Holding Steady in the Face of Market Volatility

Anyone who has even a passing interest in financial news and the investment world knows that we are in a period of unusual events and uncertainty. Although some recent developments are unprecedented, and the headlines can be alarming, history counsels against overreacting. It’s important to approach the tumult in the financial markets with an eye toward the practical and not the emotional.

Because so much has happened in a relatively short period, you may have had trouble keeping track. This summary may help bring you up to speed.

What Happened

Over the past few months, the nation watched anxiously as lawmakers wrangled over a proposed increase in the debt ceiling, a statutory limit on the amount the U.S. Treasury can borrow from the public to cover the gap between what Washington spends each month and the amount it collects in tax revenues. Ordinarily, raising the debt ceiling is a fairly routine process but this time was made more contentious by an earlier warning from Standard & Poor’s Ratings Services of a possible credit downgrade. In April, the credit rater lowered its outlook for America’s long-term credit rating from “stable” to “negative,” warning that the country was at risk of having its triple-A credit rating downgraded if the government could not agree on a plan to lower its long-term deficits.(1)

Soon after a debt-ceiling compromise was reached on August 1, the stock market entered a highly volatile period, as investors focused on other troubles that had been eclipsed by the debt-ceiling debate, such as continuing disappointment in the job market, eurozone sovereign debt problems, and weak growth in U.S. gross domestic product. The Dow Jones Industrial Average ended the week down almost 6%.(2)

After the market closed on Friday, August 5, Standard & Poor’s downgraded — for the first time in history — the U.S. government’s credit rating to AA+, one notch below AAA, the highest possible credit rating. S&P noted that the debt-ceiling compromise had not gone far enough to address its concerns.(3)

When the markets opened on August 8, trading was volatile, as expected, but also aggravated by S&P’s downgrade of Fannie Mae, Freddie Mac, and 10 of 12 Federal Home Loan Banks that were propped up by the federal government after the 2008 financial crisis. The Dow fell more than 600 points, the worst one-day point loss since December 2008 and the sixth biggest point drop in its history.(4,5)

The following day, August 9, the Federal Reserve pledged that it would leave benchmark interest-rate targets near zero for at least two years — an uncharacteristically specific time frame — and hinted that it may take further steps to prop up the economy, which the Fed chairman acknowledged could be slow to recover.(6) The Dow closed up 4%, the biggest gain since March 2009.(7) But volatility resumed the following day and may continue until it becomes clear how Washington plans to deal with the debt crisis, or until the economy shows stronger signs of recovery.

The Finer Points

Because the S&P downgrade of U.S. creditworthiness was unprecedented, some investors have reacted with panic. Here are some lesser-known points that may help put the situation in perspective.

• When a borrower’s creditworthiness is downgraded, the interest rates it pays to borrow money could be expected to increase. But it’s not clear whether or when this will actually come to pass. Yields on Treasury debt — the very same downgraded by S&P — fell to an all-time low in the wake of the downgrade as investors searched for protection against volatility.(8) Yields move in the opposite direction of prices, so falling yields can signal increased demand as investors bid up prices. This is a reminder that investors — not credit-rating agencies — determine bond yields.
• Standard & Poor’s said the United States failed to go far enough in drafting a debt plan to address the nation’s borrowing trajectory. Although the United States clearly has a debt problem, so do other wealthy nations. The United Kingdom and some European Union nations are also facing sovereign debt troubles yet retain their triple-A ratings.(9) Sovereign debt problems in other nations mean that U.S. debt may still appeal to many investors.
• The difference in credit risk between AAA and AA+ is negligible. Both indicate very low risk of default. However, the fact that the world’s largest economy, issuer of the world’s reserve currency, was downgraded can be tremendously important from a psychological standpoint. It’s not clear what the long-term effects will be.
• Moody’s Investors Service and Fitch Ratings, the other two major credit-rating agencies, have not downgraded the U.S. credit rating. This means they still consider the United States to be among the most creditworthy borrowers in the world.
• After S&P told Treasury officials about its decision to downgrade U.S. Treasury debt, Treasury officials contended the calculations included a $2 trillion error. The fact that S&P changed its rationale for the downgrade after this was pointed out, but proceeded anyway, has led to accusations that S&P’s actions were politically motivated.(10)
• The downgrade, the debate over spending and taxes, and volatility in the global financial markets are good indications that solutions may be forthcoming. Investors are telling policymakers that it’s time for structural reform and to stop papering over budget imbalances with debt.
• Treasury bills are backed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. This has not changed.11 (The principal value of bonds may fluctuate with market conditions. Bonds redeemed prior to maturity may be worth more or less than their original cost.)

