Here’s the news of the week – and how we see it here at McAlvany Wealth Management:
1. Is the Fed Laundering Treasuries? The universe of fixed income investments is far more impaired than it appears to be. Today we will look at two anecdotes and one treasury report suggesting that deterioration in the credit market is worse than commonly thought. As we mentioned last week, there are fixed-income investments that are currently under pressure. We expect this to intensify (like a throbbing pain – sometimes worse, sometimes better) over the next several months, as the structural changes in the interest rate market are acknowledged and adapted to. What can you expect? You can expect a great number of friends and family members to start complaining about losses in what they thought was a “safe, non-volatile” market.
I was reminded today, just as I was reminded early this year, that the assumption of liquidity by investors may be dangerous in volatile credit markets. This applies to income-producing real estate (personally held or securitized products such as REITS), bonds, and other income vehicles. As rates rise, this will be ever more the case.
Earlier this year, I counseled an investor who held an interest in an income-oriented limited partnership that had a generous redemption clause. That clause was enough to sway the person from ever asking for redemption of shares. I suggested he test that out. Six months later, not a dollar has been released. Implied or assumed liquidity is not liquidity.
Recently, a different client considered an additional contribution to his MWM account from an outside investment. Now, weeks into the process, he has been told that his REIT, which used to pay over 6%, will now pay 1%, and redemptions of all shares have been suspended indefinitely. Zero liquidity. As much as we’d like to help that family, the die is cast.
Liquidity is something you don’t think about until you need it, and then it may not be achievable at all. Certainly, price factors into liquidity (anything can be done at a price). But at issue here is an underlying economic reality. REITS, muni’s, and many other fixed income investments are vulnerable to a deterioration in cash flow, which in turn impacts their ability to pay and may thereby impair both the price and liquidity of the asset. Cities and states come to mind, but the whole commercial real estate complex is equally affected, with leverage an element in that market.
With tenant defaults, higher vacancy rates, reduced rental rates, or any other interruptions to expected revenue, debt service or even solvency issues arise. In our current economic environment, this is happening on a grand scale.
What we should watch closely are the vehicles set up to obfuscate such liquidity and solvency issues. If you think I’m primarily concerned about REIT investors with a few million dollars locked up and inaccessible, you are partially right. The greater concern is with Treasuries. We look at the TIC data regularly to see the flows coming into and out of the treasury market. Lately, there is more selling than buying. Yet, the market is holding up reasonably well – all things considered.
What we don’t like are the monstrous purchases of Treasuries occurring from a single source. The Fed, you might suggest? No, perhaps more nefarious than that – the Fed by proxy, we think. Regular purchases (tens of billions at a time) are occurring in London. Yet the British are too cashed-strapped to justify the purchases. As pressure comes into the fixed income world, the powers that be would have us believe in highly functional and healthy markets. We suspect that nothing could be further from the truth. While there is talked about monetization, there is a good probability that it is occurring secretly as well. (Ratchet up your real-world inflation expectations, if you haven’t yet.)
We have described the art of redirection in the past. This occurs when something is revealed (in this case, by the Fed and Treasury) that is intended to distract you from something else you’re not supposed to see. Magicians practice this subtle art of deception when they fully occupy your attention so you overlook the simple tricks of the trade. Our grave concern for 2011-2012 is that the only factor holding the fixed income universe together is this flimsy game of obfuscation, artfully presented, but duplicitous all the same.
2. Interest Rate Risk for Gold? Recently, I have witnessed a few articles espousing the notion that higher interest rates would have a negative impact on the advance of the precious metals. While it’s natural to think that some Volker-style reaction to the mounting inflationary pressures is somewhere on the horizon, betting on substantially lower gold prices in response would, in our opinion, be premature – not to mention painful.
In fact, I will go so far as to say that higher rates initially, though likely to cause a minor setback, will only serve to push the metals to all new highs. Drawing from history for some technical proof, I have provided a few charts of the Fed’s target rate, the 10-year Treasury yield and gold, as they were in the last metals bull market of the 1970s. The time series for each is roughly the same, displaying the ten-year period from 1970 to 1980. You will notice one simple relationship: as rates rise, so does gold.
The Fed Target Rate (from 4% to 20%)
10 Year Treasury Yield (from 6% to 13%)
And Gold (from 36 to 800)
The fundamental reasons supporting this dynamic, though linear in nature, are a bit more complex in explanation. They require more room than we have to spare in this letter. However, this can be said about the causal effect of higher rates in response to inflationary pressures: Higher rates reduce borrowing, and thus consumer spending, and ultimately asset values. During this long and arduous process, there is a gradual and then accelerated flight to “safety” as productive assets (stocks, bonds, and real estate) adjust lower in real and nominal terms.
Rates have been held back. We are still largely at the tail end of a 30+ year bull market in bonds, suggesting that the major adjustments to the metals markets are ahead of us. So, contrary to what some might believe, it may be some time before the metals lose their luster.
Have a great weekend.
David McAlvany
President and CEO
MWM LLLP
David Burgess
VP Investment Management
MWM LLLP
