Buffett warns of inflation, cuts duration of bonds held

(NEW YORK) Warren Buffett shortened the duration of bonds held by Berkshire Hathaway after warning that deficit spending could force inflation higher.
Twenty-one per cent of holdings including Treasuries, municipal debt, foreign-government securities and corporate bonds were due in one year or less as of June 30, Berkshire said in a filing last week. That compares with 18 per cent on March 31, and 16 per cent at the end of last year's second quarter.
'It may be a sign that Buffett expects interest rates to start rising, maybe sooner than the conventional wisdom,' Meyer Shields, an analyst in Baltimore at Stifel Nicolaus & Co said.
Inflation has fallen to a 44-year low even as the Federal Reserve more than doubled its balance sheet in two years to US$2.33 trillion to help draw the economy out of recession.
A US jobs report last week showing that companies hired fewer workers than forecast in July pushed the two-year Treasury yield to a record low. Bill Gross, founder of Pacific Investment Management, advised investors to buy longer-dated maturities.
Mr Buffett, 79, urged Congress last year to guard against inflation as the US economy returned to growth. In an August 2009 op-ed in the New York Times, the Berkshire chief executive said government must address the 'monetary medicine' that was pumped into the financial system after the 2008 crisis.
'The United States is spewing a potentially damaging substance into our economy - greenback emissions,' Mr Buffett wrote. 'Unchecked greenback emissions will certainly cause the purchasing power of currency to melt.'
Berkshire maintains a fixed-income portfolio valued at about US$32 billion to back claims against storm damage and car crashes covered by insurance units like Geico Corp and General Re.
'He's probably biased toward inflation down the road,' said Glenn Tongue, a partner at T2 Partners LLC. 'He would want to gradually make the duration decline because in an inflationary environment it's a longer-term instrument that will be the most hit.' - Bloomberg

