Trying To Get Through

The debate continues among economists as to whether or not this economic recovery will be similar to others in the recent. On one side we have equity-oriented economists who believe that a robust recovery has to materialize. Their reasoning is that it "always" happens. On the other side are the fixed income enthusiasts, such as Bill Gross and the boys at Pimco. Their argument is that the circumstances surrounding the economy matter. I am going to side with Mr. Gross on this one.

This may come as a shock to many readers as I have been an outspoken critic of Bill Gross and his tendency to talk his book after he has placed his bets. This however does not mean that his bets are incorrect. Pimco is calling for a "new normal" rate of growth, a rate of growth resulting from economic activity based on income rather than leverage. Pimco puts the expected rate of growth at approximately 2.00% over the long haul. Other economists see little difference between today's recovery and those of the past. Bank of Tokyo - Mitsubishi UFJ chief financial economist Christopher Rupkey told Bloomberg News:

"We've had financial-market crises and big workforce changes before, and growth has pretty consistently come in around 2.5 percent over the past 50 to 60 years."

Historcal data can give us clues about what we may expect to happen, but we must but past events in their proper perspectives. During the 1950s and 1960s there was very little foreign competition for jobs. Economic stimulus resulted in job growth and economic recovery. Since the Paul Volcker years, two decades of Fed stimulus, without the stimulus ever fully, being removed, sparked strong economic growth. Growth which cannot be sustained without such stimulus. There lies the problem. The Fed cannot cut rates further. It has been forced to engage in quantitative easy by purchasing treasury notes, MBS and agency debt. This could leave the Fed very exposed when long term rates rise. Fortunately, that will not be happening soon, at least not in a big way.

Yields on the long end of the yield curve fell as China once again ordered banks to reduce lending. This will hinder China's (questionable) ability to lead the world out of recession. Also helping to push rates lower was the news that net foreign securities purchases increased by approximately $100 billion in December. No folks, foreign central banks are not abandoning the dollar. They need to manage their exchange rates and inflation is not among their current concerns.

Disappointing corporate earnings, especially from Morgan Stanley and Citi, along with a drop in IBM's revenues sent the stock market plunging and attracted even more buyers to the 10-year U.S. treasury note.

The Producer Price Index reiterated what last week's CPI report told us. Inflation is not a problem at this time. This makes TIPs unattractive except as a permanent inflation hedge within a diversified portfolio. The best value is the 1.375 due 1.20 as it trades near 100 and has an inflation index near 1.00. This minimizes one's downside exposure to deflation, but allows investors to fully benefit from rising inflation.

Basically it all comes down to this. Unless high-risk loans can be written at low rates, economic activity will be lackluster. Investors who will acceot high risk for low yields are scarce at this time.