Uncharted Economic Waters

It does not matter how you measure it, the US Treasury yield curve is at its steepest level ever. Away from that, the value for expected five-year inflation, five years from now is at its highest level ever, excluding the noise that we had as our markets crashed in the fourth quarter of 2008.

This concerns me. Anytime we hit new extremes on critical financial variables, it makes me think, “What next?” Treasury yield curve slope and inflation expectations are fundamental. Reaching unprecedented levels is a big thing.

Could the US Government ever face the possibility that it could not meet its obligations? I think so, and a record wide yield curve is one of the things that I would see prior to such troubles.

Last week, I had dinner with my friend Cody Willard. His favorite idea was shorting long bonds. I indicated that I had some leaning that way but could not go all the way on that idea, as the Federal Reserve had the option of inflating during the Great Depression, and did not do so. Cody said something to the effect of “but we have so much less flexibility today.” Can’t argue with that, though I wonder whether politicians and bureaucrats favor foreign claims over domestic claims. Would they bankrupt Americans to pay off foreign claimants? Yes, they might do that. It has happened before.

Cody might be on the right track, but the steepness of the yield curve may fight him. It is very, very hard to get a yield super-steep without something breaking — inflation running rampant, etc.

The greater worry from my angle is the US pursuing Japanese solutions that have failed miserably over the past 20 years. Japan continues to follow failed Keynesian ideas, fostering a low return on asset culture, with all of the failed projects financed by very low interest rates. Now we do the same. The Fed runs a low interest rate policy via Fed Funds and buying mortgage bonds.

All that does is reinforce mediocrity by enabling assets with low returns to be financed and survive. Better that many of those should die, and the capital be released to more profitable uses.

All of this is the price for not allowing recessions to be deep — now we have to clear away bad loans bigtime. But who has the courage to do that? Certainly not our government. They avoid all short-term pain, leading to long-term problems.

That’s where we are now, in uncharted economic waters.

About David Merkel 144 Articles

Affiliation: Finacorp Securities

David J. Merkel, CFA, FSA — From 2003-2007, I was a leading commentator at the excellent investment website RealMoney.com (http://www.RealMoney.com). Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and now I write for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I still contribute to RealMoney, but I have scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After one year of operation, I believe I have achieved that.

In 2008, I became the Chief Economist and Director of Research of Finacorp Securities. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm.

Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.

I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

Visit: The Aleph Blog

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