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MAKE mONEY BLOG$/Steve Forbes interviewed Richard Lehmann
Steve Forbes: Well, Dick, good to have you with us. You’re a fixed-income guru. I want to get your theory on inflation; most normal folk think that the Federal Reserve is against inflation. Ben Bernanke surprised people when he said, “We like 2% inflation.” But you think it’s even worse than that.
Richard Lehmann: Well, thank you for having me, Steve. And the answer is yes. The fact of the matter is that when you look at the kind of problems that we have, the budgetary problems and the ability of the government to cope with that negative a problem, it looks like inflation is going to become one of the tools that they use to remedy the situation.
We’ve always thought of inflation as the consequence of bad policy. But I’m contending that inflation’s is going to become the policy, in effect. And Bernanke’s announcement of the 2% is a way of saying, “Well, you know, it’s a safeguard. And it’s better than deflation.” But I think that the real target is probably more in the 5% rage. And it typically overshoots so you can get up as high as 8% before real policy moves set in.
But if you think of it, 5 to 8% inflation over ten years would remedy a heck of a lot of problems that we have today. Creates a lot of new ones, of course. But politicians are principally focused on those short-terms problems. And those are the ones that would be alleviated quickest by inflation.
Forbes: They have a theory called the Phillips Curve, which says you need a little bit of inflation to get economic growth. Experience shows that’s nonsense but they still adhere to this theory; you thought the 1970s would have gotten rid of it with stagflation. But what leads you to believe they’re going beyond the 2%, that in their heart of hearts, they really want 5% or 8%?
Lehmann: Well, because 2% really doesn’t do much to solve the problems. And I think that the problems are so pervasive across a multiple of things, that the magnitude of the debt, the trade balance, the indexing of various cost components, which the government can modulate by the fact that it controls CPI – which is another whole topic of how that’s being manipulated – in a way, it gives the government a tool that they can use where nobody has to hold a hand up or be held accountable.
Forbes: On the CPI, let’s chat for that for a moment before we go back to QE2. You say how they concoct the thing understates inflation and therefore people don’t really realize, even though they go to the supermarket or the gas pump and see prices are rising, that it’s worse than what the official numbers indicate. Hedonic, you call it.
Lehmann: Yeah, the CPI is – first of all they take the two biggest components out of there, food costs and energy, and say, “Well, that’s too variable. It shouldn’t be in there,” which, you know –
Forbes: Core inflation.
Lehmann: Yeah, so, we’ll go with core inflation. Now, you get into that and you have what you call hedonic adjustments, where you get a $20 increase in the price of a cell phone and they say, “Oh, no, no, no, no. That’s really a $20 decrease in the price of the cell phone because it does so many more things than the old phones used to do.” And consequently, they can basically delay the recognition of the true underlying inflation for months and months. And that, of course, has huge impact on things that are indexed to inflation, which is everything from tips to government salaries, Social Security and even some of the Medicaid.
Another Bank Bailout
Forbes: Now on QE2, we all thought that that was a device to goose the economy. You think it’s part of the Fed effort to bail out the banks. Can you explain?
Lehmann: Well, after 2008 the banking industry was obviously in dire straits. So, they were terribly undercapitalized because of all the mortgage write-offs they had. And the Fed basically opted to give them an out. Rather than having to go dilute their capital tremendously by issuing new shares, they went and created this artificially low, short-term borrowing rate of 25 basis points.
And with long treasuries being about 4.5% at that time, a bank was able to, with leverage, basically earn over 4% rate of return, risk free, in U.S. treasuries. Of course, you can play that game. But the risk there is that if interest rates start to move up, you need to get out fast, if you’re leveraged.
Last November, Bernanke, in effect, said that inflation is coming. And without saying that they should be getting out of the carry trade, he was in effect saying, “We’re gonna make $600 billion available to the economy for buying treasuries,” which was a way of saying, “We’re going to deflate this carry trade bubble, so don’t everybody rush to the door here at the same time.”
And we see that that policy seems to be working pretty well. Rates have not gone up significantly since the initial round of this, where a few too many people did step up. So, we saw some uptick in the race. But effectively, he is deflating that carry trade bubble. But, of course, at the expense of buying back these treasuries at prices that are going to look pretty expensive in about six months after the program’s over.
