 2007 was not recognized until November of 2008. I suspect money will be too loose for a bit too long ultimately. If history is a guidepost, the Fed will probably overshoot, and the fiscal deficits will turn out larger than anticipated. In the short run though, let's get past deflation first and worry about inflation down the road.

Herb Morgan is president and chief investment officer of Efficient Market Advisors, LLC, an ETF separate account manger serving financial advisers and their clients. His weekly podcast is available free on iTunes . Contact Herb via e-mail:"

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