What Should You Do?

As mentioned earlier, it’s important not to let emotion determine how you may react in the near future. This is not to say that the wise approach is to place one’s head in the sand and wait for the calm to arrive. But time has demonstrated that a solid defense against market volatility is to be prepared for it — and expect it. Preparation in this case means having a long-term financial strategy based on your particular circumstances and sticking to it, even when it feels as though it’s time to panic. Panic is not only ineffective, but it can be costly. Fleeing a declining market carries the risk that you may not be in a position to take advantage of a recovery.

Sound advice such as maintaining an appropriate asset allocation and a well-diversified portfolio might be of little consolation when you see your account balance falling. But the alternative, selling when prices fall and waiting for them to recover before you venture back into the market, may only worsen the situation. Asset allocation and diversification do not guarantee against investment loss; they are methods used to help manage investment risk.

Of course, how or whether you will be affected — or whether you should consider making adjustments — will depend on your specific circumstances and risk tolerance. In fact, the current situation may represent an opportunity for your portfolio.

Although it’s understandable to be concerned when you see the kind of market volatility we have witnessed recently, be careful not to let your emotions take over. We can help address your questions and concerns.

Sources:

• 1, 3, 9) Standard & Poor’s, April 18, 2011 and August 5, 2011
• 2, 5, 7) Yahoo! Finance, 2011, for the period 10/1/1928 to 8/10/2011. The performance of an unmanaged index is not indicative of the performance of any particular investment. Individuals cannot invest directly in an index. Past performance is no guarantee of future results. Principal value and return will vary over time, particularly for long-term investments. Actual results will vary. Shares, when sold, may be worth more or less than their original cost. Investments seeking to achieve higher rates of return also involve a higher degree of risk.
• 4) ABC News, August 8, 2011
• 6, 8, 10) The Wall Street Journal, August 10 and 7, 2011

America’s Tarnished Credit Rating

Is our country going to start getting calls from debt collection agencies, or have to check its credit reports periodically?  Here’s a funny video of how the rest of us have to handle debt problems: http://www.youtube.com/watch?v=fujTIOeM2SI

By now, you’ve probably heard that the Standard & Poor’s debt rating agency has downgraded all U.S. government debt with more than a year of maturity, from the top AAA rating down to AA+.  To put that in perspective, now only 17 countries enjoy the AAA rating on their government bonds.  Typically, that means that they are considered the safest havens for cash, and therefore are able to pay the lowest interests rates on their borrowing.

Here’s the list, and we’ve included the current yields on each country’s 10-year government bonds in parentheses.  This lets you see what the top-rated countries pay on their debt, compared with the 2.34% interest our government has to pay on its 10-year U.S. Treasuries:

France (3.41%), Germany (2.83%), Canada (2.93%), Australia (5.75%), Finland (3.19%), Norway (3.29%), Sweden (2.82%), Denmark (3.06%), Austria (3.30%), Switzerland (1.53%), Luxembourg (NA), Guernsey (NA), Hong Kong (2.29%), the Isle of Man (NA), Liechtenstein (NA), the Netherlands (3.17%), and Great Britain (3.11%).

The first thing to notice is that our U.S. government is still borrowing at very attractive rates compared with the triple-A nations, and Treasury rates actually got better during the angry debate in Washington, as investors continued to beat down our doors to lend money to our government.  Why?  The downgrade and recent weakness in the stock market have made bond investors nervous, which usually causes them to buy the safest paper they can find.  As an Associated Press report notes, the U.S. still offers the deepest and most liquid bond market in the world.

The second thing to understand is that, despite the high levels of government debt, there is really no crisis in the government finances or in the economy.  S&P officials made it clear that they were more influenced by the recent messy debate in Congress than the fundamentals of government finance.  They may have been particularly rattled by public statements by key members of Congress that it might not be a bad thing if the U.S. government defaulted on its sovereign obligations to its global lenders–sort of like one of us telling the bank that we’re thinking seriously about not making any more mortgage payments.  David Beers, global head of ratings at S&P, said in a supporting statement that the agency was concerned about “the degree of uncertainty around the political policy process.”  A separate statement by the rating agency said that policymaking and political institutional control had weakened “to a degree more than we envisioned.”

Long-term, our government faces some difficult choices.  The question now is whether we’ll get action from Congress or more political posturing.  We’ll get an early look between now and Tuesday, as a new Congressional committee, made up of Democrats and Republicans, will be looking for $1.5 trillion in deficit cuts that have not yet been specified through the debt ceiling compromise.   (A total of $917 billion in cost reductions has already been earmarked).

