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Inflation Not a Problem Yet

With rare exception, I have written for the better part of a decade about why low interest rates are here for the foreseeable future. Investors who heeded that guidance invested in longer term bonds than were fashionable at the time, and have experienced handsome returns accordingly.

Investors are understandably hesitant to commit to long term loans primarily due to throbbing memories of the hangover of the Jimmy Carter years. It's probably unfair to memorialize that time period as Carter-centric, and maybe it could be better described simply as the Arab oil embargo years. Regardless of what we call it, the late 70's and early 80's ushered in a nasty bond market where rising rates were the norm and prior long term bond commitments got slaughtered. Paul Volcker put a stop to that, vowing to break the back of inflation, and so he did. The carry-on effect was that the following thirty years has seen mostly clear sailing for bonds, as 10% begat 8%, which begat 6% and so on. It stands to reason that things will continue in their current direction until they cannot. I always thought that limit was zero interest. Apparently not. Many developed nations, including Germany and Japan actually have negative interest rates. Imagine an environment so inexplicably confused as to command less money in the future for the certainty of a promise today. I'm not so certain that the trend toward lower rates in the US won't also end with sub-zero interest rates here as well. Accordingly, we are still comfortable with investing in bonds (loans) with longer terms than most people would otherwise choose.

If you read between the lines of so-called Fedspeak, you might gather that they say one thing but do another. This looks like a big head-fake to me. I think the Fed wants us to believe that dramatic forces are building that will amount to nasty inflationary forces if we don't act to hike rates. It looks like a less-honest version of FDR's famous "fear of fear itself" speech. Could it be that the Fed is scared of disinflation and has lost its power to stimulate the economy because near-zero rates has not worked so far and leaves the Fed's hands tied with no ability to drop rates further? Low energy prices are further confirmation that disinflation is likely the case.

If you're with me so far that bonds might still be a good value, there are currently two standouts in the bond world: high yield bonds and tax-free municipal (muni) bonds. High yield (junk bonds) has gotten beat up and looks poised to snap back. Munis on the other hand are less risky than high yield bonds, pay less, but still pay more than their comparable risk brethren, Treasury Bonds. Munis of like maturity still pay more than similar Treasuries before you consider they are also tax free. This creates a wide moat around munis to protect them from potential market shocks.

While low single digit returns may sound paltry, bonds have a history of providing welcome shelter from many past storms in the stock market.

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