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QE II Is Here: Why Gold Will Be A Bubble

November 3rd, 2010 No comments

As expected, the Federal Reserve announced Quantitative Easing II (QE II). There were no surprises here, the reports over the past weeks were indicating easing in the amount of a few hundred billion to up to $1 Trillion. The headline number is $600B, but the total will be closer to $1 Trillion if you include additional purchases to replace expiring mortgage bonds. The additional purchases don’t expand the Feds portfolio, they will simply replace existing positions.

This sounds like a lot of money, but put $600B in perspective. It’s less than 6 months worth of the U.S Federal Government’s budget deficit. The entire U.S economy is over $14Trillion dollars.

One of the important details about QEII is that the majority of the Fed purchases will be within the bond maturity window of 5-7 years. This is important because the Fed will eventually need to reverse QEII as well as unravel all its other existing positions.

How It’s Supposed to Work

The Fed is trying to accomplish a few things here with QEII. First, the purchases will cause interest rates to decrease because buying bonds increases prices. Bond yields go in reverse to bond prices, so these purchases tend to depress bond yields. Lower interest rates in theory makes credit more easily available (this argument doesn’t reflect reality though – just ask people who are trying to get those cheap mortgages).

Second, lower bond yields make government debt less attractive. This will make other productive, private market assets more attractive because the risk adjusted return rate of those assets should go up. This phenomenon is thought to be contributing to the rise in the stock markets, particularly income investments.  Why earn 2+% on a 10 year Treasury when much higher yields are available from the highest quality, AAA rated, stocks?

Will it work? Perhaps it might have some effect marginally though its clear that in the short term the markets think it will simply cause inflation as evidenced by the increase in prices of hard assets such as gold and commodities. In the end though, the Fed can’t make a recovery happen by printing money, that needs to happen from the private sector.

How The Fed Will End It

I think the more important question to ask is how will the Fed end it. If you have been making the right moves recently, you will want to keep an eye out for new bubbles developing that could blow up on you because of the Fed’s actions. All this Fed manipulation is after all artificial market fingering. Markets are smart, and they adapt. The best example of this is that these artificially low interest rates really haven’t done that much to make credit more available because lenders have rightly raised standards.

Buying Treasury Bonds gives the Fed a clear and easy exit strategy: hold the bonds to maturity then retire the money. The Fed’s action to focus on the 5-7 year time frame leads one to conclude that this might be their exit time frame.

Inflation could occur more than otherwise if the Fed was forced to sell the assets at lower prices or worse simply write the money off. Because bond prices are so high, any sign of a growing economy will only make these bonds lose value. So, the risk of extra inflation will depend upon if the Fed takes a bath on its assets when it starts tightening. Simply letting the bonds expire to maturity enables the Fed (or anyone else invested in Treasury bonds for that matter) to get all of their principal back. This is the best that can be hoped for to keep inflation in check.

Gold Is A Bubble

The biggest risk I see going forward is a gold bubble. Not next year, maybe not even in the next few years but at some point gold won’t be a good trade anymore (at least a long trade). Here’s why:

  1. Gold doesn’t make you money. If you buy quality stocks and overpay because of bubble pricing, at least you won’t lose your shirt because stocks can outgrow overvaluation if earnings increase. Gold can’t do this.
  2. Inflation won’t be the problem it was in the 1970s when gold was a bubble last. Don’t expect 18% interest rates, the Fed will move.
  3. Gold has technicals in the market that make it a good trade. When the trade goes against it those market speculators will be weeded out.

Gold will probably never be $300 again because world demand for jewelry and industrial uses will continue to increase as markets develop around the world. But, at some point this trade won’t work anymore.

Categories: Economy, Market Analysis Tags:

Market Analysis: Where To Put New Money

October 14th, 2010 No comments

The market has discovered “dividend” investments over the number of months. This is both good news and bad news.  Tobacco, Energy Partnerships, Oil Trusts, and Real Estate stocks, which are  long time boring income investments are on fire. These are the gains in these stocks just in the month of September:

  • Phillip Morris (PM) – 10%
  • Altria (MO) – 8%
  • Enterprise Products Partners (EPD) – 9%
  • Enerplus Trust (ERF) – 15%
  • Realty Income (O) – 4%

These are reasons why:

  • Interest rates are near zero, which depresses bond yields. Given the language of the Federal Reserve recently, its likely to stay that way for longer than perhaps was expected earlier this year.
  • All asset classes (stocks, bonds, commodities, gold, etc) are appreciating as a response to the depreciating dollar. When the dollar depreciates, everything denominated in dollars goes up in price to compensate.
  • Stocks are cheap. Investors realized that some stocks, adjusting for risk are cheap.

