106 Days and Counting
Research for Online Investors

by John Dalt

3/11/11

The clock is ticking…  What is going to happen in the Middle East?  Qaddafi seems to be putting down the protesters.  It is not pretty, but that is reality.  When a rag tag group of civilians in Toyota pickups go against a trained military, even poor training and firepower win.  The vaulted ‘day of rage’ in Saudi Arabia turned into a “day of rest” according to the Washington Post!  Police fired on demonstrators yesterday in the Shiite dominated city of Qatif in Eastern Saudi Arabia.  A witness said three people were injured.

The news out of Japan is amazing.  One hundred eighty miles north of Tokyo we have seen the results of the most powerful earthquake recorded.  European leaders are meeting in Brussels today.  According to Athens newspaper ekathimerini, Prime Minister George Papandreou is working to convince other leaders that Greece needs longer than three years to pay back loans.  He also argues the loans should be at a lower interest rate.

Papandreou met with French President Nicolas Sarkozy yesterday and German Chancellor Angela Merkel earlier this month to press his case.  Greek debt is expected to reach 160% of GDP within the next two years.  Papandreou wants the new European Stability Structure (ESS) to establish a permanent fund to buy weaker country’s bonds.  This would allow Greece to continue selling their debt at low interest rates.

Long-term investors must pay attention to daily issues and analyze the impact on holdings.  It is important to look over the horizon.  What trouble lies farther out in front of the market?  We think the end of QE 2 presents a problem and an opportunity.

The Federal Reserve started buying Treasuries in November with an announced end in June.  At that time they will have spent $600 billion dollars buying U.S. debt.  This has been a lead weight on interest rates for the last five months.  What is going to happen when the biggest buyer leaves the market?

Interest rates will surely go up.  This is simple supply and demand.  Fewer buyers (with very deep pockets) mean demand is less.  Bonds will have to be more attractive to bring more buyers to the auction.  Higher interest rates will attract more buyers.  The government could also reduce supply, but that is impossible.  The U.S. government is addicted to deficit spending.  I am reminded of the old TV commercial “Help, I’ve fallen and can’t get up!”

President Obama held a news conference this morning and was very diplomatic, but emphatic that he would veto any large spending cuts.  NPR says they would be just fine without government money, but Obama doesn’t think the $1.1393 billion the government gives public broadcasting is ‘real’ money.  Like Senator Everett Dirksen said years ago “A million here, and million there, pretty soon it starts to add up to real money.”  Except now it is billions!

A year ago, the Macondo well in the Gulf of Mexico blew out in the beginning of May.  This coincided with the market starting a steep decline that ended August 31 when traders and investors realized the importance of a speech made by Ben Bernanke in Jackson Hole a couple of weeks before.  Over the next thirty days we started to understand the Federal Reserve was committed to printing money to buy treasuries until the economy improved.

A few months later David Tepper of Appaloosa Management adeptly called it “Heads I win, tails I win.”  The Fed had committed to print money until everybody made money.  They were determined to ‘cash whip’ the economy.  You can do that when your checkbook doesn’t have any overdraft charges!

So, what happens when it all ends? Something else happened last May besides the Macondo well blow out. The Fed’s first attempt at inflating the U.S. economy (QE1) had ended in March. They had spent close to $1.7 billion in that buying binge on Treasuries and Mortgage Backed Securities (MBS) to prop up the real estate market. When it ended there was a vacuum.

The stock market kept moving higher for three weeks.  It was kind of like a kid learning to ride a bicycle.  We found out we needed daddy’s hand on the seat to steady us.  The training wheels came off the market on 4/26 and we started grinding lower.

One interesting observation was that longer term rates actually declined after the Federal Reserve quit buying treasuries. Why? Sophisticated bond buyers knew that equities had been on an easy money high since the March before and started moving out of stocks and into bonds. This increased the buying pressure for bonds and held interest rates in check.

Why will it be different this time? Bernanke is counting on the economy being strong enough to continue to grow on its own after June. There could be some hiccups, but we have had a string of good economic reports. If the wheels don’t come off equities, where does the money come from to soak up $75 billion dollars in treasuries every month?

The competition for yield between ‘safe’ bonds and the stock market means bond interest rates must rise.  The interest rates on short term bonds are currently less than the rate of inflation.  Negative real interest rates don’t exist, except when investors are scared of equities.  If the fear of equities is reduced by strong economic reports and corporate earnings, fixed term interest rates must rise.

Our Long-Term subscribers bought an ETF this week that will return double the movement in interest rates as the market passes through the ‘valley of death’ that is ahead of us.  You can read more about subscribing to the Long-Term Portfolio service.

Quote:
"The U.S. government has a technology, called a printing press (or today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at no cost."-Ben Bernanke

The information presented in this newsletter is based on generally available news releases, corporate filings, current events, interviews and the editor’s opinions.  It may contain errors and you should not make investment decisions based solely on what you believe you have read here.  Do your own research, it is your money.  If you lose it, it is your responsibility, not ours or your grandmothers!  The editor may or may not have a position in any securities discussed.  The editor may have held a position in a security earlier, or in the future.

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