Inflation — the arch nemesis not just of the fixed-income market, but potentially of a nation’s entire economy (see Zimbabwe).  There has been increased talk of potential inflation in the U.S. as the federal government debt zooms past $11 trillion with ubiquitous predictions of multi-trillion dollar deficits exacerbating the problem.

Obviously, a rising federal government debt has negative implications for future inflation.  However, this is far from the only debt threatening to storm the gates.  State and local governments are facing some of their most trying times ever in balancing their budgets — taxes are being raised and services are being cut — yet bankruptcy is a looming possibility for more and more municipalities.  Add to this the frightening situation over unfunded pension liabilities and you have a recipe for disaster.

Already, fears of governments not being able to fund their growing liabilities are spooking investors.  Just last week, Great Britain was unable to sell 1.75 billion pounds of 40-year gilts (British Treasury bonds).  The hegemony of the U.S. dollar has made it highly doubtful that the U.S. would default on its debt, though by running the printing presses overtime, the government may simply “monetize” its debt, rendering the value of the currency in which the debt is paid all but useless.

Recently, both Russia and China have made noises regarding the risks (to all countries without the initials USA) of maintaining the U.S. dollar’s place at the top of the global currency pecking order.  Last Thursday, China’s mere suggestion of introducing a global reserve currency caused a vicious selloff in the dollar on world currency markets.  Later, a United Nations panel ran with the same idea.  Clearly, a pattern of nervousness is growing in the guts of some of our country’s biggest debtholders (China currently holds a $700 billion-plus IOU with Uncle Sam’s autograph at the bottom of it).

Inflation hasn’t been a huge problem in the U.S. in a generation.  But the days of 18% mortgage rates and WIN (Whip Inflation Now) buttons could be just around the corner.  When inflation strikes, the cost of protection will be prohibitive.  What follows can be thought of as the personification of The Lamb’s Rule #7 — “If you’re gonna panic, make sure you’re the first.”

There are several ways to protect oneself from the dangers of inflation.  While some are simpler than others, each carries varying degrees of difficulty and liquidity built into it.

*TIPS — An acronym for Treasury Inflation-Protected Securities, these are U.S. Treasury notes that pay a fixed coupon plus the rate of inflation.  For example, the current 10YR TIP carries a real yield of approximately 1.25%.  That means that, if bought and held to maturity, an investor would earn 1.25% plus the rate of inflation as measured by the U.S. Consumer Price Index (CPI).  TIPS can be bought from myriad securities dealers and from Treasury Direct. 

However, while the coupon on TIPS moves in step with inflation (via adjustments to the bond’s principal), TIPS do not protect investors from increases in market interest rates.  In other words, as real yields rise, the value of TIPS will fall, often precipitously given their very high durations.  Only by concurrently shorting nominal Treasury securities against a long position in TIPS (somewhat difficult from a practical standpoint) can an investor protect himself against an increase in real rates.  As a final caveat, the CPI figure’s components are determined and calculated by the very entity paying the coupon (the U.S. government), creating somewhat of a conflict of interest.

*Rate ETFs — Exchange-traded funds (ETFs) have been around for several years.  They are relatively liquid and trade very much like stocks.  They were created to enable investors to participate in strategies or to purchase combinations of stocks (similar to mutual funds) in which they would otherwise be unable to.  The PST and TBT ETFs offer a leveraged view on Treasury Note performance.  Their performance is intended to correlate closely with double the inverse total return of different segments of the Treasury curve.

One downside to these ETFs is that rates must increase by enough to cover the coupons earned by the underlying securities.  In other words, unless rates rise by a large amount, an investor would still see her investment decline in value should the rate move be less than the coupon payments.

*Foreign Exchange ETFs –  These ETFs offer investors the opportunity to profit from a decline in the value of the U.S. dollar in relation to other currencies, without the difficulty of trading foreign exchange directly with a currency dealer.  If/when inflation becomes more pronounced as both capital account and current account deficits overwhelm the U.S. economy, the value of the dollar could fall.  These ETFs offer some measure of protection.  The CYB and UDN ETFs offer a short position in the U.S. dollar versus the Chinese Yuan and a basket of currencies (British Pound, Canadian Dollar, Euro, Japanese Yen, Swedish Korona, and Swiss Franc), respectively.