Forbes: But even so, given the fact that banks have leverage if the long bond goes from 3.5% to 4.5% to 4.75%, that’s a huge loss, isn’t is?
Lehmann: It would be if they were still in that position. But the Fed has basically held the yield at a steady rate and is taking back those treasuries at those price levels so that they’ve locked in. You think about it: They’ve earned over 4% leverage ten times. So, they’ve earned 40% for about two years. That’s a heck of a nice return.
But there was another benefit to them of doing this in that, for two years the banks have been really occupied with resolving all the mortgage problems that they had on their books. And they didn’t have a labor force to really do that. And so, effectively, by the banks employing all their assets in treasuries, they freed all their own officers, as a work force, to straighten out the mortgage that was on their books. This is why the banks weren’t lending during that time period.
The Banks’ Alibi
Forbes: How much of the non-bank lending is attributed to the fact that examiners were gonna give you a hard time if you made a business loan, which was not the same thing as buying treasuries?
Lehmann: Well, that was, you know, one of those things. It really, I guess, sort of, became a cover story, if you will, for the fact that the banks weren’t interested in lending to the private sector, as long as they could make 4% risk free.
Forbes: And in terms of QE2, it expires in June. What’s going to happen to the ten-year and the 30-year bond then? Is it going to go up?
Lehmann: They’ll be rising. It depends on how quickly the banks get back to lending out that money because the velocity of money now is going to start increasing as the banks lend this money out. And we can expect that those long rates, which right now are being still managed by the Fed, will seek market levels. And that’s going to be higher.
Forbes: What? 6%, 8% yields?
Lehmann: Not this year. No, I think you may see that next year. But I think it’ll go up 1% or 2% this year. And I think that from there, it’s anybody’s guess.
Short Treasuries?
Forbes: And so, would you advise investors who have the stomach for it to short treasuries?
Lehmann: Well, that’s difficult for most people to do. What I have been advising is for people to basically, between now and the end of June, get out of all of the fixed rate type of securities that they have, in terms of bonds, munis and such and go into things that are more tied to the stock market, because that’s going to be able to adjust more rapidly. So, we’ve been saying buy blue chip high dividend stocks.
Forbes: Let’s get into those. But I just want to hammer this home. If you have fixed income securities, now is the time to get out? I mean, fixed rate securities.
Lehmann: Yeah, especially junk bonds and such. Because it’s that below-investment rate category that’s going to get hit the hardest. It has come down to levels that we haven’t seen in a long time, in terms of the spreads between treasuries and these junk bonds. And I think that once rates turn around, they’re going to take the biggest adjustment.
Forbes: But even treasuries? If you have a ten-year, 30-yaer treasury, you’d say get out because you’re going to take a principle loss, at least on paper?
Lehmann: I think that the capital loss is that you stand to have, in the next two years, way more than the interest you’re going to be able to learn on those securities. So yes.
Forbes: Now, one of the things you seem to like is floating rate securities. How would an individual get into those?
Lehmann: There are any number of floating rate securities that are outside the bond market. Typically most of them are in the bond market but they’re difficult to buy there. But there are a number of package products on the New York Stock Exchange, mostly issued by banks – JP Morgan, Citibank, Goldman Sachs. $25 preferreds that really are backed by a bond that is tied to the CPI or to LIBOR, for the most part.
Heresy In Blue Chips
Forbes: And you also mentioned, stocks.
Lehmann: I know it’s a heresy for me to talk about stock and buying stocks. But the Canadian energy stocks have always been favorites of ours because they are high dividend paying. But even blue chip securities like an AT&T pay 4% or 5% yield. As long as they’re not paying out more than 75% of their cash flow and they have a good history of dividends, they’re good options. Because they will adjust for inflation much more readily than fixed-income securities.
Forbes: What other names would you throw out? You mentioned AT&T.
Lehmann: AT&T. Pitney Bowes. There’s a lot of funds also that we recommend – closed end funds, that specialize in these kind of securities. For example, there are what we called buy-write funds, which are funds that hold a basket of blue chip securities and then they write call options against it. And from that, they can basically get an enhanced return so that some of these are paying 7%, 8%, 9% payout rates.
