Few more articles about investors using gold as a potential inflation hedge.
Our current chairman of the Federal Reserve, Ben Bernanke, is an “inflationist.” When times were good, he supported an easy money policy. Even when the Fed raised rates, Bernanke took great pains to give the markets many warnings to insure that the higher rates wouldn’t break up the credit party, i.e. bubble formation. Now that the cycle has turned, the Fed has promised to resort to “all means necessary” to head off the effects of the collapsed bubble. Rates have effectively been lowered to zero. The Fed is making loans collateralized by toxic waste and has now begun a policy called “quantitative easing” — a fancy term for “printing money.” The size of the Fed’s balance sheet is exploding and the currency is being debased. Combined with an aggressive fiscal policy, it is clear that the authorities are going “all-in” to try to mitigate the near-term effects of the economic collapse. Our guess is that if the chairman of the Fed is determined to debase the currency, he will succeed. Our instinct is that gold will do well either way: deflation will lead to further steps to debase the currency, while inflation speaks for itself. We have bought gold, calls on gold, an index of gold mining stocks (GDX) and calls on higher long-term U.S. interest rates. We have also moved some of our cash into foreign currencies, particularly the Japanese Yen.
Pabrai Funds is primarily a stock picking outfit. We know very little about bonds or fixed income. Thus we should be the last ones to pontificate on bonds and US Treasuries. The reason I have ventured out and commented is because the situation is so extreme today. On one hand, yields on US Treasuries are the lowest in decades. On the other hand, yields on every other kind of debt are at their highest levels (relative to treasuries) in decades.
Municipal bonds are among the safest investment class out there – especially when bought as a basket. With their tax-free nature, they typically yield less than treasuries (which are taxable). Today 30-year munis have yields that are 161 percent higher than 30-year T-Bills. It is unprecedented.
Typically the yield delta between 10-year treasuries and Baa rated corporate bond has vacillated between 10 and 400 basis points (0.1% to 4%) for over 45 years – with the average being around 200 basis points (2%). It got over 300 basis points in just 6 of the last 45 years – and quickly fell back to the 2% level. In December, 2008, this delta hit 616 basis points – 6.2%! While 10-year treasuries yielded 2%, the Baa corporate bonds yielded over 8% – the widest spread in over half a century.
I believe these spreads between US Treasuries and various types of bonds will get back to historical ranges in the not too distant future. They may even overshoot (very tight spreads).
How can I setup Pabrai Funds to protect and profit from the above? Well, the best assets to own in an inflationary world are businesses whose products are inflation indexed – where prices can be raised at or above the rate of inflation. In addition if a business has done large amounts of capex using old dollars and does not have much need for capex at new dollars, yet can sell products at inflated prices, it is likely a home run. Such a business has a minimal need to take on additional debt. It is a beneficiary of both high interest rates and high inflation.