"Treasuries - A Cautionary Tale?"

Sydney M. Williams

Thought of the Day

“Treasuries – a Cautionary Tale?”

February 18, 2010

Year to date, the S&P 500 is down 1.4% (and up 4.0% from its low ten days ago). Investor confidence, as measured by State Street, peaked during last summer 120.6, has since waned to 107.9 (January), essentially the same level it was at last May. The next release will be next Tuesday, February 23. One would expect the number to be lower.

Reflecting sentiment, Treasuries have rallied, with the spread between the Ten-year and the Two-year, according to Bloomberg, at a record level. – 290 basis points. The Treasury Curve has steepened along all maturities. After a year in which Treasuries were one of the poorer performing asset classes, they have begun 2010 strongly; risk has been relegated to the back seat.

However, MarketThoughts this morning writes, “…as measured by the ECRI Future Inflation Gauge and inflationary expectations stemming from TIP prices, expected CPI inflation over the next 12 to 18 months has now risen above 3%.”

If these numbers are accurate, in terms of inflationary expectations, it puts the Federal Reserve in a tough position, as those numbers and expected modest GDP growth portend the possibility of stagflation. Current strength in the Treasury market may encourage the Fed to begin shrinking its balance sheet by selling some of their Treasury holdings and mortgage backed securities. I also believe, as I wrote in December, that the Fed may choose to raise the Discount Rate (the rate the Federal Reserve charges depository institutions) sooner rather than later. The FOMC’s next scheduled meeting is March 16.

Of course, we may well be underestimating the strength and durability of the economy. Industrial Production, out yesterday, was up for the seventh month and leading indicators, out at 10:00AM today, are expected to show at 0.5% increase, which would be the tenth month in a row. It begs belief to expect the consumer to lead economic growth, though he will remain the largest component; so for growth to exceed expectation we must rely on government, the rebuilding and restocking of inventories, business investment and exports.

Exports have risen from 5.3% of GDP in 1968 to 13.1% in 2008, based upon strength in emerging economies. That growth occurred during periods of dollar strength and weakness; the key has been the dismantling of protectionist measures and the opening of free trade agreements. The President has promised to double exports over the next five years. That optimistic prediction is possible, but depends on continued strength in BRIC nations, reinforcement of NAFTA and CAFTA and Congressional approval of trade agreements with Colombia and South Korea.

Inflation expectations of 3% plus are not reflected in Treasuries with the yield of the Ten-year at 3.73%, so either rates will rise or the ECRI Future Inflation Gauge will prove a false signal. My personal opinion is that Treasuries look rich and stocks represent more attractive value.