American Investment Services, Inc.

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Dec. 2008 – The Dangerous Flight to Safety

Risk-Free Rate of Return: the return on a risk-less asset, often proxied by the rate of return on Treasury securities.

Students of business and economics are taught, invariably, that buyers of U.S. Treasury bills, notes or bonds can be certain of receiving the interest payments they are owed, as well as the face value of that instrument upon redemption. The government, after all, prints the very dollars with which its debt is redeemed. Unlike debt issued by firms, municipalities, or even agencies, the probability that the Treasury would default on its debt is universally accepted as zero. Treasuries, it is said, are the investor’s ultimate safe-haven.

Investors have accordingly fled to the purported safety of Treasuries as the credit crisis has deepened. While the prices of other fixed income securities and virtually all other asset classes have plummeted, Treasuries have soared in value and their yields have dropped toward historically low levels.

Yet it is the government’s very power to print money that renders its debt anything but risk-free. While investors are no doubt comforted by the notion of a risk-free return, we suspect that long-term investors who have “loaded up” on Treasuries will be sorely disappointed. Through the 12 month period ending in November of this year, the Consumer Price Index (CPI) was up only 1.1 percent.

Since 1945, however, price inflation has averaged 4.1 percent annually. As of this writing, three month Treasury bills are essentially priced to reflect a nominal annualized interest rate of zero percent. Ten-year issues are yielding 2.2 percent. Even 30-year bonds are priced to yield only 2.66 percent. Clearly, investors in these issues may well experience negative real returns, even if price inflation fails to reach its long-term historical average.

The chart below depicts the market’s current inflation expectations, as measured by the difference (or “spread”) between the yield to maturity on the 10-year conventional Treasury bond and the 10-year Treasury Inflation Protected Security (TIPS). These data suggest that investors currently expect annual price inflation of roughly 0.25 percent over the next 10 years. The market is ignoring the threat of price inflation almost entirely.

The Federal Reserve Bank and U.S. Treasury appear to be equally unfazed by the prospect of price inflation. They are instead fixated on re-establishing the flow of credit in order to ignite economic growth and eliminate the threat of deflation. Scarce credit has severely reduced consumer spending. The extreme cautionary prognostication is that a deflationary environment could ensue, in which the prices of goods and services spiral downward (and the purchasing power of the dollar increases). This would be a good situation for lenders (bond investors), who get repaid in the future with increasingly valuable dollars, but bad news for borrowers (firms and government), who would have to repay these obligations. Chronic deflation could ultimately lead to mass defaults that would further cripple the economy.

The Fed is pulling out all the stops to avoid this outcome. In a fiat currency system, however, the printing press provides the Fed and Treasury with all they need to thwart deflation. Since dollars are not redeemable for gold, as they once were, the Fed has several options that allow it to pump currency into circulation. Although short-term rates are effectively zero, it can push long-term rates even lower by purchasing long-term securities, or, should banks remain stingy in extending credit, it could become a direct lender to private entities. Congress and the incoming administration are poised to stimulate the economy through deficit spending.

The Fed can in turn easily buy up this debt to keep interest rates low, and in the process send billions of more dollars into the economy. In the absence of a sound money policy, it is inflation of the money supply,not deflation, which poses the most serious threat to long-term investors. We are skeptical, given the sheer magnitude of the TARP program ($700 billion) and a deficit spending initiative being contemplated that may exceed that level, that the Fed will be able to easily reverse course and re-absorb the money that will have been created.

So What’s an Investor to do?

Treasuries are as expensive as they have been in decades. The accompanying table reveals that rising demand for Treasuries has pushed their yields well below the dividend yields of common stocks across every equity class. This disparity in yields is highly unusual, but not inconsistent with rational pricing.

Treasuries are perceived as a safe-haven and since lower-risk assets have lower expected returns, their prices are high. Conversely, in the current environment stocks are perceived to be very high-risk assets, so expected returns are high and prices are low. Similarly, the market’s apparent disregard for price inflation, though unusual, is not inexplicable.

Investors’ embrace of Treasuries appears to reflect a willingness to accept greater purchasing power risk in order to avoid credit risk amidst a credit crisis of historic magnitude. Stock market risk is high and so are Treasury prices. While all investors should devote a portion of their holdings to fixed income securities, including Treasuries, it would be unwise to abandon a well designed allocation plan by fleeing to government bonds or cash. Price inflation is endemic to any economy based on fiat currencies, and remains the primary threat to the ability of investors to meet their long-term goals.

Therefore, wise investors with a time horizon of five years or more will simply rebalance their accounts. In the case of most investors, this dictates that they sell short-term fixed income securities, particularly Treasuries, in order to purchase equities.

Also in This Issue:

Gambling on The Business Cycle
Madoff, Minsky, and Mania
The High-Yield Dow Investment Strategy
Recent Market Statistics
The Dow-Jones Industrials Ranked by Yield
Asset Class Investment Vehicles