Deflation Has Bonds Looking Sweet

Earlier this year we wrote of how the stock market, as is custom, had one eye on earnings and the other on Federal Reserve monetary policy. At the time it was a draw as earnings woes and liquidity concerns took turns depressing investor sentiment. But in March the balance of bad news, particularly on the liquidity front, extinguished any legitimate cause for optimism that market sentiment would change, earnings would pick up and that the rising tide of layoffs would ebb.

One of the primary forces of the downward tug on the markets has been the nearly 5-year monetary deflation created by the tight monetary policy of Alan Greenspan, most visible in the dramatic drop in the most monetary of commodities – gold. From 1996 to the present, the price of gold has fallen as much as over $150 as a result of Alan Greenspan's refusal to supply high-powered money to the economy through the purchase of government bonds via the Federal Reserve's Open Market Committee (FOMC) transaction desk.

The result is that a monetary deflation has ripped through the entire United States economy – now claiming corporate profits as their latest victims. One of a handful of individuals who was ahead of their time in recognizing the impact that deflation would have on corporate earnings and therefore the risk to reward ratio between stocks and bonds was Michael B. O'Higgins of O'Higgins Asset Management. In 1999 he described what happens:

"...today inflation has practically been eliminated as a matter of much concern at all in our country. In fact, our economy may be entering a period of possible deflation. Even so normally cautious a reader of economic tea leaves as Federal Reserve Chairman Alan Greenspan has gone on record and voiced this possibility due to the number of portents he sees out there. Products and services in many areas of our economy are getting cheaper.

The price of computers, that prime fixture of the booming consumer electronics industry, is just one example. Today you can buy wan extremely powerful computer with all the bells and whistles for under $1,000, whereas just a couple years ago, a computer with a fraction of those capabilities would have cost you $2,000. Oil and cars are falling in price as well. When the price of its products drops, a company's profits do, too, which is bad for its stock, shrinking or eliminating the dividend income that stockholders look for and expect from their investment. If slumping prices begin to pervade an economy, and hold on, even for a while, the comparatively lower but fixed and steady income returned by bonds will seem not such a bad alternative."

And that is exactly what has happened.

Many economists seem confused over the indicators of the US economy because they have not been able to recognize the deflationary impact which has corporate profits falling while other macroeconomic indicators remain "normal". This scenario has caused some economists to say that the U.S. is in a "profits recession" as if the problem is somehow mysteriously isolated to corporate earnings, independent of other factors. They simply don't realize that the deflationary bug which first became visible in the falling price of gold in 1996 has now worked its way throughout the entire economy and has finally begun to pull down nominal corporate earnings.

Yesterday, the combination of a poor earnings report by Cisco and the revelation of the disappointing economic information contained within the Federal Reserve beige book, generated the most visible evidence yet of the increased recognition, on the part of investors, that the stock market increasingly is not the place to be and that bonds may now be a viable alternative. Yesterday, the entire bond market moved up in response to the news and changing sentiment. The 30-year Treasury bond jumped 1 9/32 to 98 2/32, pushing its yield down to 5.509%. The 10-year benchmark note rose 29/32 to 99 20/32, dropping its yield to 5.050%. The two-year note was 8/32 higher to 100 7/32, bringing its yield to 3.742%. Bond prices and yields move opposite one another.

And this week has been a good week thus far as quarterly government auctioning of bonds known as "refunding" has attracted more interest than usual. An $11 billion sale of reopened five-year notes, was held on Tuesday, and yesterday's sale of $11 billion of 10-year notes will be followed by $5 billion of bonds today.

The high level of interest in bonds caught many by surprise. Prices rose yesterday after many Wall Street dealers found themselves outbid in the government 10-year note auction, this forced theses dealers to rush to cover short positions that they established ahead of the sale.

Prices then rose even further, pushing bonds close to a full point higher and two-year note yields down close to 8-1/2-year lows, on the government's release of its quarterly anecdotal survey of economic trends showing weakness spreading beyond the industrial sector – known as the "beige book".

The two-year note's yield of 3.73% was the lowest yield since Oct. 1993. And the 30-year note's yield of 5.51% was the lowest it has been since April of this year.

Investors who are moving toward the bond market are now determining where they want to park the cash that they are taking out of stocks. Among the most popular options for them is to either place their money in short-term securities like 1-year Treasury Bills or in the 30-year long bond.

Historically, T-bills have, on average, offered only half a percent return in real interest, when one factors inflation. But in this deflationary environment we believe the real return of interest is at least 4 to 6 times that. If one were to simply buy T-bills and hold them in their portfolio until maturity they could earn a real interest return equal to the nominal rate of the bill, which is currently 3.37%.

In addition T-bills are exempt from state and local taxes and the investor can defer the interest on federal income taxes into the next year. So if you bought a T-bill in January of 2001 which matured in January 2002, you would not have to pay taxes on the interest until April 15, 2003 which would mean that in a deflationary environment you would have 2 and a half years to watch deflation and interest make dollars that you hold in 2003 more valuable than when you held them in 2001.

The T-bill rate of 3.37% may not look attractive until one considers the deflationary environment and history. As O'Higgins explains, "...from the end of the 1929-1932 Great Crash, when T-bills were paying a nominal return of 2.7 percent a year, roughly similar to that of the 1932-1980 period (2.8 percent), the country was experiencing 4.4 percent a year deflation. As a result, the real return on T-bills during that period of time was 7.1 percent. This may not seem like much to today's bull marketeers, but if, for example, you were to look at the performance of small company and blue chip or other large company stocks during that same period, they were producing minus 18.2 percent and minus 3.3 percent negative returns per year, respectively. So, that 2.7 percent a year earnings in nominal terms and 7.1 a year earnings in real returns given off by T-bills – versus losing money in the stock market – would have felt pretty good indeed".

On the other end of the spectrum the long bond can bring even greater returns in this deflationary environment as the bondholder not only receives a regular fixed interest payment known as a coupon but also earns a capital gain as bond prices rise.

Stephen Shipman, executive vice-president and portfolio manager, George D. Bjurman & Associates, Inc. told us that bonds are looking better every day because of the effect that the monetary deflation is having on the stock market, " Most equities will trade sideways to down as they adapt to the deflationary environment. If gold can stay within the range of $250 and $275 per ounce and bonds trade below 5 percent, than an investor can reap significant returns in this environment, on the combination of the capital gain and coupon payment on bonds."

Already it appears that more are realizing this as money pours into bond funds in increasing amounts as the bond market outperforms the stock market over the last few months.

As deflation continues to take its toll not everyone has to lose.

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The above does not constitute a financial investment advisory. All readers are strongly encouraged to seek the advice of a financial adviser or licensed investment professional prior to making any investment in either the domestic or international stock or bond markets

Cedric Muhammad

Thursday, August 9, 2001

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