Forbes: In terms of those preferreds, say the name of your newsletter that you do with us so people will get into commercial here in terms of finding the name.
Lehmann: Forbes/Lehmann Income Security Investor Newsletter.
Forbes: And in that you have these $25 preferreds with floating rates?
Lehmann: Yeah, we mention those. And we also run four model portfolios to give people a sampling of a starting point, if they want to follow our philosophy there. And in terms of low, medium and high risks, though, they can pick their category, as well as a blended one.
Muni Bonds
Forbes: Muni bonds. Individuals have been in panic over muni bonds. And you’ve warned and others have warned the spreads in those are huge and you can get really hosed going out. What do you advise people who may have accumulated large muni bond portfolios?
Lehmann: Well, there’s a mixed purpose here. Most of the people, if they’re extremely wealthy, their number one concern is just preserving what they have and not particularly concerned in maximizing their income and such. If they’ve got shorter maturities and such, they’re okay. But we feel that the real risk is inflation with muni bonds, not this Meredith Whitney scare about hundreds of billions of dollars of defaults.
Because we always publish a newsletter on municipal defaults and such. And we’ve been tracking that since 1983. And I can tell you that defaults is not a big concern among municipal bonds historically or likely in the future. It’s more the inflation that should be of concern to investors.
Forbes: Tell me about defaults. Even in this environment, I mean, housing was once at a pattern which was upended in the last decade. You don’t see the same thing happening to muni bonds? What was in the past does not happen in the future?
Lehmann: There is a huge problem right now in what’s called Florida Community Development Districts. There’s several hundred of these in Florida that have issued bonds. And over 150 of them are in default on those bonds. These are housing projects for the most part got started in 2006, 2007. And by the time the infrastructure was put in place the market had collapsed. And there’s about four billion dollars worth of these bonds out there. And many of these projects will never get built out.
This is not unlike a similar event back in the 1990s in California with the districts out there, what they call the Melrose bond. And there is going to be a problem with those because Florida’s not growing the way it used to. It’s not likely to turn around any time soon. So, this is probably a decade-long problem.
Forbes: On muni bonds, would you advise people to go into funds just to spread their bets or just get out of the market?
Lehmann: I had this discussion with somebody recently. And I said, even though the reality is that there’s not a terrible default risk there in this kind of an industry, perception seems to be the predominant mood. And therefore, I think that even though the risks have been exaggerated, I think the perception will continue to have people selling. And so I don’t think that they’re a good thing to be in right now. Maybe when the inflation really kicks in and the prices have adjusted, you can get back in. But I wouldn’t want to be there when you’re going through that cycle.
Lehmann’s Grenades
Forbes: You seem like such a calm man and, yet, you’ve been throwing out these grenades that Ben Bernanke has a secret program to reflate the capital of banks, that he wants a higher rate of inflation.
Lehmann: I guess I don’t have a wide enough readership.
Forbes: But why would they think that, given the experience of the ’70s, why would they think inflation is something that can be controlled, that it has political repercussions? You don’t win many votes with inflation. The stock market, even though it can go up and down, in real terms goes down. We saw that in the ’70s. How do they think they’re going to come out politically on that? Or do they think it’s like Nixon in ‘72? You can play games, win reelection and let the –
Lehmann: Well, because the people that are in control of that aspect of it aren’t elected. Ben Bernanke, the Treasury Secretary, these are your two principal parties that can make this happen. They’re above that. And they can create these cover stories and make you concerned about deflation in order to make you think that this massive amount of printing of money is, well, we got to stop the deflation threat.
And therefore, you can do this for quite a while before it gets out of hand. But if you think of it in terms that this is actually the intention of policy – but you can never admit to that – then it all makes perfectly good sense.
The Safest Oil
Forbes: Canadian royalty trusts, which you’ve been a fan of for a long time, you’re still recommending them, even though the tax treatment’s changed?