What does all this mean for investors?  The investment markets were clearly rattled by the tone and uncertainty of the debt ceiling debate, with the S&P 500 losing 10.8% of its value over the ten trading days of the Congressional standoff.  But a Money magazine report points out that when a country loses its AAA rating, that is not always terrible news for the nation’s stock market.  Canada, for example, was downgraded from AAA status in April of 1993, but the country’s stocks gained more than 15% the following year.  The Japanese government’s bonds were downgraded in 1998, and the Tokyo stock market climbed more than 25% in the next 12 months.

The awful nature of the debt ceiling debate, plus the downgrade, has clearly added fear and uncertainty to an already sluggish economic recovery.  The Treasury debt downgrade is a blow to U.S. pride, and a warning to Congress–particularly those representatives who think the U.S. can simply walk away from its obligations without consequences.

However, as the decline in Treasury rates made clear, the downgrade is largely symbolic.  Congressional gridlock and partisan posturing could leave us with a long 15 months until the next time we have a chance to vote on their job security.  But it might be helpful to think back to last Summer, when concerns about a double-dip recession and mild panic sent the S&P 500 down a long unhappy slide to a low of 1022.58 on July 2, with a few additional bounces along the bottom until a September rally.  Investors who sold out of the markets at that time missed significant–and largely unexpected–gains through the Fall, Winter and Spring, as people gradually realized that the world was not coming to an end.

In the short term, emotions rule the market, and they are visibly tilting toward panic right now.  Longer-term, the market prices always tend to return to fundamentals, and it’s helpful to remember that corporate profits remain strong, new jobs are being added and the economy is still growing.  The U.S. markets weathered much worse than this in 2008, in 2000, during the first and second world wars and a lot of panic-stricken times in between.  Without the ability to see the future, our best prediction is that the Sun will continue to rise each morning and the U.S. will emerge from this crisis like it has all the others–and reward those who managed not to succumb to the panic like so many did last Summer and so many other inevitable periods of anxiety when things don’t go exactly as we’d hoped.

Sources:

• Country by country 10-year bond rates: http://www.tradingeconomics.com/bonds-list-by-country
• Associated Press analysis: http://news.yahoo.com/us-downgrade-raises-anxiety-not-interest-rates-212346775.html
• http://finance.yahoo.com/news/SP-officials-defend-US-credit-apf-685948715.html?x=0
• Market decline and market impact: http://news.yahoo.com/p-reconsidering-u-downgrade-cnbc-001207261.html
• Money Magazine analysis: http://finance.yahoo.com/news/SP-Rating-Your-money-in-a-hmoney-388856032.html?x=0

Two Steps Forward, One Step Back

The U.S. and many world market indices were looking at modest gains until they ran headlong into the month of June, when a variety of concerns came together to drive prices lower pretty much everywhere in the world.  If you look at the MSCI Developed Markets report, you see the column representing the month of June showing basically a vertical line of red numbers in North America, Europe, Asia and Africa.  But the losses of the second quarter were generally not enough to overcome the gains of the first three months of the year, so many indices are still ahead for the first six months of 2011.

In the U.S., the Wilshire 5000 was up 1.71% for the two months heading into the June Swoon, and it seemed as if we would experience another quarter of modestly positive returns.  Instead, the index dropped 2.63% during the month, finishing down 1.05% for the three months ending June 30.  Even so, the broadest indicator of U.S. stock activity is up 4.90% for the first half of the year.  The comparable Russell 3000 index of U.S. stocks fell an almost imperceptible 0.03% during the second quarter, finishing the first half of the year up 6.35%.

The Wilshire U.S. Large Cap index was down 0.90% for the second quarter; up 4.95% for the first half of 2011.  The Russell 1000 large cap index was essentially flat, rising just 0.12% for the second quarter; it finished the first half of the year up 6.37%.  The S&P 500 fell 0.39% for the quarter, but is up 5.01% so far this year.  Among the sectors, the biggest losers were financial services companies (down an aggregate 6.27% for the second quarter of 2011) and energy stocks (down 5.07%).  Publicly-traded health care companies were up an aggregate 7.29% and utilities rose 5.01%.

The Wilshire U.S. Mid-Cap index fell 0.86% for the second quarter, but is still up 8.70% for the year.  The Russell Midcap index was up 0.42% for the second quarter; up 8.08% for the first six months of 2011.

