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Counting the Cards

By: Kevin Doyle

“Unless entitlements are substantially reformed, I am confident that this country will default on its debt; not in conventional ways, but by picking the pocket of savers via a combination of less observable, yet historically verifiable policies — inflation, currency devaluation and low to negative real interest rates.”

These are the words of William Gross, founder and co-chief investment officer of the Pacific Investment Management Co. just a few months ago. Accordingly, the world’s largest bond fund, managed by PIMCO, dumped all of its U.S government holdings in February of this year and effectively sold short government securities in March. Presumably, this strategy has not performed as expected, given the decline of more than one half of one percent in intermediate Treasury securities since yields peaked in February.

Despite the recent rally in bond prices, and the market’s implications, there is little doubt the cost of money will increase in the years ahead for the world’s largest debtor nation. Although there are near-term pressures and “wild card” events that could substantially curtail economic growth and hold down interest rates, there are both fundamental and technical reasons to position the fixed-income portfolio for an inevitable increase in interest rates.

Credit concerns. Standard & Poor’s recently lowered its outlook for the creditworthiness of U.S. debt. Although the rating agency did not lower its AAA assessment of the debt, the probability of a reduced rating at some point in the future has now been recognized more formally. The timing of this change has added fuel to the political fire pertaining to budget deficits that are projected to exceed $1 trillion a year and the debt ceiling that has doubled within the last decade to more than $14 trillion.

Supply and demand. Given the inability to limit government spending, the volume of government borrowing is on a trajectory that will likely exceed any increase in the demand for U.S. debt.

Domestic investors, including the Federal Reserve, have been doing their parts to keep pace with the escalating issuance of U.S. debt securities. After two rounds of quantitative easing, the Federal Reserve is now the world’s largest holder of U.S. debt securities with an expanded balance sheet of about $2.7 trillion. As the QE2 buying program comes to an end, the U.S. central bank has given no indication that it is preparing to liquidate its balance sheet. Nonetheless, the biggest buyer of U.S. debt securities will no longer be absorbing $75 billion per month.

Foreign investors have likewise been absorbing a record volume of our debt. Despite concerns for the world’s reserve currency, China and Japan have continued to increase their record holdings of U.S. securities. Additionally, the sovereign debt crisis plaguing Europe has provided a safety bid that has enhanced demand for the U.S. dollar and its bonds. Nonetheless, foreign investors are increasingly questioning their exposure to dollar-denominated investments, because of our fiscal and monetary policies, and the political difficulties of restraining unsustainable deficits. Price is always a function of demand relative to supply.

Inflation and inflation expectations. Central bankers around the globe have been raising interest rates in response to rising prices and expectations of higher growth and faster inflation. Higher commodity prices have the attention of fixed-income investors, as heightened demand from developing countries has combined with the modest demand from the more developed countries. Notwithstanding global pressures, the U.S. central bank has held to an extraordinarily accommodative policy, believing commodity price increases will be transitory and that underlying inflation in the United States will remain subdued for some time.

There has been no shortage of criticism regarding monetary policy, and there is a growing concern for unintended consequences. The trade-weighted value of the U.S. dollar has declined some 15 percent in the last year, while the value of gold is up 25 percent and silver has doubled. Investors have been seeking to hedge financial assets against accelerating inflation. The good news is that employment is improving, albeit marginally, and economic recovery is a good bet. The price of this success is a loss of purchasing power.

Serious poker players endeavor to play the odds. Bankers should likewise count the cards. Inflation, currency devaluation and negative real interest rates are already observable and verifiable. Eventually, market forces will prevail and the cost of money will increase. The variables are when, how much and what to do in the meantime. Cash and cash equivalent securities are expensive and excessive liquidity should be avoided. Portfolios that are postured defensively will outperform in time.

Kevin Doyle is senior vice president with Country Club Bank, Kansas City, in the Capital Markets Group. Contact him at kdoyle(at)

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