Sunday, May 24, 2009

The US Dollar, Inflation and Bonds

Yesterday, I paid $2.70 for a gallon of gas.

The economy is in the tank, three friends told me they got laid off this week and I paid $2.70 for a gallon of gas. Why?
Did you notice the US Dollar this week? It is down -4.1% in 6 days. It is down -8.1% since April 21st.

Crater the Currency
In 1980, Paul Volcker said the following (I know I have written this a dozen times, but it is playing out before our eyes and is central to investing over the next few years) –

“At some point you need to make a choice between cratering the economy and cratering the currency.”

In 1980, Inflation was rampant and the only way to kill it was to increase Interest rates to shockingly high levels. Money Market yields spiked to 22%. The 30-year US Treasury spiked near 15%. This killed economic activity and the economy “cratered” (recession).

In 2008, we were (are) faced with Deflation. Deflation has the opposite “cure” of Inflation – you need to make everybody believe that the government will “recklessly” print money. This expectation of massive future Inflation becomes the “cure” for deflation (see Bernanke’s speech in 2005).

But what are the consequences of massive inflation?
The real cause of rampant Inflation is that foreigners no longer trust the currency and sell it. This causes the currency to lose purchasing power, making it harder to compete in the international marketplace for goods and services – making stuff more expensive to you and me.

The policy is to kill the Dollar and make everything cost so much that you and I have to take more risks with our money to maintain our standard of living. Nothing in any of these policies has anything to do with fixing the economy or building a middle class. It has everything to do with inflating asset prices and inflating away the real value of all of the debt we have as a country.

I have been a raving lunatic about how adverse the consequences would be from the horrible policy decisions of the US Government. I have been very afraid of the problems caused by Quantitative Easing and massive “Stimulus” designed to do nothing more than keep people working at inefficient jobs (think Government jobs) and prop up asset prices by making money artificially cheap (sound familiar Mr. Greenspan?).

US Dollar vs Crude Oil
Here are the charts of West Texas Crude ($WTIC) and The US Dollar ($USD). Since Obama told us all to buy stocks in early March, USD and WTIC have been mirror images of each other. Very simply put, people have been fleeing the Dollar and buying Real Assets to protect their purchasing power as the US, the UK and the IMF have created over $1.5 trillion of new paper money.

Now you know why I was (am) afraid. Inflation is the net result of all of this money printing. Inflation will be created by imploding real value of the US Dollar.

Nixon
In the early 1970’s Richard Nixon had the brilliant idea to try and force the economy to maintain a 3.5% Unemployment Rate. He tried this by increasing the money supply by 10% in a very short period. The result was Inflation. He took us off of the Gold Standard and cranked up the printing press (The Money Supply has been increased by 110% over the last year).

Price Controls
Because Oil and Agricultural Commodities (Food) are priced in Dollars, the price of Gas and Food went up – to unacceptably high levels. The pain of such high prices during a period of economic weakness led to the brilliant idea of controlling the prices and wages. This led to shortages and long lines for gas. We just increased the Money Supply at 11 times the rate of Nixon – how scr**ed are we?

The US Dollar is now at the “Line of Death” at 80. A break from here is devastating. A near term bounce and short squeeze should be anticipated.

If (when) the Dollar breaks long term support, we will see the price of stuff go parabolic. As an investor, you will need to own a lot of Real Assets. Not Real Estate, because it is valued in US Dollars and will see its purchasing power devastated by the falling Dollar, but Raw Materials. Raw Materials can be very efficiently owned through ETFs that trade anywhere from 3 million to 30 million shares a day.

Bond Prices
I have had a lot of inquiries lately from people looking to get higher yield from longer maturity bonds. For several years I have been warning of the impending Inflation Wave and the surge in Interest Rates which will inevitably accompany it.

Real Bond Prices
Here is a chart of the performance of the 30-Year US Treasury Bond adjusted for Inflation. Taking the annual return of the Bond and subtracting the Annual Inflation Rate, you get the after-inflation Rate of Return – the “Real” rate of return. In times of inflation, the “Real” return on Bonds can be very negative!
This chart makes it fairly clear that Bonds have incredibly long periods of sustained real gains and real losses. From 1940 – 1981, you lost more than half of the Real Value of your bond portfolio. Holy cow. Remember, this chart takes into consideration the fact that the annual interest payments on the bond are being reinvested.

In 1982, Interest Rates peaked and have been falling ever since. These falling rates have led to a quintupling in the Real Value of these Bonds.

I obviously like charts, and I am telling you that crashes tend to occur after a 500% to 600% run in an asset class. This chart of US Treasuries looks like Real Estate in 2006, Emerging Markets in 2006, The NASDAQ in 2000. US Treasuries are Grandma Money and Grandma is gonna get killed in these things…

So Where Can You Hide?
Here is a chart comparing the return of the 3-Month Us Treasury Bill (3-Month) versus the Consumer Price Index (CPI). As you can see, the compounded return of the 3-month Treasury kept up with inflation through the bulk of the inflation wave through the 1970’s. Short Term is where you want to focus your money.

You want to do this, because the Short Term holdings will see their Interest Rates reset much more quickly as inflation increases. Here is the chart of the 3-month US Treasury yield (IRX) versus the CPI (Inflation). IRX does a very good job of capturing most of the increases in CPI for investors.

Inflation started to uptick in 1967 and was finally “cured” in 1982. Here is how the 3-Month and the 30-Year Treasuries performed –

I will continue to focus on protecting principal from the ravages of inflation versus trying to get a higher short term yield from longer maturity bonds.

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