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The Fed's buying bonds like we've got money. TIPS are returning less than nothing. Huh?

By Dian Vujovich

Two news items have puzzled me recently. One, yields on TIPS fell into negative territory, so who would even want them. And second, the Fed’s announced U.S. Treasury bond buying binge.

Trying to figure out how either makes sense for us and our economy is complicated. Fortunately, there are smart guys around, like Gibson Smith, co-chief investment officer of fixed-income at Janus Capital in Denver, who can help explain.

BTW, Smith is one of three investment experts who will participate in a Nov. 9, “Market Views: Great Expectations or Grim Reality?” program In Denver that welcomes questions from readers like you. More on how to do that later.

Here are Smith’s answers to my questions regarding TIPS yields and the Fed’s announcement to buy $600 billion in Treasury securities.

From Gibson Smith:

“The Fed’s latest salvo to stimulate the economy is a new program to buy $600 billion in Treasury securities over the next few months (on top of existing asset purchases). By doing so, the Fed hopes to lower long-term interest rates, which stimulates lending and business activity. The move also increases the monetary supply and sends a signal to the financial markets that the Fed wants to “reflate” asset prices. This makes “risk assets” like stocks and high-yield bonds more attractive. And the markets reacted favorably, sending the Dow to levels not seen since Lehman Brothers collapsed in 2008.

In short, the Fed has sent a signal that it will pull out all the stops to boost the economy by pushing asset inflation and loosening monetary policy. The strong reaction by the markets is similar to past Fed easing, when a “don’t fight the Fed” mindset has taken hold. This is very positive for equities and other risk assets, and it may ripple through the broader economy. The goal is to raise confidence and encourage more “normalized” risk taking as well as demand for credit. Remember: the desire to make money can be a powerful driver of the economy and credit creation.

Still, there is skepticism that the economy needed this stimulus. Economic data points have been strengthening lately; the economy created over 150,000 jobs in October, for example, well ahead of forecasts. Pumping $110 billion a month into the system—essentially by printing money—also kindles fears that it will create asset bubbles and trigger runaway inflation. Some areas of the bond market are already anticipating this. Yields on TIPS turned negative in October. Investors hope to profit from a pickup in inflation (which results in higher yields for these bonds), even if it means essentially paying the government to lend it money now. Irrational? Maybe. But when you consider it’s not much of an “insurance” premium for inflation protection–and the fact that we are in unchartered economic territory–it seems to makes more sense.

We see inflation as a longer term problem, and we’re concerned with how the Fed plans to unwind its $2 trillion balance sheet. But we believe the bond market will serve as a regulator in the medium and longer term. The bond vigilantes will force discipline on the Fed as a more broad based recovery takes hold.

In Janus’ view, job creation is the one true catalyst that could propel U.S. growth above its current anemic state. We’ve argued that the credit creation problem in the economy has been more demand driven than supply driven. The bottom line: the Fed’s latest move is good for risk assets, but we need more growth for the economy as well as a pick-up in hiring and wages.”

To ask a question of Gibson Smith of Janus; Brian Barish, president of Cambiar Investments; or Zach Jonson, portfolio manager of ICON Materials Fund e-mail me no later than Monday at: mismutual@aol.com . For more info visit:www.viewfromtherockies.com .

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