Relationship Between Inflation, Interest Rates, and U.S. Treasury Bonds

Inflation has resurfaced over the past few months as an economic outcome we should all be acutely aware of.  Besides fiscal policy, a huge determinant of inflation is monetary policy established by the Federal Reserve.

In an effort to spur the economy, the Fed is essentially manufacturing money to the tune of $600 billion to buy U.S. Treasury bonds.  If the demand for Treasury bonds rises, pari passu (all things being equal), the price will rise as well.  An increase in bond prices also translates to a decline in interest rates.  Here is a simplified illustration:

Current Bond Price	Interest Rate	End Payment
$80.00	25%	$100
$90.91	10%	$100
$95.24	5%	$100

In this example, the current bond price is what you’re willing to invest today to receive $100 in one year.  The interest rate identifies the rate of return that will entice you to buy the bond (lending money with the promise of being paid back at a later date).  A company or government borrowing money through bonds will pay a lower interest rate if it is viewed a safe investment.

The Fed’s policy of buying Treasury bonds has the effect of keeping interest rates exceptionally low since, pari passu, more demand à higher bond prices à lower interest rates.

In effect, the Fed is trying to keep interest rates lower than what the Treasury market would ordinarily dictate.  Part of the reason is because interest rates on other debts (particularly residential mortgages) are tied to Treasury yields.  This explains why mortgage rates have been at historically low levels over the past 6-12 months.

Debtors are benefiting from these low rates, but there are major costs to this approach.  Savers are earning next to nothing on bank deposits, which depresses their interest income.  Insurance companies and pension funds are also generating less investment income, which is added concern for state pension funds that may be insolvent within a decade.

Furthermore, the Fed’s policy actions are devaluing the U.S. dollar (namely because it is manufacturing $600 billion not previously part of the money supply).  If one U.S. dollar today is believed to be worth less than it was three months ago, pari passu, suppliers of goods and services would raise their prices to compensate.  People’s incomes are relatively static over the course of a year, but anyone who has shopped for groceries or filled a car with gasoline knows that these expenses rose substantially just in the past few months.

These price increases are especially problematic because spending on necessities is increasing while incomes remain constant, effectively making people poorer.  With a constant income, consumers paying more for food and energy takes away from their discretionary income, thus reducing their ability to make discretionary purchases and pay down debt.

An even more troubling scenario is if investors in U.S. government debt become concerned about 1) the country’s ability to pay its debts and 2) the value of future dollars used to make principal and interest payments.  By monetizing the debt, the Fed’s actions are helping stoke these fears, and it is absolutely imperative that foreign and domestic investors do not lose confidence in the U.S. government.  Sustained concern about our debts will drive up interest rates considerably, making it more expensive to service our debts.  Higher borrowing costs will depress the economy, making it even more difficult to repay investors, which in turn produces a death spiral as evidenced by Greece, Ireland, Portugal, and Spain.

Like with so many other fiscal issues, it is tempting to enjoy artificially low interest rates now and deal with the consequences later, but a little sacrifice now could help prevent an economic cataclysm.

Golf in Hawaii

The PGA Tour begins its year at the Kapalua Resort in Maui.  Here is a view of Molokai Island from the golf course:

Source:  http://www.kapalua.com/accommodations/villas/image-gallery.php?album=2

From January thru March, the PGA Tour will host events in Hawaii, California, Arizona, and Florida.  Particularly for those of us who experience winter in northern climates, it is always pleasant to take in the pristine scenery that the world’s best golfers enjoy this time of year.

The Next Time You Shop

Fresh off the holiday season, we were constantly being enticed by retailers to spend money.  This presents an opportunity to talk about tax-effecting.  While this topic isn’t nearly as fun as buying gifts, they are inextricably linked.

When you are saving money to buy presents, have a great dinner, take a vacation, etc., it is natural to view a savings goal in terms of the amount of time you need to work to earn that money.  If someone hypothetically makes $20/hour, it reasons that (after fixed expenses) 5 hours of working can translate to affording $100 worth of purchases.

However, you need to tax-effect your earnings for a true portrayal of how much something costs.  Someone making $20/hour may face these marginal tax rates:  25% federal, 5% state & local, 6.2% Social Security, 1.45% Medicare.  This totals to 37.65%.

