05 Jan 2010

"A Savvy Bond Man Bets on Rising Inflation"

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John Cochran (not the Chicago guy, the Vienna guy) sent me this wonderful WSJ article from Dec. 26 profiling Bill Tedford. For longtime readers, just look at how many of Tedford’s points are the same things I’ve been harping on:

Bill Tedford is encouraging investors to bet against remarks by Federal Reserve Chairman Ben Bernanke, who told a group of Washington-area business leaders this month that “inflation could move lower from here.”

For more than 20 years, Mr. Tedford has run a benchmark-beating bond portfolio for Little Rock, Ark.,-based Stephens Inc. And though Mr. Bernanke sees slack in the economy that could push inflation down, Mr. Tedford says inflation already is evident in the consumer-price index and will lurch higher in 2010 and 2011.

He and Stephens have begun encouraging clients to invest more money in timber, oil and gas, agricultural commodities and industrial and precious metals—historically good places to be amid rising inflation.

“The alarming part,” Mr. Tedford says, “is the possibility that inflation could explode beyond the numbers we’re looking at.”

Across the country these days debate rages about whether U.S. fiscal policy has primed the country for a bout of inflation—and just how bad any inflation might be. Count Mr. Tedford among the group of inflation bugs who worry that all the dollars now sloshing around the economy can only have an inflationary outcome.

For 20 years Mr. Tedford has managed a portfolio now amounting to about $1.25 billion, including $800 million in government bonds. During that time, his audited performance has topped the benchmark Barclays U.S. Intermediate Government Bond Index in the one-, three-, five-, 10-, 15- and 20-year periods. In the 12 months ended Sept. 30, his 8.87% return outpaced the index by more than 2.6 percentage points.

Because his focus is riskless U.S. government debt, Mr. Tedford’s only concern is federal economic policy and the outlook for inflation. And these days, the model he has relied on for two decades insists that inflation is bubbling to the surface.

The key data point in Mr. Tedford’s model: the monetary base, basically money circulating through the public or reserves banks on deposit with the Federal Reserve. Over long sweeps of time, he says, inflation closely tracks increases in the monetary base that exceed economic growth.

For instance, he notes, in the 40 years to 2007 the U.S. monetary base grew at 7.08% a year. Gross domestic product, meanwhile, grew at 3.04%. The resulting surplus monetary-base growth of 4.04% closely matches CPI and the personal-consumption-expenditures price index, another measure of overall inflation.

In the wake of the U.S.-inspired global financial crisis, the nation’s monetary base has ballooned to more than $2 trillion at the end of November from less than $850 million in August 2008, before the crisis began, according to Federal Reserve data. Even subtracting the more than $1 trillion in excess reserves, the nation’s monetary base has grown by more than 11% in the past 15 months, “one of the highest changes I’ve ever measured.” Mr. Tedford says.

U.S. GDP during that period shrank by about 2%.

“The weight of that sharply increased monetary base points to significant inflation in 2010 and into 2011,” he says.

His model “anticipates that trailing 12-month CPI goes positive by the end of this year, up to 3% or 4% by the end of 2010, and then toward 5% or 6% by mid-2011.” And if some of the excess reserves start leaking into the banking system, as Mr. Tedford thinks is happening, “inflation could go much higher.”

Already, Mr. Tedford says, inflation is apparent. While the unadjusted year-over-year CPI reading for October showed prices sank by 0.2%, the year-to-date change since January indicates prices are up more than 2.3%.

For two years Mr. Tedford’s bond portfolio trailed its benchmark by as much as 1.2 percentage points—”a very painful period for us,” he says. “The model was right about inflation, but the interaction between inflation and interest rates didn’t follow the norms.”

Nevertheless, he says the model “has been extraordinarily accurate in the last 20 years [and] is responsible for our track record against the benchmark.”

I’m too busy/lazy right now to capture and reproduce the WSJ chart, but you should click on the link and check it out. It is nostalgic for me because when I worked at Laffer Associates we used a similar metric. (And yes, go ahead and put stuff about Peter Schiff in the comments if you must, I’m still saying I learned a lot about monetary theory while there.)

Among other things, I loved this article because it shows the limits of the efficient markets hypothesis. There is nothing wrong about me thinking that my model is better than “the market’s model,” because there’s no such thing as the market’s model. The market price is that which balances the competing forecasts and risk tolerances of everyone who wants to put money on the line.

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