Inflation staying low over next few years

Business Times - 11 Aug 2010
MONEY MATTERS

By SHANE OLIVER
FEARS about inflation and deflation have fluctuated wildly in recent times. In late 2008, at the height of the global financial crisis, the big worry was a 'debt deflation spiral' dragging the world into depression. Six months ago, many were worried about inflation.
Global growth was recovering and fears abounded that major developed countries would print money to get out of their public debt problems. However, in the last few months, fears of deflation have regained the upper hand, on the back of still falling inflation rates and worries about a return to global recession.
Our base case is ongoing low inflation in major countries over the next few years, but the risks are skewed to deflation rather than accelerating inflation. But what is deflation? Why worry about it? Why is it more of a risk than a surge in inflation? And what would deflation mean for investors?
Deflation refers to persistent and generalised falls in prices. It used to be common, but with the advent of paper currencies not backed by gold and macro stabilisation policies, it became less common last century.
Nevertheless, there was a bout of deflation associated with the Great Depression of the 1930s. Japan has also experienced deflation since the 1990s.
Most people would see falling prices as a good thing because it means that their income and assets will buy more. Indeed there have been periods of 'good deflation'.
For example, in the period 1870-1895 in the US, deflation occurred against a background of strong economic growth, reflecting rapid productivity growth and technological innovation. Falling prices for electronic goods are a modern-day example of good deflation.
However, there can also be 'bad deflation', when falling prices are associated with falling wages, rising unemployment and falling asset prices.
For example, in the 1930s and more recently in Japan, deflation reflected economic collapse and rising unemployment made worse by a combination of high debt levels and falling asset prices. What's more, falling prices can cause people to delay spending, which in turn weakens economic activity.
In the current environment, deflation could cause serious problems because household debt and/or public debt levels are high in many major countries. A swing into sustained deflation would increase the real value of debt at the same time that asset prices would be falling and nominal incomes and government revenue would be weakening. If individuals or governments attempt to reduce their debt burden by cutting spending and selling assets, the risk is a 'debt deflation' spiral may take hold.
The standard arguments of those fearing a surge in inflation are that central banks have been printing money that will drive inflation up and governments will inflate their way out of high public debt levels.
More recently, some fret that the adverse weather-related 80 per cent or so rise in world wheat prices in the past two months signals a new bout of inflation boosting food price surges.
However, there are several reasons not to be too concerned by either of these. First, while quantitative easing has boosted narrow money supply measures such as cash and bank reserves, until this flows on to increased credit and spending increases to levels so that the spare capacity caused by the recession is all used up, there will be no threat to inflation. In fact, there has been no increase in credit growth and excess capacity remains huge.
Second, while it's easy to say 'governments will just inflate their way out of their public debt problems like they did post World War Two', this is now a lot harder to accomplish because it is central banks that control the money printing presses and in most major countries these days, they are independent of governments and firmly focused on keeping inflation in low single digits. Reversing central bank independence and inflation targeting will take a lot to change - and so far there is no sign of it.
Finally, while the surge in the wheat prices may boost food prices in the short term, weather-related surges and slumps in food prices are nothing new and usually give way to a reversal in prices six to 12 months down the track as the weather returns to normal and supply responds. So far, the surge in wheat prices doesn't appear to have led to a big flow on to other agricultural prices.
With underlying inflation rates now below one per cent in the US, Europe and Japan and headline inflation rates falling again, after a brief bounce on the back of the rebound in oil prices, it is little wonder that deflation worries have escalated. The key to the inflation outlook is capacity utilisation. The continuing downtrend in underlying inflation rates essentially reflects the normal lagged response to the global recession. This is because the recession led to global spare capacity which still hasn't been used up. It is readily evident in the 10 per cent or so unemployment rates in the US and the eurozone and in measures of business capacity utilisation.
A measure of business capacity utilisation averaged across the US, Europe and Japan fell well below normal levels during the 2008-09 recession. Historically, as long as it is below normal levels, inflation has continued to fall or remained weak.
While capacity utilisation has recently improved, it has only increased to levels associated with the early 1980s and early 2000s recessions. Levels that still saw inflation fall. Now with global growth slowing, it will take even longer to get back to normal levels of capacity utilisation, so spare capacity will be with us for some years to come, implying ongoing downward pressure on consumer prices.
So the bottom line is that as long as the recovery in major developed countries remains slow and excess capacity both in industry and labour markets remains, then inflation will likely fall. If the major economies return to recession, then the risk of deflation will escalate.
The risk of deflation varies between regions. Japan is already in deflation. The risk is highest in Europe because the recent fiscal tightening there and the European Central Bank's hard-line approach to monetary policy imply a greater risk of a faltering European economic recovery.
In contrast, countries in the Asia-Pacific region have had stronger economic recoveries, have less spare capacity and have higher inflation rates to begin with - implying a greater buffer against deflation - so the risk of deflation is much less.
Deflation is also less of a risk in Australia as there is less spare capacity, unemployment is low and a range of factors including increases in utility charges, health costs, rents and local government rates are boosting common perceptions of the cost of living. But global deflationary forces will nevertheless have a dampening impact on the local inflation rate via lower import prices, particularly if the Australian dollar remains strong.
While the risks of deflation exceed those of higher inflation, a sustained bout of Japanese-style deflation is unlikely.
· First, while goods price inflation may fall, services price inflation is relatively resilient because it has a higher wage element and wages are often sticky.
· Second, central banks including the US Federal Reserve are likely to step up the pace of quantitative easing if the risk of deflation increases. This is likely to include more aggressive buying of government bonds.
· Third, while comparisons with the US today and Japan over the past twenty years are common, there are big differences. In particular, the US has moved more quickly than Japan to stimulate its economy and the US corporate sector today is in good shape, unlike the Japanese corporate sector of the 1990s, so there is less pressure to sell assets and cut business investment.
As a general rule deflation would favour government bonds and cash over equities, property and corporate bonds for investors and defensive shares with good pricing power, such as utility stocks.
Fortunately with share market earnings yields, commercial property yields and corporate bond yields now well above government bond yields, it could be argued that the risk of deflation is partly factored into these assets.
While deflation is not our base case, the significant risk of its occurrence in major developed countries implies interest rates will be maintained at low levels well into next year and bond yields will likely remain low despite worries about high public debt levels.
Our base case is that inflation will remain low as more aggressive quantitative easing and sticky services prices will prevent an outbreak of sustained deflation.
However, with global spare capacity remaining high, at this stage the risks are still skewed towards deflation rather than a surge in inflation. This in turn means it is still too early to get particularly bearish on government bonds.
The writer is head of investment strategy and chief economist, AMP Capital Investors