Instead of a $100 gift being financed by 5 hours of work, it actually takes 8 hours.  To tax-effect $100 of after-tax income:

Pre-tax = After-tax / (1 – combined marginal tax rate)

Pre-tax = $100 / (1 – 0.3765)

Pre-tax = $100 / 0.6235

Pre-tax = $160

So in actuality, someone making $20/hour would need to work 8 hours to earn $160 pre-tax.  Once taxes are applied, that gets effectively reduced to $100 which enables him or her to make the purchase.

Depending on your income, you can calculate your combined marginal tax rate and use that figure to identify the true cost of whatever you’re purchasing.

As a general rule, the higher your tax rate, the more relatively expensive purchases become.

Applying this concept to the discourse on taxes, it stands to reason that progressive proposals to extract even more tax revenue from higher-income families could produce adverse consequences.  Millions of households would not only experience an income reduction but it would become more expensive for them to consume goods and services.  With 2/3 of the U.S. economy driven by consumption, a pronounced decline in purchases by affected taxpayers would be unsettling for the entire country.  This concept is often overlooked in the taxation debate, but it clearly merits attention and should be given proper consideration when evaluating the costs and benefits of different tax proposals.

Most Homes Still Cost Too Much

This blasphemous statement flies in the face of conventional wisdom, and differs from what you may hear from groups with deep ties to the housing market, which includes the government.

Skeptics of my statement will make the following arguments:

1. Home prices are down considerably from 2005-2007 levels nationwide
2. Interest rates are low, which makes financing more affordable
3. When the economy improves, home prices will rebound substantially
4. Owning a home is a good long-term investment

While many of these points are valid on their own merit, it is imperative to look deeper by factoring in macroeconomic trends, supply and demand in the housing market, income growth, geography, home financing, property taxes, insurance, maintenance costs, and inflation.

After carefully weighing these issues, I believe home prices in most regions will (and should) drop further. Some people believe that home prices should not be allowed to fall further, and massive government intervention is necessary to prevent that from happening – while I contend that the sooner we reach a legitimate equilibrium, the better.

The following illustrative exhibit shows an artificial price floor (red line at $400k) that is higher than the natural equilibrium (where supply [blue] and demand [green] lines meet at $250k). In my view, the current approach is delaying the inevitable, and the housing market will only make a full recovery once we reach pricing levels where the supply of homes for sale equals the demand of homes to purchase.

Source: http://blogs.reuters.com/rolfe-winkler/

Many future blog posts will analyze these issues and how they affect us all – whether or not you're a homeowner.

What is Likely to Cause Inflation?

There are three major causes of price increases: wage growth, lower supply or higher demand for a good or service, and a depressed currency.

For the next few years, wage growth is likely to remain fairly static, as a persistently high unemployment rate reduces the bargaining position of employees asking for raises.

If one believes, as I do, that we are unlikely to experience robust economic growth anytime soon, prices on discretionary items are unlikely to jump. With higher living standards in China and India in particular, it is quite probable that food and energy prices will rise more than American wages, thus reducing our purchasing power. Energy in particular is a topic of utmost importance that I will address in future blog posts.

Barring a huge shock to food or energy prices, I believe the biggest inflation risk we face is the devaluation of the dollar. Individuals and foreign governments invest trillions of dollars in Treasury bonds at fairly low interest rates. These bonds are backed by the full faith and credit of the U.S. government, and investors believe that despite its problems, America remains the safest place in the world to invest in government bonds. Investors purchase Treasuries with U.S. dollars, and coupled with the safety of our debt, that makes the dollar the world's reserve currency. Anytime investors get spooked about riskier assets, they typically flock to Treasury bonds, a process that increases the value of the dollar and reduces interest rates.

We are huge beneficiaries of having the world's reserve currency, because our government is able to borrow money cheaply, which makes it possible to finance our deficits.

However, our fiscal trajectory is nightmarish, with deficits projected to exceed $1,000 billion each year over the next decade. At some point, investors (e.g. mutual funds, pension funds, individuals, China, Japan, etc.) could scale back their holdings of U.S. government bonds. They could demand to receive a higher interest rate for the increased risk that the U.S. will have trouble paying its debts.