Of course cheap is relative. While some stocks may still be cheap, it looks at though prices have moved too quickly. The bad news, higher prices mean less income.

One of the trades that I am making this month is to buy into preferreds, as I talked about over the weekend.

Here in summary are what I see developing as good investments in this market:

  1. Preferreds still are paying good yields, if you buy investment quality below par.
  2. Defense contractors are very cheap right now, in response to expected lower defense spending going forward. See this article which talks about Lockheed Martin. This is still developing, the key is to find the ones that are beaten down but can otherwise survive with businesses outside of defense contracts.
  3. The foreclosure mess has come up again, this time as banks are stopping foreclosures due to bad paperwork. Banks stocks are taking a hit, but I think the better play here is the bank preferreds. These stocks survived the 2008 Recession, so its unlikely that this wave will kill them this time.
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Why the Fed and Obama Are Willing to Wreck the Dollar

September 30th, 2010 No comments

The rise of gold to over $1,300 is no accident. We saw a similar rise of gold in the 1970s to over $2,000 per ounce. The reason? The U.S had just dumped the gold standard (the link that makes a dollar worth a certain amount of gold) and had started to print like crazy to pay for the Vietnam war. Japanese bondholders of U.S government debt took it on the chin.

The mechanics are the same, but this time around the reasons are different. The Federal Reserve and the U.S Government will do whatever it takes to “save” the economy because governments at all levels are “invested” too much in suckling from the private economy pig.

There is a sharp contrast to the 1970s when government had gotten bigger, but not anywhere as big as it is now. You might say, well, as a percentage of GDP the government (at least at the Federal level) is taxing at about the same as it was in the past decades. This might be true, but there is a clear disconnect between what governments collect and what they spend, borrow, and have committed to in future expenditures through entitlements.

Here’s a quick run down on what has changed over the past 40 years:

  • The baby boomers are near retirement. The accrued benefit promises have outstripped expected tax revenues for Social Security, Medicare, and Medicaid.
  • 401ks and other tax deferred retirement accounts were invented and now contain 100s of billions of dollars. Governments need a good stock market so that they can reap their share of these accounts in the future.
  • It’s been bi-partisan, or non-partisan that government entitlements are expanding even though we can’t pay for the ones we have. George W. Bush (Republican) passed a prescription drug bill onto Medicare. Obama (Democrat) signed legislation that expanded the involvement (and funding) of health care for those younger than 65 (outside Medicare age).
  • We have gotten into a few wars, all put onto the credit card. No money was asked for from the taxpayer.
  • States are broke. They too have over committed on pensions and health benefits.

The message that I get from the Fed is this: start spending and investing now, otherwise I will print more and more dollars and trash the currency until you do. Governments need a strong economy and if they don’t get one, they will simply take your money by inflation.

This is why gold is so hot.

Categories: Economy, Market Analysis Tags:

Why Low Mortgage Rates Mean Higher Cost Mortgages

September 23rd, 2010 No comments

Personal finance is very often interfered with by well meaning government policy. There is perhaps no more interference by government than the housing market. I don’t want to talk about all of the ways that the housing market is distorted (it would be quite a long post), instead I will focus today on just one distortion: very low mortgage rates.

How We Got Here

U.S Housing mortgage rates are near all time lows, as of this writing they are below 4.5% for a 30 year fixed mortgage. The reason why the rates are so low, is due to interference by the U.S Federal Reserve in the Mortgage Backed Security (MBS) market and in the U.S. Government Treasury Bond market. In a normal market, the Federal Reserve sets short term interest rate policy by expanding or contracting the money available to banks. Since we are in unusual times,  the Federal Reserve has taken additional steps to buy MBS and U.S Government debt.

Buying debt increases the price, while depressing the interest rate on the bonds. The yield on U.S debt is near all time lows. Mortgage rates are in large part tied to the interest rates on U.S Debt. The Federal Reserve expansionist policy has lead to very low mortgage rates.

How The Banks Respond

Banks write mortgages by borrowing short term and lending long term. The difference in this spread is the basis for their profit. The question is, would a bank want to lend money out at 4.5% or lower for 30 years? No they wouldn’t because they understand that the near zero interest rates don’t last forever.

So, how do you get a mortgage if banks don’t want to write them? Well, chances are you will be getting a loan held or insured by Freddie Mac or Fannie Mae. According this this NY Times article, 98% of the new mortgages are processed by these Federal agencies.

Banks have problems of their own. Their existing mortgages that they hold have credit problems, and at the same time the U.S Congress has toughened up the reserve requirements for banks which lowers the amount of money available to be lent.

Therefore, given the state of the market, banks are content to make money originating and servicing mortgage loans instead of on the loan itself. So, all the higher fees that the banks are charging to originate loans is the main way they make money today.

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