Recently, Goldman Sachs forecasted that by the end of 2013 the yield on the 10 year Treasury will jump to 2.40%. This is almost a 30% rise from current levels and that’s a huge increase for a supposedly riskless investment. The most likely reason is it’s an inflation adjustment, which means we should probably talk a little more about inflation: what it is, who gets burned, how to minimize the damage – the Tedford Model.
What is Inflation?
Inflation is an inverse measurement of the decline in the purchasing power of the dollar. It’s inverse because if inflation is one way, the value of the dollar would be the other way. If inflation was up 10% it would mean that over the last 12 months, the purchasing power of the dollar has gone down by 10%. If the government announced that the economy experienced deflation of 2.4%, it would mean that over the past 12 months the dollar actually gained 2.4% in purchasing power. Fortunately, not all investments are affected equally by inflation; in some, the value of the investment declines and in some it doesn’t (although there may be a lag.)
Who Gets Burned
Investments (investment: the purchase of a stream of income) have either fixed or variable payments. Inflation erodes the value of fixed return investments (bonds, fixed rate mortgages) because their payments don’t go up to offset the purchasing power lost to inflation. Remember the cap rate formula (net income divided by cap rate equals value)? If the net income remains the same while the cap rate (interest rate) goes up, the value must go down. ($1,200 divided by 0.10 cap rate equals $12,000 value; $1,200 divided by 0.25 cap rate equals $4,800 value). Inflation can thus reduce the principal value of a bond or mortgage but that doesn’t mean that the bond becomes unsellable. For example, if inflation was 15% would you buy a bond that carried a 3% interest rate? Certainly, but the seller would have to reduce the price of the bond until the stream of income payments received was the same 15% that you could get in a competing bond . . . and that would be a big haircut.
Hard assets whose income adjusts with inflation (variable payments) are not hurt as much. Remember the key: income must adjust with inflation. Using an apartment building as an example, one would expect rents to rise at least as much as inflation. That means the building’s value will increase as rents / inflation go up. In other words, in inflationary periods it’s a good thing to hold assets whose income can be increased to offset inflation.
Putting it Together
If there is a mortgage, somebody has to eat the inflation adjustments and it’s either the borrower or the lender, depending on what the contract says. Apartment building mortgages can have a fixed rate period (when the bank eats inflation) followed by a variable rate period (when the borrower eats it). The banks aren’t stupid: the variable rate period is longer. In times of inflation the borrower can maximize his gain / minimize his loss by refinancing so his mortgage interest continues at a fixed rate, even if the interest changes between refinances. The total interest saved by serially refinancing during a period of rising rates can be significant. Even in the event of rates increasing over an entire 30 year term (a very unlikely event), this might require as little as three refinances (assuming initial 10 year fixed rate periods).
Quantitative Easing (QE) is sort of the last arrow in the Fed’s quiver. They don’t have anything else, that’s probably why they keep shooting the same arrow again and again. The hope of QE is to reduce interest rates in the expectation of stimulating a morbid economy. It is used when a central bank has already pushed interest rates to near zero without noticeable effect. QE can, when sufficiently aggressive, force interest rates below zero. If Quantitative Easing doesn’t work to regenerate the economy, there’s not much else available.
Banks hold most of their reserve capital in government bonds. Under Quantitative Easing the Federal Reserve buys the government bonds from banks, on each occasion allowing a small profit to the banks. The bank is now free to use the same money to buy more government bonds, the Fed again purchases what the bank next buys, the small profit taken, and the cycle continues. Notice that although the bank makes a trifling profit for their participation they face no risk and their bond inventory can be turned over many times during the year. As long as the banks receive their small riskless profit (net of inflation) they have no incentive to alter course.
If the plan works, eventually the economy begins to recover and the minimal profit the banks realize by participating in QE is overcome by nascent inflation. Money starts to leave the bank in the form of business loans which pay interest at a rate greater than inflation. It’s important to realize that until this happens, until banks begin to lend their excess reserves, the reserves don’t count in the economy. That’s the reason we never saw the 11% inflation predicted by the Tedford Model back in 2009.
