Banking & Finance and Federal Reserve Bank and Investing and Opinion and Investing Column and Bonds and Wealth Management

SKARBECK: Fed's monetary policies drag down bond returns

April 2, 2011

Ken Skarbeck InvestingWhen the manager of the world’s largest bond fund sells completely out of U.S. Treasury securities, it is time to sit up and listen.

Bill Gross of the Pacific Investment Management Co.’s Total Return Fund, fondly known as the “Bond King,” eliminated all U.S. government debt holdings in his $237 billion dollar fund in February, saying investors aren’t being compensated enough for the risk in holding them.

Gross wrote in his monthly letter that yields are about 150 basis points (1.5 percent) too low when viewed historically. As such, Gross thinks the current 10-year Treasury yield of 3.4 percent should be closer to 5 percent.

Other bond gurus are in agreement. Highly respected Dan Fuss of the $150 billion Loomis Sayles Bond Fund thinks interest rates will begin to rise for a long time. A Wells Fargo bond manager called the end of the 30-year bull market in bonds the “biggest sea change we are seeing in our careers.”

Back in 1981, interest rates reached a historical peak when former Federal Reserve Chairman Paul Volcker raised the fed funds rate to 20 percent to fight inflation. Today, fed funds are targeted by Fed Chairman Ben Bernanke to range between 0 percent and 0.25 percent.

What has these observers worried is the massive monetary stimulus being carried out by the Fed under the moniker of QE2 (quantitative easing, round 2). The term is economic-speak for the Federal Reserve’s practice of buying Treasury and mortgage securities on the open market to increase the money supply.

The Fed’s goal in QE2 is to inject $600 billion into the financial system and keep interest rates historically low, while in the process stimulating the economy. Eventually, officials hope the economy will regain enough momentum to move forward on its own and these measures will end.

Critics believe quantitative easing is doing more harm than good. Gross wonders whether it heals or just covers up our economic problems. He notes that the Fed has been responsible for buying 70 percent of the annual issuance of U.S. government debt since the start of QE2. So he asks the question, “Who will buy Treasuries when the Fed doesn’t?”

Foreign buyers with surplus reserves, like China, will buy some, but there is likely to be fewer buyers. Hence, interest rates will need to rise to attract investors.

Another sign that interest rates are likely to increase—U.S. debt has nearly doubled since 2006, to $9 trillion. And the budget deficit will be nearly 10 percent of GDP this year, the highest since World War II.

There are three ways to reduce government debt: raise taxes, cut expenditures or inflate our way out. It is impossible to reduce the debt by raising taxes alone. When it comes to cutting expenditures, the only way to extract meaningful deficit reduction is to attack the entitlement monsters—Social Security and Medicare. Unfortunately, politicians have not shown the fortitude to address these unfunded, irresponsible promises.

Therefore, investors like Warren Buffett conclude that the government is on the path to the third unpleasant option—inflation.

Inflation is a sinister sort of tax that confiscates wealth. Investors who cannot earn above the rate of inflation are doomed to lose purchasing power. Bonds will lose value in an inflationary environment as interest rates rise. Which explains Buffett’s recent pronouncement, “I would recommend against buying long-term fixed-dollar investments.”•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.

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