Irrational Fears Of Inflation And Default Leading To An Opportunity In TLT
Fear of inflation has been part of the mainstream investment zeitgeist for the past year, and along with the debt ceiling, has contributed to higher bond yields. In this excerpt from our weekly summary analysis we make the case for lower 10-year rates and higher prices for TLT.
Inflation
The mainstream fear that inflation is now permanent, comes from the same misunderstanding of inflation that was being promulgated by the Austerians after the GFC; insisting that too much money supply causes inflation. Inflation is not solely a monetary phenomenon — if it was, we would have had inflation as a result of the stimulus that followed the GFC, and Japan would have hyperinflation.
Inflation is a supply issue. Shortages lead to price increases, and shortages can be caused by monopolies (the 1970’s oil embargo) or by production disruptions of various types. The current supply disruption is a direct result of the Global economic shutdown. Since the economy is not at full capacity, the current supply issues are temporary and will be fixed. In the case of real and persistent inflation, the economy has to be at full capacity (maximum resource utilization) and incapable of increasing supply. That, is not the current situation; capacity is at only 75% (chart below).
Source: FRED
Inflation in energy prices is transitory, as can be seen in the backwardation of oil futures prices, Prices are lower for future delivery (chart below).
Source: ANG Traders, highcharts.com
Industrial commodities, like lumber and copper, and transportation costs, as measured by the Baltic Dry Index, have started to drop rapidly (chart below).
Source: ANG Traders, stockcharts.com
Interest Rates and TLT
The 10-year bond rate, which had risen with the commodities early in the year, started falling over the summer along with lumber and copper. However, when the debt ceiling was reached at the end of August, rates sprinted higher, once again, because of fear that the US could default on its obligations (chart below).
Source: ANG Traders, stockcharts.com
This fear of default is irrational; the US is monetarily-sovereign and cannot run out of money and be forced to default.
How-on-Earth can the US be considered three-times more likely to default than non-monetarily-sovereign Spain? Spain could run out of Euros because they are only users of Euros, not creators of Euros, but the US is the monopoly creator of dollars and can never run short of dollars (chart below).
Source: www.wj.com
This irrational fear of US default has led to a mispricing of US debt that we have been taking advantage of for months with our investment in the i-Shares 20+year Bond ETF, TLT.
With the $480B extension to the debt ceiling in place, the clear statement from the Fed that rates will not rise anytime soon, and with the Q3 GDP coming in at 2%, the irrational fear of the US defaulting and the Fed raising rates is fading. Rates are starting to come down and TLT is rising (chart below).
We expect 10y rates to continue to trend lower, and TLT to continue moving higher.
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