Tuesday, January 12, 2010

German Bonds vs. U. S Treasuries & Inflation

A recent Bloomberg.com article entitled, "Bernanke Bond Spread Most Since 2007 Shows Decoupling", exemplifies the constant need to apply critical analysis when reading any article, book, or information from any source.  The article begins, "The correlation between Treasuries and German bunds that has prevailed since credit markets started freezing in 2007 is breaking down as U.S. economic growth leaves Europe behind." It immediately continues with "Yields on U.S. 10-year Treasury notes rose twice as fast as German debt with a similar maturity since the start of December ...".

Reading that one would think the US is tromping Germany, but why would Pimco be selling US Treasuries and buying German bonds (Bunds)?  The decoupling is actually the investor view that the German Bund is a safer investment and they are willing to pay for it while investors apparently believe U. S. Treasuries are a riskier investment demanding a lower purchase price to face value.  While investors generally seek higher yields, the perception appears to be that the ECB has been setting its interest rate policy not only to provide liquidity but with a constant eye on inflation (a dual focus).  Consequently, the Fed, which lowered interest faster and to near zero (zero to 25 basis points while the ECB is at 1%), will have a more difficult time shifting its focus from liquidity to inflation with inflation expectations already stoked and heating up.

As we said last month on the radio show, CPI going forward from this past January will show increasing inflation, because it will be comparing year to year with a past period of declining inflation.  With oil prices continuing to go up despite 26 miles of full oil tankers sitting offshore in the oceans around the world, because there is not enough storage on shore given the lower demand, it will be even more aggravated.  If there are food shortages as the result of growing conditions, as some have predicted (rice, soybeans, sugar), the price of food will be going up.  We are already starting to see a variety of commodity prices going up.

The recovery is fragile.  What is going to happen when China starts tightening its economic, monetary, and fiscal policies to fight its real estate/housing bubble, spending bubble, increased use of leverage, and the threat of inflation?

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