If this occurs, the dollar would lose value and it would become more expensive for consumers to purchase goods sold in the world market. Not only could the dollar weaken relative to foreign currencies, but it could undergo devaluation domestically if enough people question the creditworthiness of our government. This would produce significant inflation without sizeable economic growth, which could be likened to the stagflation period of the late 1970s.

Inflation is often accompanied by economic growth, where increased productivity and a mobile workforce induce employers to give their employees raises, which in turn contributes to price increases. However, stagflation results from dollar-denominated goods and services getting more expensive without the economic growth to support it. This outcome is very worrisome, as it would make society poorer and destroy incentives to save and invest, which is the key to future growth prospects.

Unfortunately I believe stagflation – or worse – is a very likely outcome of damaging fiscal policies that our nation has engaged in for many years. A future post will dive into inflation and illustrate why it is more ruinous to your personal finances than you might suspect. 

Source: http://online.wsj.com/article/SB10001424052702304410504575560711579850350.html

Paying Down Debt – The Bad News

Especially in these challenging economic times, it's crucial to know the terms of any debts you have incurred. While compounding interest is great for your investments, it could financially destroy you on liabilities.

At first glance, it may seem that a 9% or 12% interest rate isn't all that bad. Intuitively, if debt grows at 9% per year, it seems that it would take about 11 years for that amount to double. The reality is far more sobering though. Use the Rule of 72 to figure out how long it takes for debt to double at a specified interest rate:

72 / interest rate = number of years to double

Using this equation, it only takes about 8 years for a balance to double at a 9% interest rate. And not paying down a $5,000 credit card balance at 12% will result in a $10,000 balance in only 6 years. Unfortunately, with credit card rates often far higher than 12% nowadays, making minimum payments does not put a significant dent in your balance.

Getting on solid financial footing requires discipline and prudent money management. While this may seem quite difficult, it is recommended to set aside a "rainy day" fund that covers at least 3 months of living expenses. Once you're comfortable with the rainy day fund you have established, any additional funds should be used to pay down high-interest debt. This approach entails short-term sacrifice to achieve long-term financial security, but being disciplined enough to follow it will enable you to start building wealth much sooner than you otherwise could.

Paying Down Debt – The Good News

If you have money deposited in the bank, you know that interest rates are minuscule. Even the best online rates don't yield more than 1.5 or 2.0%.

However, paying down debt can potentially yield a risk-free, double-digit investment return. Psychologically, you should treat debt repayment as a tremendous investment. And while it may be less alluring for some than investing in the stock market, statistically you'd be far better off paring your debts since it is risk-free.

To reinforce this concept, suppose you have an extra $1,000 after setting up a "rainy day" fund in case you lose your income. If your debt is accruing interest at 10% annually, here are two options:

Invest $1,000 in the stock market

Hope for a 12% pre-tax rate of return

Pay long-term or short-term capital gains taxes

Net a 10% after-tax rate of return ($100 on the $1,000 investment)

Use the $100 in proceeds to offset $100 in additional interest
($1,000 debt * 10% annual interest)


Pay off $1,000 of debt

Same economic outcome as above

Equivalent to a 12% investment return, but without the risk of stock market fluctuations or downturns

The Perils of Leveraged ETFs

The staggering decline in the stock market in 2008 and early 2009 has led to many people re-evaluating their views on investing. They have now steered away from the traditional strategy of buying and holding diversified mutual funds for the long term. A portfolio fully invested in small, medium-sized, and large companies, with both domestic and international exposure, likely experienced a peak-to-trough loss in the 35 to 50 percent range.

Not surprisingly, in response to the events of 2008, an increasing number of people have sought to profit when the market goes down. In addition, some people harbor a conviction that a certain sector will perform particularly well or poorly. This line of thinking is a major departure from conventional wisdom, and a series of financial instruments have been recently created to meet this demand. However, I want to spotlight the dangers of certain investment vehicles, in an effort for others not to act on the same mistaken beliefs I held.