The Wilshire U.S. Small Cap index declined 2.01% during the second quarter; but is up 6.31% for the year.  The comparable Russell 2000 fell 1.61% in the second quarter; it was up 6.21% for the first half of the year.

The technology-heavy NASDAQ Composite Index was down 0.59% in the second quarter, but is up 3.30% so far this year.

Looking abroad, the MSCI EAFE index, which tracks a basket of developed-economy indices, was up 0.33% for the second quarter, up 3.00% for the year so far.  There are always lessons in the returns; the MSCI Europe index was up 0.78% for the quarter, and is up 6.71% in the first half of the year, when many analysts were betting on a decline due to the widely-publicized debt woes in Greece, and less dire sovereign debt issues in Ireland, Portugal and Spain.  The EAFE Emerging Markets Index, which measures the overall performance of less-developed nations, was down 2.11% for the second quarter, down 0.45% for the first half of the year.

Among the notable countries, England’s FTSE 100 index fell 1.07% for the first quarter; down 1.13% for first six months of 2011, while Germany’s DAX index rose 2.74% for the second quarter; up 5.53% for the six months ending June 30.  Japan’s Nikkei average is up 1.11% in the second quarter, but in the first half of the year it has lost 5.6% overall.  Chinese shares fell 6.92% on the Shanghai stock exchange; down 3.18% over the past six months.  The Hong Kong Hang Seng index fell a similar 5.90% in the second quarter, and has so far posted a 4.43% loss for the year.  India’s Mumbai Sensex index was down 2.96% in the first three months of the year, down 8.34% in the first half of 2011, while Brazil’s Bovespa Stock Index was one of the biggest losers internationally, down 9.91% for the second quarter; down 10.80% for the year so far.

In real estate, the Wilshire REIT index rose 3.64% for the second quarter of 2011, and is now up 10.62% for the year.

Commodities prices were almost unanimously down for the second quarter, led by energy (down 7.94%), agriculture (down 12.09%), livestock (down 9.80%), aluminum and nickel (down 5.32% and 10.32% respectively).  Gold was up a modest 4.29% to finish the first half of the year at a 5.42% gain.

Bond yields continue to scrape along the floor; you can get a 0.02% yield on 3-month Treasuries currently, 0.10% on 6-month government bonds, and the two-year (0.45%), three-year (0.79%) and 5-year (1.75%) are not dramatically higher.  The benchmark 30-year Treasury is currently yielding 4.36% a year.  The Bloomberg web site shows 1-year muni bonds yielding an average of 0.211%; if you go out to ten year maturities, you can get an average yield of 2.729%.  If you’re curious about interesting anomalies in the bond market, check out the rare inverted yield curve in Brazilian debt (http://www.bloomberg.com/markets/rates-bonds/government-bonds/brazil/), where you can be paid 12.75% a year if you buy a 3-year bond, but just 12.46% if you lock in your money for 10 years.

Where do we go from here?  The U.S. Bureau of Economic Analysis reports that America’s economy–the gross domestic product (GDP)–rose 1.9% in the first quarter of 2011, which is significantly less robust than the 3.1% growth rate reported for the fourth quarter of 2010.  If you’ve take a trip to the gas pump, you are probably not surprised that the inflation rate reached 3.9% in the first quarter.

As you’ve no doubt read elsewhere, we are experiencing an unusual recovery from an unusual recession; in past economic downturns, the economy has come roaring back during the recovery, but today we are dealing with a more deliberate climb out of the hole.  A quarterly survey by the Associated Press suggests that the U.S. economic recovery will be slow and deep, held back by shoppers reluctant to spend and employers hesitant to hire.  A poll of 42 economists has concluded that economic growth will probably stay below 3% for the rest of this year and early next year, and their crystal balls say that the U.S. unemployment rate will end the year about where it is now: between 9.0% and 9.5%.  GDP growth would have to reach 5% for a full year to drive the unemployment rate down by one percentage point; 125,000 jobs must be added each month just to keep up with population growth.  In May, the latest month where we have statistics, 54,000 net jobs were added, down from 194,000 in March and 232,000 in April.

The other headline-grabbing issue is housing.  A series of charts created by the web site NumberNomics.com makes clear that existing home sales, new home sales median new home prices have all been essentially flat since January of 2009.  But with interest rates at record lows, a new house is far more affordable today than it was in 2007; the site notes that the cost of purchasing a home is now actually lower in many sections of the country than what it costs to rent.  Distressed sales represented 31% of total sales in May, down from 37% in April–which is progress of sorts.