China won't dump US Treasury securities

Jul 8, 2010

BEIJING: China yesterday ruled out the 'nuclear' option of dumping its vast holdings of United States Treasury securities but called on Washington to be a responsible guardian of the dollar.
In the third in a series of statements explaining its work to the Chinese public, the State Administration of Foreign Exchange (Safe) sought to allay concerns in the outside world that arise whenever Beijing shifts its holdings of US government debt.
'Any increase or decrease in our holdings of US Treasuries is a normal investment operation,' said Safe, the arm of the central bank that manages China's official currency reserves.
It said it constantly adjusts its portfolio to maximise returns, and any changes to its US Treasury portfolio should be seen in that light and not interpreted politically.
In a series of questions and answers posted on its website, Safe asked rhetorically whether China would use its US$2.45 trillion (S$3.4 trillion) stockpile of reserves, the world's largest, as a 'nuclear weapon'.
Safe said such concerns were completely unwarranted.
'The US Treasury market is the world's largest government bond market, and US Treasury bonds deliver good security, liquidity and market depth with low transaction costs.
'The US Treasury market is a very important market for China,' the agency said.
China held US$900.2 billion in US Treasuries at the end of April, according to US Treasury data released on June 15. Bankers say China's total holdings of dollar-denominated assets are much greater, accounting for perhaps two-thirds of its reserves.
Safe also gave a qualified vote of confidence to the dollar. It acknowledged that financial markets were very concerned at one point that massive US government borrowing would drive the American currency lower.
But it said economic conditions elsewhere were also a factor in determining the dollar's trend. The euro zone, for instance, was struggling with high government debt levels.
One of the prime concerns of Chinese Internet commentators is that a long-term decline in the dollar or euro will erode the value of Safe's portfolio.
To that end, Safe called on the US and other major countries to take 'responsible measures' to maintain the value of their currencies. This meant withdrawing monetary stimulus in a reasonable manner and relying less on deficit spending.
Safe was lukewarm about gold as an investment. 'It cannot become a main channel for investing our foreign exchange reserves,' the agency said

Crunch awaits world's banks with trillions due

Jul 13, 2010

FRANKFURT: The sovereign debt crisis would seem to create worry enough for European banks, but there is another gathering threat that has not garnered as much notice: the trillions of dollars in short-term borrowing that institutions around the world must repay or roll over in the next two years.
The European Central Bank (ECB), the Bank of England and the International Monetary Fund have all recently warned of a looming crunch, especially in Europe, where banks have enough trouble raising money as it is.
Their concern is that banks hungry for refinancing will compete with governments - which also must roll over huge sums - for the bond market's favour. As a result, credit for business and consumers could become more costly and scarce, with unpleasant consequences for economic growth.
'There is a cliff we are racing towards - it's huge,' said Mr Richard Barwell, an economist at Royal Bank of Scotland and formerly a senior economist at the Bank of England, Britain's central bank. 'No one seems to be talking about it that much.' But, he added, 'it's of first-order importance for lending and output'.
Banks worldwide owe nearly US$5 trillion (S$6.9 trillion) to bondholders and other creditors that will come due in 2012, according to estimates by the Bank for International Settlements (BIS). About US$2.6 trillion of the liabilities are in Europe.
US banks must refinance about US$1.3 trillion in 2012. While that sum is nothing to scoff at, analysts seem most concerned about Europe because the banking system there is already weighed down by the sovereign debt crisis.
How banks will come up with the money is an open question. With investors worried about government over-indebtedness in Greece, Spain, Ireland and other parts of Europe, many banks have been reluctant or unable to sell bonds, which they typically use to raise money that they lend, on to businesses and households.
The financing crunch has its origins in a worldwide trend for banks to borrow money for shorter periods.
The practice of short-term borrowing and long-term lending contributed to the near-collapse of the world financial system in late 2008 when short-term financing dried up. Banks suddenly found themselves starved for cash, and some would have collapsed without central bank support.
Government bank guarantees extended in response to the crisis also inadvertently encouraged short-term lending. The guarantees were typically only for several years, and banks issued bonds to match.
Other banks took advantage of the gap between short-term and long-term rates, borrowing cheaply from money markets or central banks and lending to their customers at higher, long-term rates.
A study in November by Moody's Investors Service found that new bond issues by banks during the past five years matured in an average of 4.7 years - the shortest average in 30 years.
Since then, worries about Greek and Spanish debt and whether Europe is headed for another recession have caused new problems. Investors are unsure which institutions are in good shape and which are sitting on piles of bad loans and potentially tainted government bonds.
Bond issuance by financial institutions in Europe plunged to US$10.7 billion in May, compared with US$106 billion in January, and US$95 billion in May last year, according to Dealogic, a data provider. New issues have recovered somewhat since, to US$42 billion last month and US$19 billion so far this month.
Bank stress tests being conducted by European regulators could help if they succeed in convincing markets that most banks are healthy.
Bank regulators plan to release the test results, covering 91 large banks, on July 23.
Mr Sandeep Agarwal, head of financial institutions debt capital markets in Europe at Credit Suisse, predicted that the market could be separated into haves and have-nots, with healthy banks raising money fairly easily but weaker banks being required to pay a premium.
'There is cash at the right price for many institutions, not all institutions,' Mr Agarwal said.
That could add pressure on the weakest banks to merge, seek government help, or scale back their activities. Some might even fold.
The Landesbanken in Germany, savings banks in Spain or other institutions that have struggled may be forced to confront difficult choices.
A shortage of bank finance also could create quandaries for the ECB, which appears anxious to wean banks from the cheap cash that it began providing in the heat of the global financial crisis.
If institutions are unable to raise the money that they need on the open market, the ECB would have to decide whether to continue to prop them up.
'Banks that have trouble tapping new funding sources will have to shrink,' the BIS said in its annual report late last month. The BIS brings together the world's main central banks.
Mr Jean-Francois Tremblay, a Moody's vice-president who has studied the refinancing issue, said that so far banks had managed to roll over debt better than expected.
They have increased customer deposits, drawn on cash from central banks, or simply reduced their lending and their need for new financing - which is exactly what some economists feared.
NEW YORK TIMES