Velocity of Money
Inflation will rise when banks take money from their reserves to once again fund loans on things not yet built, on projects not yet started, on expansion not yet taken. Money lent is money spent. Machinery is bought, raw materials purchased, third-party charges paid. The funds are received and payrolls are met. Groceries are purchased. The dry-cleaner’s paid. The same dollar is passed from one hand to another again and again, doing the work of many dollars. The restaurateur notices all his tables are filled, the bar is packed and there’s a line out the door. Naturally, he raises prices. The appearance of prosperity is achieved and inflation is its familiar spirit. http://research.stlouisfed.org/fred2/categories/32242.
This column last referenced the Tedford Model in late 2009, when it anticipated an inflation rate of 11% which never happened because the banks haven’t yet begun lending their excess reserves. Meanwhile, the monetary base has since expanded mightily. Currently the U.S. is running a deficit of about $1 trillion and the Fed, through its QE program, is buying about $85 billion of government debt each month. Essentially, the Fed is paying for the government’s deficit. The Tedford Model forecasts the national consequences of this credit binge.
- Who: Bill Tedford is director of fixed income strategy at Stephens, Inc. Wealth Management and runs a $1 billion portfolio of U.S. government bonds. Over the past two decades he regularly surpasses his benchmark. With that kind of record, he’s earned his t-shirt.
- What: The Tedford Model recognizes that, over time, inflation closely tracks the monetary base (monetary base: money in circulation plus bank reserves on deposit with the Federal Reserve) minus growth in GDP. Over the last 50 years or so the U.S. monetary base has grown a little over 7% per year. The economy, as measured by the Gross Domestic Product, grew at just over 3% annually. That’s a 4% difference and closely matches CPI growth for that period. The formula is: Growth in monetary base minus growth in GDP equals expected inflation.
The monetary base grew from about $900 billion in the first quarter of 2008 to $2,986 billion at the end of the first quarter 2013. That’s a compound annual growth rate of 27%. (http://research.stlouisfed.org/fred2/series/BASE).
U.S. Gross Domestic Product was hovering around $14,500 billion in 2008 and rose to $15,864 billion in late 2012. That’s a compounded annual growth rate of 1.85% (which we’ll arbitrarily round to an even 2%). (http://usgovernmentspending.com).
Any increase in the monetary base exceeding the increase in GDP is ultimately inflationary but it doesn’t necessarily happen immediately, not until banks begin lending their excess reserves, not until inflation quickens, and then it will probably start slowly for a short period before it gathers the potential to increase exponentially.
Plugging the monetary base and GDP numbers into the Tedford Model currently generates an anticipated inflation rate of about 25%. This number is temporary and only valid if the Fed immediately stopped increasing the monetary base. If they don’t, the number will rise.
The Tedford Model forecasts how high future inflation will be. Its weakness is that it doesn’t tell us in advance when inflation will arrive, only that it shall. Our job is to act (a) when we first notice the start of inflation or (b) when QE ends, as we all know it someday must, whichever is first.
When Quantitative Easing ends and inflation begins, what might be the effect of 25% inflation on mortgage rates? We don’t have a domestic history of 25% inflation. That’s outside the data. The closest we can get is when inflation last peaked at 14.76% in March 1980, resulting in mortgage rates of 18.45% in Oct 1981. Back then, mortgage rates rose to be 25% greater than the inflation rate. The direction of inflation may be upwards, but I fervently hope we never reach the Tedford Model’s prediction: 25% inflation and an indicated 31% interest rate. Take a sip of tea, dear, you look like you need it.
Executive Summary The rise of consumer prices will signal the beginnings of inflation, confirmed by the re-start of business lending. That will tell us “when”. The velocity of money tells us “how fast” inflation will rise. The Tedford Model tells us “how high” inflation we’ll probably get. High inflation generates subsequent high interest rates, which reduces the velocity of money. When high interest rates peak, it means growth in inflation has tapered off. High interest rates tell us “how long” ever-rising inflation will last. If you think I can help, call me.
Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected].
If you’ve missed some of the prior articles, basic “beginner” guidelines on successful investing are in my book “Stairway to Wealth” available at www.LuLu.com