None of this is bad news for investors, who prefer the recovery to continue, slow or otherwise.  But the rocky month of June, which started with six straight days of losses in the U.S. markets, is further evidence that even positive growth and positive returns don’t guarantee a smooth ride.  The returns of the first half of the year have come with a certain share of anxiety, but it may be helpful to remember that the great returns of 2009 came at a time when many investors were living in a state of fear bordering on terror.  Let’s count our blessings; the mild reversal of the past three months wasn’t enough to offset the gains in the first quarter of the year for most of the elements in a diversified investment portfolio.

SOURCES:

• GDP estimates, inflation and corporate profits: http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm
• Wilshire index data: http://www.wilshire.com/Indexes/calculator/
• Russell index data: http://www.russell.com/indexes/data/daily_total_returns_us.asp
• S%P index data: http://www.standardandpoors.com/indices/sp-500/en/us/?indexId=spusa-500-usduf–p-us-l–
• Nasdaq index data: http://quicktake.morningstar.com/Index/IndexCharts.aspx?Symbol=COMP
• International indices: http://www.mscibarra.com/products/indices/international_equity_indices/performance.html
• Individual country data: http://investing.businessweek.com/research/markets/world/worldmarkets.asp
• Also: http://money.cnn.com/data/world_markets/americas/
• Commodities index data: http://www.standardandpoors.com/indices/sp-gsci/en/us/?indexId=spgscirg–usd—-sp——
• Treasury market rates: http://www.bloomberg.com/markets/rates-bonds/government-bonds/us/
• AP Economic predictions: http://www.manufacturing.net/News/2010/07/Financial-AP–2011-Economic-Outlook–Bleak/
• Labor market recovery:  http://blogjobs.biz/jobs/2011/06/jobs-report-economy-adds-54000-jobs-in-may-unemployment-rate-rises/
• Numbernomics.com: http://www.numbernomics.com/nomicsnotes/

The Nudge that Roared

What does the end of the Fed’s QE2 initiative mean for the markets and the economy?

President Obama’s speech on Afghanistan collected most of the headlines, but Fed Chairman Ben Bernanke’s press conference the same evening was, for some economists, more interesting. Among other things, Bernanke made it clear that the Fed was ending, on schedule, a widely-publicized initiative known as QE2, more formally referred to as the second round of quantitative easing by the U.S. Central Bank.

Some of you may have read dire headlines telling us that without QE2–or a new QE3–the economic recovery will stop in its tracks and the stock market will go into a tailspin. Elsewhere, you may have heard grumbling that QE2 has set the stage for bouts of future inflation.

People should feel free to panic if they want to, but let’s take a moment to understand what they’re panicking about. To do that, put yourself in the shoes of the Chairman of the Federal Reserve Board back in November. You settle into a comfortable chair behind a very large desk, look at a bunch of economic reports and realize that the economy is still, two years after 2008, growing very sluggishly. You notice, not for the first time, that unemployment is way too high. So you reach for your normal stimulus tool–the Fed Funds Rate; the rate at which your Federal Reserve system is willing to make short-term loans to the banking system. If you lower these rates, then banks can offer lower interest rates to their corporate customers and still make a profit, and those corporations will have cheap money to go out and build factories, hire new workers and report higher profits to people who might want to buy their stock.

Better yet, when money markets and bonds are paying next to nothing, it tends to drive money off the sidelines into what are known as “risk assets”–higher-yielding corporate bonds and stocks, causing the market to go up and making it easier for companies to raise capital.

So, as Fed Chairman, you reach for your handy Fed funds rate instrument, and you realize that the Fed Funds Rate is already down in the 0% to 0.25% range. At 0%, your central bank is essentially giving away money. Any further lowering, and the Fed is paying banks to borrow from it.

Your normal method of stimulating the economy has gone about as far as it will go.

At the same time, you notice–as an analysis from the Sratfor Global Intelligence service made clear back in November–that some of America’s global competitors are openly manipulating their currencies to gain an unfair advantage in the export markets. The report notes that Japan hoped to pull out of its post-recession malaise by intervening in the global currency trade, actively driving down the value of the yen. Brazil and South Korea were following a similar tactic. Germany, another major export economy, was benefiting from the weak euro–the result of the European debt crisis.

As all of these currencies weakened against the dollar, the manufactured products of Japan, Germany, Brazil, Korea and others were priced ever-more attractively to American consumers. The more they sell, the more money is diverted from the U.S. economy into theirs–or, in economic terms, the wider our current account deficit becomes.