IMF warns of risks to Asian economies

Jul 13, 2010

DAEJEON (SOUTH KOREA): Asia may be experiencing a sharp and quick rebound from the global financial crisis, but it has received a word of warning from the International Monetary Fund (IMF).
The region, said IMF chief Dominique Strauss-Kahn yesterday, should brace itself for possible further shocks, including being hit by a potential spillover from the euro zone crisis.
Or exuberant investors could pour so much capital into Asia that parts of the region could overheat, bringing about dangerous credit and asset bubbles.
The warning comes just after last week's growth forecast by IMF for all of Asia - a buoyant 7.5 per cent this year, well above the average 4.6 per cent worldwide. But the IMF managing director also sought to soften the blow, stressing that a global double-dip recession was unlikely as recovery remains on track.
'Asia's time has come, no one can doubt that Asia's economic performance will continue to grow in importance,' he said yesterday at the opening of a high- level economic forum in the central South Korean city of Daejeon.
'But downside risks - including the recent turmoil in Europe - mean that Asian policymakers need to remain attuned to negative shocks.'
The region also faces a real threat in the sharp rebound in capital flows that is likely to emerge as investors avoid Europe, the United States and Japan, where growth has been sluggish, for a burgeoning Asia. 'Such huge inflow of capital can create instability,' he warned.
To manage such a problem, Asian nations could consider measures such as currency revaluation and even temporary capital controls, he suggested.
Jointly organised by the IMF and South Korea, the two-day forum on Asia brings together senior policymakers and economists including Singapore's Finance Minister Tharman Shanmugaratnam and his Thai counterpart Korn Chatikavanij. Both men are due to take part in a round-table discussion today.
Yesterday, South Korea's Finance Minister Yoon Jeung Hyun echoed Mr Strauss-Kahn's concern, noting that developing countries were not doing enough to withstand external shocks from the high volatility of capital flows.
According to media reports, Seoul and the IMF are looking at a possible global financial safety net that would give nations quick access to funds, helping them stave off crises and also discouraging emerging market nations from hoarding foreign reserves. Details are expected to be unveiled in November when South Korea hosts the G-20 summit.
The warnings for Asia come amid emerging signs that the global economic recovery may be losing steam. China's economic growth appears to be slowing down, while the US has reported a stream of disappointing economic data.
Last week, an IMF report also warned that Europe's credit woes could hit bank funding and corporate financing elsewhere, especially Asian economies that are more dependent on foreign currency financing.
As if that was not enough, the European Central Bank and the Bank of England also sounded an alarm bell on a looming credit crunch.
Institutions worldwide, including banks and cash-strapped governments, will have to repay or roll over trillions of dollars they owe under short-term loans in the next two years. As they compete for the bond market's favour, it could squeeze the credit available for business and consumers, dampening economic growth.
Together, these risks pose a longer- term challenge for export-driven Asia, as Mr Strauss-Kahn and other speakers noted.
'It is a trigger for change,' he said.
Asia, he pointed out, needed to nurture a 'second engine of growth' by boosting domestic investment and consumption.
It is a strategy that some nations in the region are already pursuing, as they try to strengthen their social safety nets to boost private consumption, and introduce more flexible exchange rates.
China, for instance, recently raised the minimum wages of workers in the hope of revving up domestic consumption, a move hailed by Mr Victor Fung, honorary chairman of Hong Kong's International Chamber of Commerce.
He said: 'They are putting money into the hands of those who can actually spend.'