Lehmann: More than ever. Because the safest oil in the world is coming to us from Canada. And you don’t have to put it on a tanker; it’s a pipeline away. And it’s been a good revenue source. There’s also a dynamic to these Canadian trusts that is playing over the next few years. And that is a fact of the oil sands that are coming into play, where the principal cost of converting oil sands to oil is gas to heat it up.
And it’s projected that before the end of the decade, Canada will not be exporting any more gas. They’ll be consuming it 100% for oil sand conversion. Now, that’s a great dynamic for most of these trusts, which are typically 50% oil and 50% gas, that as they develop oil sand resources, they’ll be utilizing internally their cheapest product to create a much more valuable one. So, that creates value over and beyond having to buy additional reserves.
China’s Gold Hoarding
Forbes: Another thing. You have an interesting theory, talking about throwing grenades out, about China and gold. Please explain.
Lehmann: Yeah. I had thought for many years that our relationship with China was they sent us goods and we sent them paper. That was the ideal situation for us. I mean, how can you lose? I mean, you keep sending them promissory notes and then you let the dollar erode and the value of what they’re holding is deteriorating.
But it’s gotten to such a level now that I’m concerned that basically China is probably already on a program to diversify the dollar into gold. I don’t think they want any other fiat currencies or want to minimize that amount. But if they can establish a large gold reserve for themselves, they would be in a position of some day in the future, effectively saying, “We’ve decided to come to buy our last resort for gold. And today’s price that we’re willing to pay for it is $1,500 an ounce.”
Dollars, not Renminbi. Which means they’ve, in one stroke, basically taken control of the gold market and tied the dollar to gold so that effectively, if every six months the dollar deteriorates 5%, they can just upgrade the stated price at which they wanted to buy gold at and thereby, upgrade and up-value their gold reserves but also keep the dollar in check.
Forbes: That’s not like the Hunt brothers?
Lehmann: Well, the Hunt brothers basically didn’t have deep enough pockets. The big difference here is that I think it was estimated that the total value of all the gold out there is something like five trillion dollars. And the Chinese are sitting there with over two trillion dollars in the dollar reserve. So, they obviously have a deep enough pocket to handle anything that anybody wants to throw at them.
And besides that, you know, if they did something like this, the world would embrace it. I mean, there are other central banks and certainly enough speculators out there who would love to have somebody to peg gold and put a floor under it, in effect.
So it’s not inconceivable that this would happen. I think it’s a little more than the Chinese, they’re not sophisticated enough right now to try to pull off something like that. I think there are going to be unintended consequences. But I’m afraid most of them are going to be bad for us.
Forbes: Now what if Ben Bernanke decides to go back to academia — which would be a great service to the world — and somebody gets in who says “Sound dollar,” and suddenly the gold market, as it did after Volcker and especially Reagan killed the inflation of the ’70s – gold price went down? What would the Chinese do then?
Lehmann: Well, as I say, if they’ve got a balance between, they’ve got a large gold holding now and a large dollar holding, what they’re losing over here they’re going to pick up on the other side. So for them the balance is still there.
Forbes: So, they can’t corner the market, they’re just ahead.
Lehmann: I don’t think the intent would be to corner the market. The intent is basically to preserve the buying power of the two, three trillion dollars of reserves that they do have.
Forbes: So, would you buy gold now?
Lehmann: I’ve been buying gold since 1973. And I don’t have any faith in any of the currencies because all the industrial countries have the same problems we have. And all the currencies are going to be fiat currencies. I think over the long haul, it’s going to be a race to the bottom as to whose currency deteriorates the quickest.
Forbes: So, you don’t see a sound dollar on the horizon?
Lehmann: No. it’s just too costly. And the politicians are going to look for the easiest solution. And I think devaluing the dollar and inflation are two of those tools that you can implement without having to take responsibility for it.
Forbes: So, a fixed income guru says, “Sell fixed rate assets. Buy stocks with dividends that have a history of going up and not being overly paid out now, 70, 75% ratio. And buy Canadian royalty trust. And you’ll do all right.”
Lehmann: And at some point when the inflation’s kicked in and you can lock in 8, 9% rates of return, do it.
Forbes: Thank you, Dick.
Lehmann: Thank you.
source: http://blogs.forbes.com
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