Tuesday, August 10, 2010

Quantitative Easing Redux?/More on Investments for Deflation/Bought 50 PFX at 16.12/Sold 50 OKSB at 13.19

1. Another Round of Quantitative Easing?: A few weeks ago, the pundits were saying a prayer over the grave of the Euro and announcing the ascendancy of King Dollar. Now that the EURO has regained its footing and the USD has resumed a decline against most major currencies, the talking heads have given up on the USD and found a new crisis brewing. Based on the recent small decline in the CPI, which remains in positive territory year-over-year, the brainiacs are now forecasting a Japanese style stagnation lasting for years or even decades. Consequently, these pundits are already urging the Federal Reserve to embark on another quantitative easing campaign to jump start inflation, as I understand the underlying basis of this theory. The Fed ended its earlier program in March 2010, having purchased 1.7 trillion dollars of treasury debt, GSE debt and mortgage-backed securities with money created by it.

Jonathan Laing in a column in this week's Barrons summarizes the arguments given by those who favor this approach now. Jan Hatzius, the chief economist for GS, believes the FED will return to "unconventional monetary easing" late in 2010 or early 2011 with the purchase of at least 1 trillion more in assets. NYT

Back in March 2009, I discussed the relationship of quantitative easing launched by the Federal Reserve shortly before FDR's inauguration in 1933 and the subsequent spurt in GDP growth and one of the most robust stock market rallies in history. Stock prices quadrupled during the Great Depression period from 1933 to 1937 after the 80% or so collapse between 1929 to 1933. Stock Rallies and Quantitative Easing If the Fed embarks on another QE campaign, I would anticipate that the USD will accelerate its decline, as its value is cheapened by money creation. Bonds would most likely fall based on renewed fears of inflation creation. Stocks and commodities would probably rise as investors reassess the prospects for GDP growth and corporate earnings. (see generally: Quantitative Easing May Change Stock Market Dynamics) Though, there is no guarantee that such a program will accomplish any of those results, but that would be the playbook based on history. The most recent proof would be what happened in all of those markets after the FED embarked in 2009 on its quantitative easing program.

It would not be surprising to see the Fed restart massive money creation when and if the economy starts to sputter. This may start to occur when fiscal stimulus winds down and additional options for fiscal stimulus are already practically non-existent given the budget deficit and the current political situation. A worsening in unemployment may be another factor causing the Fed to pursue quantitative easing again.

Quantitative easing may prove more beneficial over the short term than other policy prescriptions. However, money creation does not address the structural problems created during the Age of Leverage and may aggravate them when coupled with a continuation of zero short term interest rates. One structural problem is that consumers borrowed and spent too much money and consequently saved too little. It will just take time for that kind of structural problem to correct itself. Keeping interest rates at zero aggravates that problem, as individuals are deprived of any return on their savings. The current 2 year treasury yield of around .5% indicates that the market currently believes that the federal funds rate will remain near zero until 2012.

2. Investments for a Deflation to Low Inflation Scenario: I previously discussed some of planning for this scenario which I do not view as the likely one over the intermediate or long term. Coping with the Federal Reserve's Jihad Against Savers & Responsible Americans & the Potential Major Correction in Bonds Down the Road This article in the WSJ also discusses investments for a deflationary environment. I discussed in the preceding linked post the categories of investments mentioned in this WSJ article, except for zero coupon treasury bonds which I do not currently own. The article quotes a financial advisor from Nashville who believes that zero coupon treasury strips provide the "best protection" as a deflation hedge.

Treasury zero-coupon bonds are created by the financial industry. The interest and principal portions of the security are separated. The zero coupon bond does not pay interest and is sold at a discount to its par value. Zero Coupon Bonds Types of Bonds

The Nashville based financial advisor may be correct in his contention, but treasury strips would also be a bad investment in the event inflation starts to accelerate and treasury bond prices fall. The strips will give an investor more bang for the buck when treasury bond prices are rising (and yields declining), but the converse is also true. The strips would be one of the worst investments in a rising rate scenario since there prices would decline more than comparable maturity bonds . And, importantly, treasuries will be more sensitive to interest rate increases than other types of bonds as explained in this T. Rowe Price publication from the Spring of 2010 at page 9: individual.troweprice.com Spring 10.pdf

Given the tax issues with strips, I would buy them only in a retirement account. Bond Taxation Rules eHow.com I am familiar with one ETF that invests in treasury strips, EDV, that is offered by Vanguard. Vanguard - Extended Duration Treasury ETF - Overview Late last year, EDV had a short term capital gain distribution of $11.108, Vanguard - Extended Duration Treasury ETF - Distributions. That would be another reason for owning it only in a retirement account. I have no position in EDV based on my views that inflation will be the end result of too much fiscal and monetary stimulus maintained for too long.

There are also some mutual funds that invests in zero coupon bonds:

American Century Target Maturity 2015 BTFTX - Fund Top 25 holdings
American Century Target Maturity 2020 BTTTX - Fund Top 25 holdings
American Century Target Maturity 2025 BTTRX - Fund Top 25 holdings

I have no position in any of those funds. In addition, the treasury strips are actively traded which gives the investor the option of buying individual securities and holding them to maturity.

I do own a small amount of a trust certificate that contains a treasury strip as one of its sixteen underlying securities. Bought 100 of the TC IPB at $16.99 Calculations On How to Recreate Trust Certificate IPB

3. Bought 50 PFX at 16.12 (see Disclaimer): PFX is a senior bond issued by the Phoenix Insurance Company (PNX) that is deservedly rated junk. I am most likely a short term holder of this security due to my opinions of its credit risk, an opinion manifested in the minimal investment made yesterday. The coupon is 7.45% on a $25 par value. This translates into a 11.55% yield at a total cost of $16.12. Interest payments are made quarterly with the last ex date in late June. That kind of yield suggests heightened danger in the current rate environment.

The bond matures on 11/15/2032.

This is a link to the prospectus: www.sec.gov

I have successfully traded PFX in the past, noting on more than one occasion during the Near Depression period that its price movement was causing heartburn to the OG and was even too wild for the LB. Phoenix Senior Bond: To Wild for LB/ Sold PFX at $17.57/ PHOENIX SENIOR BOND: PFX /

The recent earnings report that showed a operating loss led to a small downdraft in this bond's price. THE PHOENIX COMPANIES 10-q For Q/E 6/2010 One of the main problems is that Phoenix lost its main distribution channels for its annuity products in 2009, as both State Farm and Nationwide dropped Phoenix products. Those firms accounted for around 80% of annuity deposits and 30% of life insurance sales. Phoenix is trying to develop new distribution channels but it remains to be seen whether those efforts will successfully resurrect its business.

I view PFX as high risk.

4. SOLD 50 OKSB at $13.19 (see Disclaimer): LB, now in charge of the trading desk, is going to be more aggressive in managing the regional bank basket strategy. For those banks with a large percentage gain, and no or minimal dividend support, serious consideration will be given to harvesting the gain. OKSB was bought at 6.84 in January 2010 and currently pays no dividend. The last small dividend was paid before the bank entered into a memorandum of understanding with the Controller of the Currency on 1/27/2010 (item # 10 OKSB). While the last earnings report was better than expected by the analysts (item # 3), the 2011 consensus estimate of 4 analysts is only 63 cents (OKSB), which gives the stock a forward P/E of almost 21. Given the large percentage profit, the lack of a dividend, and the current valuation, the Stock Stud decided to harvest the profit.

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