The US will not default

I was very curious why the markets tanked when S&P put out a notice that their credit outlook on the USA is negative. It is not like the world knew that they were incurring massive deficits and will find it mathematically impossible to bridge the gap without a political stimulus of the world turning off the capital spigot.

The USA also has the advantage of being able to print its own money, and borrow in its own money. This advantage is compared to the Eurozone countries, which cannot print Euros willy-nilly.

Instead of defaulting, it is quite apparent that the USA is choosing to inflate and dilute the value of its currency. This is not a permanent solution – they still must address the fundamental issue, mainly pouring more money out the window than taking in.

Although there will not be a default, holding US cash is a very difficult decision because its purchasing power will continue to whittle away. People have found diversification avenues in commodities, but you have to weigh in a whole bunch of other dynamics that you wouldn’t have to with plain cash – just ask investors in Uranium. Diversification is also available in real estate, but that has not been very good for US investors for the past few years – and indeed, real estate implicitly bets on the ability of the various states to enforce and respect land titles and property rights. This generally leaves the stock markets – where you can take a risk that companies will be able to maintain their cash flows, assuming the US government doesn’t tax it away to pay off their debts.

An interesting starting point is to look at your own personal consumption habits and invest to simply hedge your lifestyle consumption – for example, if you consume gasoline, purchase an oil company that has sufficient reserves. If you use a mobile phone, purchase shares in that telecom company. Assuming you are paying fair value, you will be able to offset cost increases in your consumption with equity valuation rises.

Bank of Canada holds at 1%

The Bank of Canada continues to hold its short term target rate steady at 1%. The salient quotation:

While underlying inflation is subdued, a number of temporary factors will boost total CPI inflation to around 3 per cent in the second quarter of 2011 before total CPI inflation converges to the 2 per cent target by the middle of 2012. This short-term volatility reflects the impact of recent sharp increases in energy prices and the ongoing boost from changes in provincial indirect taxes. Core inflation has fallen further in recent months, in part due to temporary factors. It is expected to rise gradually to 2 per cent by the middle of 2012 as excess supply in the economy is slowly absorbed, labour compensation growth stays modest, productivity recovers and inflation expectations remain well-anchored.

The persistent strength of the Canadian dollar could create even greater headwinds for the Canadian economy, putting additional downward pressure on inflation through weaker-than-expected net exports and larger declines in import prices.

My own metric, the spread between the short term rate and the 10-year government bond, is at a 2.48% spread as of present. If this goes higher then the Bank of Canada might consider raising rates. BAX futures still imply a rate increase is on the horizon before year’s end. 3-month corporate paper is yielding 1.18%.

TFSAs to increase?

One of the campaign trail promises was to double TFSA contribution limits to $10,000/year if/when the budget is balanced.

Given the existing projections of the federal government, this may not happen for a few years, if ever.

However, an increase in TFSA contribution limits would make them much more significant vehicles for investing than present. It is a much more functional solution than giving some form of relief on capital gains taxes – effectively the TFSA becomes the conduit for this, or for relieving people from paying taxes on interest income.

Because of the contribution limit rate, TFSAs disproportionately favour lower net worth individuals – for example, if your net worth was $20,000, you could invest it all tax-free but if your net worth was $1,000,000 then it would be a drop in the bucket. It is a surprisingly egalitarian method to allowing tax-free compounding of capital.

The only negative part of the TFSA is that you can’t write off capital losses – so make those choices carefully.

Treasury yields creeping up again

I know a few days of trading don’t make a market, but the spike up in yield seemed a bit unusual:

If long term interest rates continue to use, it will have a dampening effect on the rest of the marketplace. Inflation expectations are also baked into this chart.

If somebody asked me to receive 3.55% over the next 10 years, versus dumping that money into selected equities, one would think that equities would outperform.