Interest Rates and Investing – Is The Fed Out of Ink? (EDV, TLT)

by Ivan Martchev | July 1, 2010 7:26 pm

Investors watch interest rates for many reasons, from mortgage rates on their home loan to the economic trends caused by Fed action. But interest rate investing can be tricky, since what the Fed says is one thing and what rates do is very different.

With all this printing by all the major central banks, we are again seeing negative readings on inflation in the past two months — that is a fact. And I know full well what Bernanke & Co. is fighting: Serious dips in CPI — outright deflation — the likes of which we saw in the early 1930s.

So far, in the U.S. the credit aggregates are contracting — there is money in the system but it is not being lent! — which is why those negative CPI readings occur. But, how do you lend money to people that are out of work, or, that have too much debt to begin with? The same goes for corporations in weak financial conditions. The Fed can increase the supply of money, but can it increase the demand for credit?

This situation lasted far longer than anyone expected in Japan — and it is still ongoing. I don’t know how long it will last here, but already it is approaching nearly two years.

So, I would not be surprised to see the U.S. bond market retest the highs in bond prices seen in 2008 this year. We have negative readings in U.S. CPI as well as flight of capital from weak European bond markets that ends up parked tin U.S. assets, mainly Treasuries, as you can see from the chart below. You cannot deny the relentless bid chasing U.S. bonds since April with very little pullbacks.

The most sensitive bonds to a fall in interest rates are zero-coupon bonds. Since they have no coupon interest payments, the interest rate is factored in as a discount to the bond price. Note how the Vanguard Extended Duration ETF (NYSE: EDV), which is the only zero-coupon bond ETF,  is quite a bit perkier than the iShares Treasury Bond 20+year ETF (NYSE: TLT), making it great for hedging in dicey conditions like credit and currency crises, such as right now.

There are also leveraged bond ETFs — but they should be avoided except for short-term trading purposes, so I won’t include any ticker symbols here. Leveraged ETFs are terrible for buy-and-hold investors because the compounding works against you. If bonds stay in a trading range both bullish and bearish bond ETFs decline substantially!

And while deflation is good for high-quality bonds, it’s terrible for banks. Since deflation is only a problem in the West,  we prefer BRIC banks that have no such issues and all this Western printing is  great for them. BRIC investments hold a lot of promise. They have not rallied a lot this year yet, but if the situation remains contained, I am highly confident that they will.

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