The economic and financial outlook remains uncertain

Despite a steep rise in bond market interest rates in recent months, the supposed reasons for the yield rise do not, in reality, adequately justify the move. That does not preclude a further bond yield rise, but it does suggest that the rise will be eventually reversed.

There are numerous factors behind the market's mistaken yield rise, including the Fed's indication that it will soon begin tapering its $85 billion monthly purchases of Treasury and  mortgage securities. The market reaction is both a response to the promised first step in an eventual reversal of the Fed's accomodative policy and a wrong-headed assumption that the Fed's decision indicates the economic recovery is not only turning more robust, but sufficiently to foreshadow accelerating inflation,which is a key determinant of bond yields. The Fed's expansion of money is also widely but mistakenly believed to make an upsurge in inflation a certainty. The slowdown in World economic growth was thought to have been the major force keeping that Fed induced inflation from occurring. But, disinflation prospects only appeared to be lightening with some dubious signs that the economy in Europe and China was improving  Another force behind the market yield rise has been panic selling by holders of troubled municipal bonds, both by individual investors and by mutual bond funds, which needed to get ahead of withdrawal requests. The rise in equity prices is an additional factor in a shift of investor funds from bonds to equities, which has contributed to the yield rise.

Let us look a little more critically at these various issues. Yes, the Fed is under pressure to at least begin the process of reversing its stimulus. The Fed is trying to prevent outright deflation and create some speedup of inflation. But, the realty is that the Fed expansion is merely replacing private debt in the extended deleveraging process that has years yet to go. There is no inflation risk. Not with huge excess, unused, capacity to produce and still massive unemployment and underemployment. Some cite the formula MV = PT (where M is the money supply, V is its velocity or turnover in terms of GDP, P is prices in GDP and T is GDP  transactions) to attempt to prove that the rise in M, money supply growth, with a stable V, or money velocity,  will necessarily produce a rise in P, prices, in other words, inflation. But, the velocity of the money supply is declining. Nevertheless, there are some in the Fed, and many outside the Fed who do not recognize that truth. However, in order to placate those pressures, Fed Chairman Bernanke has been willing to appear to begin the process. But, he and others likely to be at the helm at the Fed, after Bernanke leaves, including Summers and Yelen, recognize that the economic recovery is both fragile and vulnerable, with no inflation.  One of the few bright spots in the economy had been the recovering housing sector.  But, the rise in mortgage rates has curtailed the housing recovery. That and the still weak employment picture will keep the Fed maintaining an accomodative policy through next year and probably beyond. There is a pronounced shift in employment toward part-time work, of less than 30 hours a week, instead of full-time work. This undoubtedly reflects employer efforts to avoid health-care costs. The labor force participation rate, the percent of the population in the labor force, is at a 35-year low. The non-farm payrolls and unemployment rate are artificially improved by such perverse trends. With all this in mind, the tapering of Fed bond buying will be slight and slow and will certainly not be a precursor of a shift to a restrictive Fed policy for a very extended period of years.

As if this were not enough, the European economy is certainly not out of the woods. More signs of the true state of their economic problems will be evident after the German election. And China has a real estate bubble that has not yet burst. Also, there is a transfer of low cost manufacturing from China, where there are rising costs, to still lower cost producers, which will be disruptive to China's economy. In addition, there are economic uncertainties ahead introduced by the threat of  a US attack on Syria, the potential for a shut down of the Government over a stand off on the debt ceiling, worries over Puerto Rico's finances, unknowns over the Affordable Care Act, and the possibility of a strike against Iran's nuclear facilities.

Where do you invest in the midst of these and other potentially adverse developments. The July decline in durable goods orders to below year ago levels may portend weakness ahead, but it made GE bonds a better buy. One investment to consider is an investment grade Wells Fargo Corporation preferred issue (WFC+L ) with a coupon of 7.5%, yielding 6.7%, that is not callable, but that can be converted by Wells Fargo only when the underlying stock roughly quadruples.

Philip Braverman, President
Braverman Economic and financial Consulting
One Hewitt Square #249
East Northport, N.Y. 11731