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Feb. 14, 2012, 12:01 a.m. EST
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Michael A. Gayed, CFA, is chief investment strategist at Pension Partners, LLC. , where he helps structure portfolios and develop strategies to maximize the amount of time and capital spent in potentially outperforming investments. Prior to this role, Gayed served as a portfolio manager for a large international investment group, trading long/short investment ideas in an effort to capture excess returns. From 2004 to 2008, Gayed was a strategist at AmeriCap Advisers LLC, a registered investment advisory firm that managed equity portfolios for large institutional clients. In 2007, he launched his own long/short hedge fund, using various trading strategies focused on taking advantage of stock market anomalies. Follow him on Twitter @pensionpartners and YouTube youtube.com/pensionpartners.
By Michael A. Gayed
"Things don't go wrong, they simply happen." Jacob Ghitis
I think its relatively safe to say that SuperBen and the League of Extraordinary Bankers want to be wrong.
There has been quite a bit of debate in recent weeks regarding the Fed's ZIRP (Zero Interest Rate Policy) extension to 2014. On the one hand, it's clear that the ultimate fear all bankers have is for a deflation-like scenario to grip the U.S. economy as it has for Japan following the 1989 top in the Nikkei. In an effort to counter this, Bernanke not only told the market that interest rates likely will remain low for an even more extended period of time, but also that the Fed explicitly wants to achieve 2% inflation.
Inflation in a highly leveraged society is effectively the lesser of two evils. I say this because with deflation, the debt load that's already been incurred becomes heavier and heavier as fewer dollars are circulating throughout the economy to pay off those liabilities. Deflation benefits savers since dollars become worth more, while inflation benefits borrowers since debt becomes worth less.
So the Fed wants to fight off deflationary concerns resulting from a European growth austerity-driven slowdown, and remove the "tail risk" of a bank failure similar to what happened in 2008 with Lehman. However, the Fed in truth wants to be wrong about its future outlook for the economy. It doesn't want the low growth environment to persist because the world needs some combination of growth and inflation to pay off years of accumulated debt. Note that I am not making a moral argument here about this being right or wrong, but rather a comment on the real macro issue that central banks face.
Markets seem to be anticipating that all of this will result in another round of asset purchases and quantitative easing (popularly known as QE3). I am fairly certain that the Fed would prefer to NOT implement this because if the recent economic data continues to get stronger and Europe (for now) is resolved, then it means the deflation scenario they are so afraid of may not actually come to pass, resulting in them not having to further attempt to stimulate the economy and increase animal spirits.
The ultimate indicator now of seeing whether the Fed will be right or wrong ultimately is the long bond itself. While it seems to be commonly accepted now that the Fed will attempt to further depress long-dated bond yields, the recent action in the bond market seems to be suggesting that deflation expectations are no longer as severe a concern.
Why do I say that? Take a look below at the price ratio of the iShares Treasury Bond 7-10 Year ETF /quotes/zigman/1480156/quotes/nls/ief IEF +0.21% relative to the iShares Treasury Bond 20+ Year ETF /quotes/zigman/1480195/quotes/nls/tlt TLT +0.53% . As a reminder, a rising price ratio means the numerator/IEF is outperforming (up more/down less) the denominator/TLT.
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Click here to enlarge chart .
The above chart is one way of seeing if the yield curve on the long-end is flattening (downtrend/deflation concerns) or steepening (uptrend/inflation pulse). We can clearly see how severely the trend declined as the Summer Crash unfolded last year. The ratio since October has been in a wide sideways trend, but now does appear to be in the early stages of an uptrend.
As I have noted numerous times, when inflation expectations are rising, that is a bullish environment for stocks relative to bonds. A continuation of the relative trend means investors are now anticipating reflation to occur. Notice that this is still in its early stages even with equities having a nice rally so far this year.
The implication is that the Fed's paranoia about deflation means they want to be wrong about their assessment, and investors in the bond market may be coming around to that idea. Don't fight the Fed when the Fed itself wants to lose.
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
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