So here you are, sitting in the Fed Chairman’s office, looking around for a way to do two things at once: stimulate the U.S. economy by applying some new tool that hasn’t been used before, and at the same time fire a warning shot across the bow of those exporting nations who are busily trying to pull themselves into recovery on the back of the U.S. economy.

Your solution–the Fed’s QE2 initiative–is simply an announced commitment, by the U.S. Federal Reserve, to purchase $600 billion worth of U.S. Treasury securities over the eight months from last November through the end of June 2011.

Treasuries are sold at auction; that is, everybody who wants to lend the government money submits a bid for how much interest they are willing to accept. Theoretically, the more bidders, the lower the rates, so QE2′s first impact is to push down the rate at which the government borrows money, which has the nice side effect of reducing the government’s debt burden.

How much? If you have a little free time, you can go to a web site called Treasury Direct, and look at the amounts of bills and bonds that our government puts up at auction. (The weekly press releases can be found here: http://www.treasurydirect.gov/instit/annceresult/press/press.htm) You’ll find that the government borrows about $28 billion a week in 4-week T-bills, another $27 billion a week in 90-day T-Bills, $24 billion a week in six-month bonds, $24 billion a month in one-year Treasuries, and–well, by now you probably realize that $600 billion spread out over eight months is not likely to tip the overall supply/demand numbers dramatically. Consider it a nudge in the right direction.

But QE2, plus the threat of additional future intervention in Treasury rates, had a remarkable effect on those exporting nations. Within days of the original QE2 announcement, the Wall Street Journal was quoting finance ministers and economists from Brazil, France, Korea and Germany, all criticizing the purchase and calling for an immediate cease fire in the currency wars. Meanwhile, as Treasury rates drop a little, and speculators worry that they could drop a lot, the dollar begins falling against foreign currencies, putting a little wind at the backs of U.S. exporters, and in the face of foreign imports.

That’s one reason why QE2 is considered a stimulus measure. Another has to do with liquidity in the U.S. economy. Whenever the Fed purchases anything, it is effectively creating new money–and, at the same time, replacing buyers of Treasuries, who will have to put their investment capital into something else (like stocks or steel mills).

Once again, however, we are talking more about a nudge than a hard shove. It is helpful to remember that the U.S. GDP–the value of all goods and services produced in a year–is currently running at about $14.3 trillion a year. A $600 billion infusion would probably be enough to stimulate your own personal lifestyle, but to the American economy, it represents at most a visible, highly-publicized drop in a large bucket.

Nor is QE2 likely to spur new rounds of inflation–at least, not by itself. As Stratfor pointed out last November, creating $600 billion in eight months is not dramatically different from the Fed’s normal actions in managing the money supply. With $8 trillion in circulation (this is the M2 money supply figure, which does not include certificates of deposit or institutional money market fund balances), QE2 didn’t suddenly make dollars dramatically more plentiful.

So what will be the effect on the economy now that QE2 is over? Separate analyses by BlackRock Investment Management and ForEx.com suggest about what you would expect: that Treasury rates might (or might not) bump up a little, with a consequent bump in bond rates generally–which would be good news for people who have been trying to live on the (almost nonexistent) interest provided by today’s fixed-income investments. The long, slow decline in the value of the dollar may reach a logical bottoming, and any upward pressure that QE2 might have been putting on the inflation rate will be gone.

But it’s helpful to remember that even though the Fed won’t be a net buyer of Treasury debt, it will still have a lot of options related to QE2. In his press conference, Chairman Bernanke pointedly did not outline any plans to sell off the government bonds that the Fed has already purchased. When the Treasuries “mature”–when the bond terms are up–then the Fed will have the flexibility to make a long, gradual series of decisions based on what it sees in the economy.

If the economic recovery continues, those assets might be allowed to quietly slip off of the Fed’s balance sheet gradually over time. If not, the money collected could be reinvested in Treasuries without any expansion of the Fed’s current balance sheet–helping to keep Treasury rates low and continuing the effect of the stimulus for as long as you (the new Fed chairman) think it’s needed.

The bottom line here is that QE2′s effect may have been more powerful psychologically (see the inflation worries, the white flag flown by exporting nations and now fear that the recovery is doomed if the Fed stops purchasing Treasury debt) than its actual effect on the economic landscape. If you’re the Fed chairman, right now you’re probably surprised that your newest policy tool stirred up so much excitement–or worked so well. And you’re probably also surprised that whoever writes those headlines would think that such a small, albeit creative, nudge could be the main reason the U.S. economy is climbing out of the hole of the Great Recession.

