Long-time market observer Victor Sperandeo penned a well-worth-reading editorial commentary in the December 20 issue of Barron’s. He argues from history that when governments cannot borrow, hyperinflation is frequently the result.
Developing his thesis, Sperandeo points out that since the French Revolution in the late 1700s, hyperinflation has frequently occurred when governments borrow more than 40% of their expenditures over an extended period of years. If the U.S. Government had borrowed the full amount of its budget deficit in fiscal years 2009 and 2010, the borrowing rate would have exceeded 40% in each year. While the Congressional Budget Office projects that rate coming down in the years immediately ahead, the projection is based upon a real GDP growth assumption of 4.4% annually from 2012 to 2014. Such growth looks highly unlikely in light of Fed Chairman Ben Bernanke’s recent projections about housing and unemployment.
For several years we have asserted that the ability of the U.S. Government to fund its deficits at reasonable interest rates will depend upon investor confidence that they will ultimately be repaid in dollars that retain the vast bulk of their purchasing power. With the Fed’s having committed to inflate its balance sheet from $850 billion to over $3 trillion in just three years, that prospect of retained purchasing power has to be called into question. When confidence disappears, investors sell their bonds, rates rise and, in extreme situations, hyperinflation unfolds.
Notwithstanding today’s uncomfortable budget statistics, such a hyperinflationary event remains an outlier. Countries around the world all have a stake in maintaining a relatively stable financial system. At the same time, recent Fed actions are increasing the potential for hyperinflation. Sperandeo reaches essentially the same conclusion that we have voiced for the past several years since interest rates approached half century lows. We retain our conviction that while the Fed may succeed in keeping rates low in the short run with its aggressive buying program, the penalty for being wrong in the bond market over the next couple of years is far greater than the reward for being right. That’s a poor risk/reward equation.
Despite the longer-term concern, we committed twenty percent of our Controlled-Risk Flexible Allocation portfolios’ assets to the 30-year U.S. Treasury bond last week at 4.6%. That was just two ticks below the 4.62% peak in the bond’s rate surge from below 3.5% in late-August. While we are not making a long-term judgment about interest rate direction, we believe that the rate rise has been overdone, at least in the short run. Should deflationary or disinflationary conditions prevail in the period ahead, we might hold the position for quite a while. On the other hand, should inflationary pressures appear, we may move away fairly quickly. So far rates have come down rapidly in the first week of our holding the position.
The dramatic rate rise of the past four months has turned investors’ earlier strongly bullish outlook on bonds to strongly bearish. At extremes, such sentiment levels can be helpful contrary indicators. In light of inflation, economic growth and budgetary prospects, the run-up in yields has returned the long bond to fair valuation relative to other securities’ yields. And the spreads between the 30-year yield and yields on much shorter maturities have ballooned to record levels, promoting the probability of a profitable flattening of the yield curve. At the very least we anticipate a positive short-term return, which could turn into a longer-term position if inflationary expectations can be harnessed. Hyperinflation, however, cannot be ruled out.
We wish you and yours a very Merry Christmas.
Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.