- Economic-Political Commentary -

September 18, 2010 (FinancialWire) (Investrend Forums Syndicate) (By Dr. Albert M. Wojnilower) — Editor’s note: For our readers with an interest in treasury bond ETFs such as the PIMCO 25+ Year Zero Coupon U.S. Treasury (NYSE: ZROZ), the Vanguard Extended Duration Treasury (NYSE: EDV), the SPDR Barclays Capital Long-Term Treasury (NYSE: TLO) and the iShares Barclays 20 Year Treasury (NYSE: TLT), FinancialWire(tm) contributor Dr. Albert M. Wojnilower offers some informed insights:

The outstanding investment of recent times has been U.S. Treasury obligations.  Although Treasury note and bond prices have gyrated along with the other instruments being played in the financial casino, huge volumes have continued to trade uninterruptedly even in times of crisis.  Amid downtrends in real estate, equities, and many other sovereign bonds, Treasury prices have soared.

The uptrend in prices clearly has not been due to any scarcity of new issuance, whether actual or expected.  Enormous budget deficits are virtually certain for years to come.  Meanwhile the two principal buyers, the Federal Reserve and China, have stopped adding to their holdings.

These negatives notwithstanding, the publics of the world have decided that, when sizable amounts are at stake, U.S. Treasury securities (or instruments directly or indirectly guaranteed by the Treasury) are the preferred, perhaps the only, global store of value.  They are turning their backs on bank deposits, many sovereign credits, and other assets and markets where corruption has forfeited the public’s trust.  That is why the demand for Treasuries seems insatiable.  The Treasury has become the printing press (more precisely, the electronic depository) for the world’s precautionary balances, a service for which we collect huge seigniorage in the form of lower-than-otherwise interest rates on our debts.

For the world’s economy in general and the sluggish U.S. economy in particular, however, the overwhelming predominance of U.S. Treasury obligations is a mixed blessing.  It leads to the chronic overvaluation of the U.S. dollar because of the bloated capital inflow.  It also creates the potential for abrupt rises in interest rates whenever the public deems the future less threatening and decides to reallocate its capital in more risky directions.  But the most serious flaw for now is that, in contrast to rising prices of private securities which sooner or later generate more physical investment, the higher prices of Treasury securities do not stimulate more government spending and borrowing. Yet that may be the only way to fill the world’s need for a cushion of safe assets before it takes on more business risk.

At this time in the U.S., the ideological aversion to deficit spending is deep.  Who dares to advocate larger budget deficits in the longer run as well as the present?  Since deliberate increases in Treasury debt require greater-than-planned Federal spending and/or tax reduction, they are not going to happen in the foreseeable future.  Neither, therefore, is a material quickening of U.S. economic growth.

Paralleling the turnabout in budgetary ideology from years of indifference to today’s panic, is the Fed’s new-found aversion to prolonged monetary ease after years of careless accommodation.  Before and especially since the post-Lehman crisis, Fed economic forecasts have been too optimistic.  As a result, policy-makers have chosen to focus on how to exit from or reverse “undue” ease, rather than on how to broaden financial-institution rescues into help for the real economy.

Paradoxically, the Fed has chosen to reward banks for inaction by paying interest on their idle excess reserves, when it should be taxing such holdings (through negative interest rates) so that they will be used more actively.  Although bank examiners are now belatedly concentrating on making banks’ loan portfolios “squeaky clean,” simultaneously Fed policy-makers should be at work making sure that lenders continue to incur at least the routine risks needed to sustain economic activity.  So-called “quantitative easing,” which probably is coming soon (however grudgingly), will help only if it eases credit for small business and household borrowers.  Large firms are generally cash-rich and already pay de minimis interest rates on borrowings, reflecting strongly rising profits on sluggish sales volume.  Needed is a Fed guarantee for a portion of small loan portfolios, as in effect was done for open-market commercial paper when that market was in free fall.  Or the Fed might guarantee or acquire tranches of packaged education or small business loans.  This would be more useful than buying hundreds of billions more of Treasury securities which, as explained above, are already scarce relative to demand.  But for the Fed to innovate in such ways is almost as unlikely as it would be for Congress to take measures deliberately designed to increase the budget deficit.

In fiscal as in monetary policy, the original “stimulus” was much too narrow and small, and attention quickly shifted to limiting it as soon as the worst of the financial crisis had passed.  The Administration’s economic forecasts, probably based on models similar to those used by the Fed, were and remain overly optimistic.  Among their other shortcomings, models ignore uncertainties, such as next year’s tax rates, which seriously impede private economic decision-making.  Perhaps these uncertainties will soon be mitigated by some political deals, but such resolution may be months off and cannot be taken for granted.

These quarterly letters have consistently taken the view that U.S. economic recovery would be slow.  At times this view has been regarded by other commentators as pessimistic, and at other times as optimistic, with the consensus shifting frequently depending on surface noise in the statistics.  All along, however, the underlying economic outlook has remained unchanged.  GDP growth in the second half of this year will probably average near 2% and speed up some in 2011. Construction and auto production are probably near their lows, while retail sales are creeping higher.  The Fed will not raise short-term rates, much as some members would like to, and high-grade bond yields are more apt to fall than rise.

The change in monetary and fiscal policy ideology raises the probability that later on, perhaps in 2012 after unemployment has started to shrink, policies will tighten prematurely.  No “double-dip” in the economy is impending soon, but a policy-induced slowdown or recession is likely before anything resembling full employment is restored.

Source: Dr. Albert M. Wojnilower, Craig Drill Capital.  Go to http://www.financialwire.net/2010/04/30/craigdrill-capital/ for important disclosure/disclaimer information and more about Craig Drill Capital.

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