Sources:

• Press conference: http://www.guardian.co.uk/business/richard-adams-blog/2011/jun/22/ben-bernanke-press-conference-live
• Forex report: http://www.forex.com/post?SDN=43b28e1d-6a13-4d21-a0b4-80a9aad87d81&Pa=20db1fa6-e674-420c-9a87-2ee29261d638
• Blackrock report: http://4150326.polldaddy.com/s/advisor-perspectives-end-of-qe2
• Stratfor analysis: http://www.stratfor.com/memberships/175231/geopolitical_diary/20101103_washingtons_warning_shot_currency_front
• U.S. money supply: http://en.wikipedia.org/wiki/Money_supply
• Size of the U.S. economy: http://en.wikipedia.org/wiki/Economy_of_the_United_States
• Wall Street Journal articles about the Fed’s repurchase: http://online.wsj.com/article/SB10001424052748704353504575596203544367856.html

Playing Chicken With Greece

The EU remains at a critical point in its young life as it must solve some very serious problems.  The borrowing costs for highly indebted countries like Greece remain at unsustainable levels and they cannot rollover or extend their debt without being deemed in default.  Thus, the current market riot is not unexpected.  The EU central bank, and the economic community at large, knew this was coming because they didn’t solve the problem last year – they just kicked the can down the road.

The EU (controlled by wealthier Germany & France) certainly doesn’t like the position it’s in, but its back is against the wall.  If they let Greece default, then banks all over Europe that have loans to Greece will begin to fail and need rescuing.  As much as the EU resents being put in this position, they have more control of the outcome if they don’t let it spread to the banking system.

As events progress, we are most likely to see a bailout – not a default.  Markets like bailouts, but voters hate them.  However, looking back over the past 3 years, despite all the bailouts that did occur, most people will agree that had Lehman been saved, some of our own financial mess could have been averted.  So, in the end, it’s not that we’ve had too many bailouts, but one too few.  The EU will bailout Greece!

The EU central bank will keep Greece alive by using the Bernanke playbook and digitally conjuring money with a very low interest cost to buy the Greek’s higher yielding bonds and earn a spread on the difference.  The EU’s very own QE2!

As the EU’s central bank ramps up its purchases of Greek debt, it will be able to state that this will help European taxpayers by earning a nice interest payment from Greece while using their very own low cost money to pay off current Greek debt.  To make this work well, the EU central bank will strive to keep their interest rates low to bring down their financing costs; create some inflation to offset the deflation battering the financial system; and weaken the Euro making their companies’ exports more competitive overseas.

If it is this simple, then why haven’t they done it already?  It has and will be politically impossible until the wealthier EU countries believe they have extracted the maximum pain in concessions out of Greece.  This game of chicken is what is currently roiling the markets.  It is the price to be paid to make sure that Greece reforms its ways and the typical EU voter/taxpayer supports the bailout out of fear of a Greek default and a subsequent banking crisis spreading to their home turf.

The EU will deal with the problem, markets will settle down, and we’ll see the Euro continue to weaken and move much closer to 1:1 parity with the U.S. dollar.  However, the road to recovery will be played out with political drama, market volatility, and some good old-fashioned brinksmanship.

Inflationary Politics

McDonald’s began selling hamburgers in 1955, when a burger cost 15 cents.  In Garrison, Minnesota (the smallest city in America with a McDonald’s), a burger now costs 89 cents.  That same burger sells for $1.69 in New York and $1.96 in Los Angeles today.  However, if you calculate inflation since McDonalds started selling burgers, it should cost $1.24.

Most people are very afraid of the thought of inflation.  Do you remember the Jimmy Carter era inflation? Money markets were paying 18 percent, home mortgages and auto interest rates were 12, 13, and 14 percent or higher.  The actual inflation rate was 14 percent.  Did people survive?  Of course they did.  And you can too, if you know the strategies to take advantage of inflation as it returns.  Wouldn’t it be nice to be in a position to benefit from a bad financial occurrence?

That bad day is approaching.  David Walker, former United States Comptroller General, says our budget debate is “like arguing about the bar tab on the Titanic.”  His fancy title means he was the head accountant for the United States Government.  First, the most aggressive plan proposed by Wisconsin Republican Paul Ryan reduces spending by $6.22 trillion over 10 years. It sounds like a lot doesn’t it?  But divide $6.22 trillion by 10 years and it is $622 billion. Our current deficit is approximately $1.5 trillion.  Even doing every part of Ryan’s plan still leaves us with almost a $1 trillion deficit every year.