Of course, as inflation rises and the Federal Reserve attempts to fight it, the Fed could raise short-term interest rates (as Chairman Paul Volcker did in the late 1970s).  This could squeeze U.S. dollar shorts as the cost of financing those positions increases.

*Commodity ETFs — Like other ETFs, these funds make it easier for investors to gain exposure to a given asset class, in this case — commodities.  Precious metals such as gold are often considered the “classic” inflation hedge.  However, any commodity denominated in U.S. dollars can serve as an effective inflation hedge.  There are a variety of commodity ETFs available, including ones for gold (GLD), oil (USO), and grains (DBA).  There are also more generic commodity ETFs that cover a more diverse set products, such as the GSG ETF.  Essentially, in purchasing these ETFs, an investor is wagering on the relative value of these products against the U.S. dollar.  In a sense, buying equities accomplishes much the same thing.

*”Hard” Assets — Vacant land, a farm, even the house in which you live (if you own rather than rent) can serve as an effective inflation hedge.  This is perhaps the simplest and easiest way to hedge against inflation.  Simply by owning a home, one can protect against the ravages of inflation.  Owning a home can have a dual benefit, depending on how it is financed.  This leads to the next inflation hedge…

*Financing — As long as payments are affordable, financing a large (80%?) portion of any purchase on a fixed-rate basis, particularly one as large as a home, has several (inflation fighting) advantages.  For example, take a homebuyer who borrows money at, say, 6%.  If inflation and interest rates skyrocket, as occurred some thirty years ago (remember those 18% mortgage rates), not only has the borrower saved himself a huge opportunity cost, but he can essentially monetize his debt to the bank by investing any current savings/income in higher interest bearing instruments, effectively arbitraging the remainder of his loan.  Fixed-rate financing brings with it another built-in advantage — if mortgage rates drop, the homeowner can refinance (assuming adequate equity) at a lower rate, decreasing his monthly payments.  This exemplifies positive convexity, a key benefit of a mortgage’s refinancing option.

*Payer Swaption — This is The Lamb’s preferred means of inflation protection.  As a background note, The Lamb is a HUGE fan of insurance.  You name the insurance, The Lamb owns it —  health, property, life, long-term care — The Lamb’s got it all.  He likes the safety, the protection, and most of all, the peace of mind.  So, it should come as no surprise that The Lamb likes “payers” as inflation protection.  Like other insurance, a payer swaption can be thought of as an “option premium”, or the cost of buying insurance.  Your “downside” is that nothing happens, and all you’ve lost is the premium you paid for the insurance. 

While most insurance doesn’t pay off, and is viewed by some as a waste of money, try buying hurricane insurance in Miami when a Category 5 monster is in the Florida Straits — you may find it a tad expensive.  It’s the same with inflation.  Buying protection is cheapest before you see the whites of its eyes.

So, back to payer swaptions.  Essentially, payer swaptions give the buyer, in exchange for an upfront premium (just like insurance), the right (but not the obligation) to pay a pre-determined fixed interest rate for a certain period of time beginning at a certain time in the future.  Think of them as puts on interest rates.  For example, if you own a payer swaption struck at 6% and rates are at 8% when the put expires, you would exercise the option and pay a 6% interest rate when market rates are at 8% (as a practical matter, you would “cash settle” the trade, pocketing the present value of the difference between the two rates).

Payer swaptions can be utilized to garner inflation protection while only risking a small cash outlay.  As an example, a payer swaption giving the buyer the right to pay a 5.50% fixed rate (versus a series of floating three-month rates equal to LIBOR) for ten years, beginning in ten years, can be purchased for roughly 3% of the notional amount (e.g. — $30,000 for a $1,000,000 swaption).  A relatively small premium, an investor can lose 3% in just one day of stock market moves. 

If, in ten years, inflation and interest rates are higher, say even at just 7% (just above the average over the past 20 years, and far below the 10% in 1989, and the mid-teens reached a decade before that), the swaption would be worth approximately $100,000 — more than triple the initial premium.  What’s more, unlike other types of insurance, this insurance provides ten years worth of protection.