Many Exchange Traded Funds (ETFs) have been created recently that apply leverage and shorting capabilities to a given index, like the S&P 500 for example. If the S&P 500 drops 5% tomorrow, an ultra-long fund tied to the index will fall 10%, a short fund will rise 5%, and an ultra-short fund will rise 10%. Most ultra funds have double leverage, but ETFs now exist that are levered by a factor of 3. As you can imagine, the downside risk is quite large if you guess wrong.

These funds have an additional property, however, that is quite startling. Over time, ETFs that are ultra-long, short, and ultra-short are guaranteed to lose value if the underlying index remains the same. This is far from an intuitive concept, and one that few people are aware of, but it will cause investors to lose money with these ETFs in all but the very best of circumstances.

As a quick demonstration, let's say an index has a value of 100. It increases by 25% to 125 on Day 1, and decreases by 20% back to 100 on Day 2. You would think that the other ETFs based on this index would also have a value of 100 at the end of Day 2. However, you can run the calculations and will find that the ultra-long fund would be worth 90, the short fund would be worth 90, and the ultra-short fund would be worth 70. In this example, you would actually lose between 10 and 30 percent of your investment even though the index was flat over that time period:

	Initial Value	Day 1		Day 2
Underlying Index	100	+25%	125	-20%	100
Ultra-Long Fund	100	+50%	150	-40%	90
Short Fund	100	-25%	75	+20%	90
Ultra-Short Fund	100	-50%	50	+40%	70

What could possibly explain this disparity?  The ETFs are designed to produce daily returns relative to the index, not long-term returns.  The effects of compounding, particularly in a volatile market environment, cause these specialized ETFs to decay over time.

As a final demonstration of this, consider the Dow Jones U.S. Real Estate Index.  From January 2, 2008 thru January 2, 2009, this index declined 41.7% because of the major weaknesses in housing and commercial real estate.  If you predicted this decline perfectly, and sought to profit from this insight, you may have purchased the ultra-short ETF tied to this index.  Yet instead of making a great deal of money, you would have actually lost a staggering 47.9% of your investment!

In short, don’t touch any of these short or levered ETFs unless you envision a noticeable movement occurring over the span of a few days.  The longer you hold these instruments, the odds of making a profit are reduced dramatically.  Even hedging with these ETFs is not a great idea because of their erosion.  My thoughts are to use extreme caution, or more simply, to stay away.

Pleasant Diversion

Pebble Beach – 8^th Hole

Source: http://www.andx.com/attachments/2008/01/1_200801080309171.jpg

Every so often, golfing reflections will make an appearance on my blog.

Time Horizons

A recurring theme of my blog will involve the tension between policies that are Band-Aid approaches vs. ones that directly address the root cause of an issue. Particularly at this juncture, a sick patient is a good metaphor for the United States economy. Simply put, what is the best way to nurse the patient back to health?

The first approach is short-term in nature, prioritizing how the patient will feel in the next day or two. In this scenario, you might provide steroids and other energy boosters to help maximize the patient's quality of life during that time frame.

The second approach is long-term in nature, prioritizing how the patient will feel next week and afterwards. Here, you might recommend administering antibiotics, and confining the patient to a bed and urging plenty of rest to recuperate.

In the short run, the bed-ridden patient suffers from a reduced quality of life and undergoes a more painful experience. But over time, that extra rest and recuperation translates to better and more stable health than the patient who never had the underlying ailment treated.

This scenario can be likened to politicians enacting policies that affect the economy, and therefore the financial well-being of us all. Unfortunately, elected officials are motivated by re-election prospects, as frequently as every two years in the case of the House of Representatives. As a result, numerous bad policies (e.g. $8,000 homebuyer credit, Cash for Clunkers) get enacted because it is politically expedient to "help" the economy in the short term, which is often sufficient to win votes for the next election.

These programs may only worsen the situation in the long term and create a whole host of unintended consequences. Affordable housing mandates are a perfect example, as policies designed to aggressively provide mortgages to people who weren't creditworthy helped ruin the economic prospects of the very people they were designed to benefit. Moreover, these misguided policies also helped trigger a near-collapse of the entire financial system.

Many issues of paramount importance need to be addressed to ensure the nation's fiscal stability. It is up to you and me to elect representatives who will put the best interests of our country ahead of their re-election prospects, which means making difficult decisions now to avoid catastrophe later.