Wednesday, November 26, 2008

More Bad News and TIP Pricing

It would be difficult to be surprised now by bad news.  Any reader of the financial news would already be numb to it.  The current quarter will not show a ray of sunshine.  All the news will be bad.  I am to the point that a 4% fall in GDP for this quarter would be good news.  The government reported today durable goods order plunged by 6.2% in October. Yahoo! Finance Consumer spending fell by 1% in October, the worse fall since 9/2001.Yahoo! Finance   While these numbers were worse than the estimates, October was basically already known to be a bad month.  Hopefully, the economy will halt its slide during the first half of 2009 and return to normal trend growth in 2010.  

The announcement yesterday of a 800 billion program by the government to buy mortgages and consumer loans will relieve the credit crunch over time.  Forbes.comBut you need to step back and look at the overall cost of these bailouts.  One estimate is that it will cost the government over 8 trillion dollars.   CNBC.comDo we  have 8 trillion?  I do not think that it will end up costing this much since some of the money will be repaid and the government may actually make money on some of the programs.  In my view, we are already broke using the same accounting standards applied by corporations so even a 1 trillion dollar cost aggravates an already serious condition.  The money will be either borrowed or created.  While the problem is certainly deflation now, it is hard for me to envision coming out of this crisis with clear sailing ahead.  With all of this money creation, and its stimulus effect that it will ultimately have, I would anticipate a return of inflation as a serious problem in a couple of years.  The U.S. debt, already a serious problem, will become more so.  The issues that the nation faces in funding its promises to the retiring baby boom generation, including me among the hoards of millions, will become even more serious and problematic.  All we are doing now is kicking the can a few feet down the road.  The more serious problems will become even more evident in a few years.  But, possibly the least appreciated issue is that the current crisis is a continuation of certain trends that have accelerated in this country during my lifetime, a belief in entitlement, a lack of responsibility and accountability, an attitude that is okay to cut taxes and increase spending, the national debt at 12 trillion is no big problem, that the government is responsible even liable for the mistakes of individuals, that financial engineering is more important than manufacturing stuff, that the financial titans deserve to be among the most highly compensated "talent" in the U.S,  and the increasing wealth disparity.   This brings me to a discussion of the pricing today of treasury inflation protected securities.

I touched on this topic earlier.  TREASURY INFLATION PROTECTED BONDS (TIP)As deflation concerns have accelerated over the past few weeks, the price of the TIP has continued to fall as regular treasury securities have risen.  In short, the market has punished the TIP for inflation protection.  If we enter an era of deflation, the price of the TIP ETF will continue to fall since the principal of the bond is adjusted for both increases and decreases in inflation,  so with negative inflation the amount of the bond would actually be reduced which is not good.  Reuters  Before this year,  the spread of a 10 year treasury compared to an equivalent treasury inflation bond was over 2%.  Now, they are virtually equivalent, which simply means that nothing is being paid for the inflation protection component of the inflation protected bond.   

I am in no hurry to add to my TIP position.  But I do agree with the article in this week's Forbes about inflation risk down the road caused by this year's events.  So I will be adding shares in TIP in small increments over the next year or so.

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