Via The Bloomberg (click on image for better view):

Historic 10YR Swap Rates

The House of Representatives is set to vote today on a measure that would effectively tax MORE than 100% of some Americans’ income.  In an attempt to placate the public’s wrath over bonuses paid to employees at AIG and other TARP recipients, Congress will seek to cut off bankers’ noses to spite America’s face.

As we examine this issue, let’s keep in mind that at many companies, particularly on Wall Street, the term “bonus” is nearly interchangeable with the term “compensation.”  The difference is just semantics.  The rationale for paying the bonus is to have a carrot for employees to strive for during the year (over which time these employees receive comparably less in the form of a salary, or draw).  No performance, no carrot.  While it’s certainly true that some bonuses have been paid for subpar performance, the overwhelming majority are paid as the result of success.

Paying a higher salary and lower (or zero) bonus removes the incentive to perform and increases risk to shareholders, including (now) the government.  The less profitable a given company, the less likely the government is to continue receiving its preferred stock dividend, via the TARP program, and ultimately the return of its original investment.  (Recall that many of these firms were forced, essentially at gun point, to take these government funds whether they wanted them or not — the strings were attached later).

While it is clearly Congress’s intent to strip TARP firm employees of any “excessive” compensation, the effort is misguided.  The vast majority of these “bonus” recipients have generated profits for their respective firms, often far outweighing the losses of their colleagues that Congress is endeavoring to punish.  To paint them all with the same broad brush does a great disservice to the good performing employees as well as to the Treasury’s collective wallet.

Let’s look at this from another angle.  Take General Motors.  Here is a company that has lost tens of billions of dollars, not for one quarter or one year, but year after year after year.  This company has also received billions of dollars of taxpayer money — money that GM was NOT forced to take, unlike the situation at many banks.

Would it be just as fair for Congress to enact legislation confiscating taxing 90-100% of the wages of UAW workers because the company for which they work was (is) a financial disaster?  Similarly, how about the workers at GM subsidiaries such as OnStar?  Many of these employees (one of which is a close friend of The Lamb) received bonuses for contributing to OnStar’s success despite the fact that GM was hemorrhaging money like a broken Vegas slot machine.  If these employees can escape the Congressional tax assessor, why should bank employees whose units were profitable labor under an exorbitant tax regime?

The illustrious Charlie Rangel, Chairman of the House Ways and Means Committee that is shepherding the bill, in explaining how he arrived at the 90% federal tax rate for TARP bonuses, explained, “we figure the local and state governments will take care of the other 10 percent.”

This reminds The Lamb of (in)famous Ohio State football coach Woody Hayes.  Leading archrival Michigan (Go Blue!) 42-14 late in their annual football death match in 1968, the Buckeyes scored a meaningless touchdown to go up 48-14.  Rather than kick the extra point, Hayes elected to attempt a two-point conversion in order to hang half a hundred on The Lamb’s alma mater.  The attempt was good and tOSU won 50-14.

After the game, a reporter asked Hayes why he had decided to go for two.  The old coach growled, “Because they wouldn’t let me go for three.”

In their vindictive attempt to punish successful employees for the failures of a minor few, Congressman Rangel and his legislative cohorts are demonstrating a poorer sense of fair play than Coach Hayes did over 40 years ago.  If they succeed, The Lamb is one alumnus who won’t be singing Hail to the Victors.

More than 200 years ago, a French Canadian named Julien Dubuque became the first white man to settle in what would later become the state of Iowa.  At that time, the area was inhabited by the Mesquakie Indian tribe and the main industry was the mining of lead.  Though not the first miner in the area, and certainly not one of the indiginous people, Dubuque was nevertheless one of the more productive miners in the area.

Fortunately for Messier Dubuque, national origin was not a qualification for working with the Mesquakie.  Fast forward a few hundred years.  Enter Senator Chuck Grassley.  The honorable gentleman from Iowa has introduced legislation that prohibits American companies from “replacing laid off American workers with foreign workers.”