But that’s not all!  When will these budget cuts be proposed, and if passed, when would they take effect?  First, no legislation of this sort will be presented before the 2012 Presidential election.  That means that when Congress convenes in January 2013, they will be debating fiscal year 2014′s budget.  Keep in mind, Medicare is predicted to go bankrupt in 2017, yet legislation to deal with this impending disaster would not be debated until fiscal year 2014.  Even if passed as currently presented, (and really, how likely is that?) it would not even make a dent in the future liabilities of these entitlement promises.  Careful reading of the proposed legislation reveals that Medicare isn’t even addressed until 2022 – 5 years after the program goes bankrupt!

President Obama wants to merely increase taxes by $1 trillion over the next decade.  No Cuts!  $1 trillion divided by 10 is $100 billion per year.  That would still maintain trillion dollar annual deficits for the next decade.  To put this into perspective, even if we taxed everyone who makes over $250,000 at 100%, we would not even raise half of the revenue necessary to balance the budget.

Inflation is on its way because spending is out of control, causing our government to print even more money to pay our bills.  Several long-term trends are fueling this process:

• Demographics trump promises…There are currently only three workers for every recipient of social security benefits.  That number will soon be reduced to two.  In 1950, there were 16 workers for every recipient.  The math no longer works!

• Benefits last too long…When Social Security was proposed in 1935, an American’s life expectancy was 62.  When Medicare was passed in 1965, life expectancy was 70.  Currently life expectancy is above 78.   Shouldn’t these programs be brought back into actuarial balance with current life expectancy?

• Benefits are too high…Salaries account for only 51 percent of income in our country.  That is the lowest percent since records started being kept back in 1929.  American households received $2.3 trillion in government benefits in 2010.  That now exceeds federal tax revenues!  Our federal government pays about 90 percent of those benefits, which average $7,427 per citizen.  That is up from $4,763 in 2000 and $3,686 in 1990.  Did you get your check for $7,427?

• Taxes are too high…In California, our tax freedom day is already April 16th, meaning we work 106 days to pay all our federal, state, and local taxes.  The earliest tax freedom day is in Mississippi where it still requires 85 days (March 26).  Approximately 30% of your time working is just to pay taxes.  Have you been getting your money’s worth?  Does your government respect how hard you work to make a living?

Too often when people start thinking about higher taxes and inflation and how catastrophic it could be, they are actually discouraged to take action.  But, for a moment ask yourself if there have been financially bad times in the history of our country and our world? (Yes)  Were there any people who made money during those bad times? (Yes)  Were the people who prospered the ones who planned for those challenges or the ones who decided to just let it happen to them?

Which one do you want to be, and when do you want to get started protecting your future?

Manchester Financial’s Robert Katch Named Master Elite Advisor

Westlake Village, Calif. – Robert Katch, president of Manchester Financial – a wealth management firm specializing in private banking, investment counsel, and tax and insurance guidance – has just been named a Master Elite Advisor for the Ed Slott Elite IRA Advisor Group.

Ed Slott is a registry that helps people locate their region’s top financial advisors. Their Elite IRA Advisor Group selects only the top one percent of advisors in the country, putting Katch in an esteemed group of experts who have helped countless people nationwide navigate the changes to Roth and Roth IRAs.

“I am honored to receive this distinction from such a nationally renowned and trusted organization as Ed Slott,” says Katch. “Manchester sets out to deliver a high standard of service for our clients, and we want to continue to provide the best advice in times when issues like the Roth are so important to financial well being.”

Katch founded Manchester Financial in 1990 while serving as Pepperdine University’s Associate Treasurer, where he was responsible for the University’s corporate finance function, including cash and debt management. He also managed the institution’s $250 million investment portfolio, covering asset allocation, portfolio analysis, manager evaluation and in-house investments for donors. Katch was an Adjunct Professor at Pepperdine from 1991 to 2003, teaching investment, accounting and finance courses for the university’s undergraduate and graduate programs.

To learn more about Manchester Financial or to schedule a complimentary evaluation with Robert Katch, please call (805) 495-4405. For more information on Ed Slott’s certifications, log on to irahelp.com.

ABOUT MANCHESTER FINANCIAL

Manchester Financial specializes in wealth management services, offering guidance with private banking, investments, trust and estate, and tax and insurance, working alongside CPAs, insurance agents, or other existing banking relationships to help provide sound financial advice. Since 1990, Manchester has been providing assistance to a wide variety of clients in Ventura County and beyond. For more information, log on to www.mfinvest.com.