Of what long-term remunerative benefit is this to the American or global economy?  Shouldn’t job openings go to the most qualified applicant (acknowledging, of course, that “qualified” includes valid H-1B visas, etc.)?  Augmenting the quality of a company’s workforce increases productivity and profitability, generating greater tax revenue for the government (while lowering the tax burden for others) and maximizing value for shareholders.

Furthermore, according to Jeff Segal of breakingnews.com, “many visa holders eventually settle permanently in the U.S., make money and pay lots of taxes.”  Why discourage that?

In a weak economy, especially, the government should take actions to ease, not restrict, the employment of the best and brightest minds from working in the United States.  They should resist temptations to practice discrimination which would keep both innovation and productivity from an American economy when it most needs it.  Hindering competition will simultaneously lower the quality of work while raising its cost for producers — a cost which is inevitably passed on to consumers in the form of higher prices and lower quality goods.

But what of the argument that foreign workers are simply providing the innovation/productivity that would otherwise have been produced by domestic wage earners, and thus “steals their jobs and compensation?”  This week’s Economist, citing a study by Harvard economist William Kerr and University of Michigan (Go Blue!) economist William Lincoln, argues that access to employment of foreign workers actually has synergistic effects on domestic innovation:

When the federal government increased the number of people allowed in under the programme by 10%, total patenting increased by around 2% in the short run. This was driven mainly by more patenting by immigrant scientists. But even patenting by native scientists increased slightly, rather than decreasing as proponents of crowding out would have predicted. If anything, immigrants seemed to “crowd in” native innovation, perhaps because ideas feed off each other. Economists think of knowledge, unlike physical goods, as “non-rival”: use by one person does not necessarily preclude use by others.

Senator Grassley’s legislation is frighteningly reminiscent of the infamous 1930 Smoot-Hawley Tariff Act, but with a side order of xenophobia.  Smoot-Hawley greatly exacerbated the country’s economic recession by restricting the international flow of goods via record tariffs, decreasing imports and exports by over 50%, and contributing to the decade-long Great Depression.

The dangers of protectionism, both economic and social, are risks the country can ill-afford.  While prejudice against foreign workers and foreign goods might serve political expediency, it is a short-sighted and ineffective solution to economic trials, even if it does garner a few extra votes in Dubuque, Iowa for Mr. Grassley.

"Speak American, son."

It has been nearly two years since the beginnings of the current economic crisis.  And while many culprits have been put forth to assume the mantle of blame, the most critical item now on the agenda is the jumpstarting of the U.S. and global economies.

With equity prices down over 50% from their highs and residential/commercial real estate not far behind, asset price deflation is the most visible symptom of today’s economic malaise.  While dismal unemployment statistics certainly play an integral role in consumer confidence and spending, the public is bombarded with daily report cards on the nation’s (world’s) economic health by way of asset price reports, particularly those of equities.

Whether it has been the ubiquitously mentioned Troubled Asset Relief Program (TARP), the Commercial Paper Funding Facility (CPFF), or any other government-led attempt to kickstart the economy, the major flaw in each has been the lack of capital to purchase assets which serve as the backbone for so much of this nation’s daily lending — securitized products.  Knocking down this one pin, the theory goes, will raise asset prices, stimulate consumer and business confidence, and grease the country’s economic gears.

Arguably, a big enough pool of capital aimed squarely at these assets would be sufficient to break the financial logjam and get capital flowing again.  Up to this point, the problem hasn’t been that assets were not cheap enough for investors to buy, but that funding was not available to lend to those who wanted to purchase these assets at current market prices.

Now, the Fed and Treasury have launched the Term Asset-Backed Securites Loan Facility (TALF) to provide as much as $1 trillion in funding for specific, highly-rated asset-backed securities (ABS).  The program certainly has holes — funding will only be available for newly issued securities (not secondary paper), and only for securities rated AAA.

However, as the Fed provides investors with advantageous funding for ABS, prices for these securities should rise, potentially dragging the prices for other similar assets higher as well.  While the TALF is far from a sure thing, its success could represent the knocking down of that one all-important economic pin.

Come on, Rodney!

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