Bernard.. i read very carefully your recent lengthy post on why to get into
Corp High Yield now (i had printed it out.. wish i had it attached here
though).. i have several problems with what you say.. and that is not
because i do not understand bonds.. inflation.. etc.. (or maybe i don't!).
Please bear with me as i do not have your actual post.. and thanx for any
clarifications.

Paragraph 2: Why do you think inflation may occur with a shrunk buget
surplus? (which i think will definitely occur).. the Fed may cut or raise
the rates in an effort to maintain optimal inflationary levels (which are
affected by other factors too.. like productivity).

Paragraph 3 (bold at the end): Are you saying that LT rates may move higher
by themselves due to the suplus shrinkage and possible inflation?

Paragr 4: The Fed would not always raise rates to fight inflation would
he?.. the economy and what the rest of the world is doing have an impact on
that too..  at the end of this paragraph you also talk about LT rates with a
logic that escapes me.. is there a need to change a word in that sentence
that talks about LT rates?

Paragr 5: why do you say bonds will be hit with inflation.. if the surplus
dies the Fed may lower rates again and the value of the bonds will move up
then.

Last Q: How is the reverb of the Fed cutting ST rates on LT rates.. is that
generally an opposite action by the nature of the math?

A smaller surplus can tend to cause inflation because it means more money in
the private economy chasing the same number of goods.  When it creates a
surplus the government sucks money out of the private economy.  When it runs
a deficit it does the opposite which is why Keynsians always push for
deficit spending in bad economic times.   When it comes to bonds the smaller
surplus will cause  more treasury bonds to be issued and the increased
supply of t-bonds will lower their present lofty prices.  Also, I don't have
as much confidence as you in the Fed's ability to successfully fight
inflation if it does occur.  The interest rate weapon is pretty crude and I
question whether the fed can do much about inflation without really damaging
the economy.  

Rates on long-term treasury bonds are very low right now because people have
perceived that the Federal debt was disappearing--meaning that the supply of
long-term treasury bonds was disappearing.   Those who believed that bid up
the prices of existing bonds and helped to invert the yield curve (driving
long rates lower than short rates).  So I'm saying that if the surplus
shrinks and the idea that the debt will go away in 5 or 10 years becomes
less believable, that will push the prices of long T-bonds down (and long
rates up).  Another way of looking at it is that the larger than recently
anticipated federal debt (because of a lower surplus) means a larger than
anticipated supply of T-bonds which would tend to lower their price.

My impression is that the current Fed and it's leader Mr. Greenspan believe
that their job is to maintain the stable purchasing power of the US dollar
in domestic terms and NOT to worry about the value of the dollar vis a vis
other currencies in world markets.   Obviously they do care about things
like the economy, but mainly because their inflation/deflation-fighting
efforts can hurt the economy and they try to minimize those effects.  That's
what's happening now I think.  I believe they now think they went too far
trying to fight incipient inflation last spring and hurt the economy too
much so they are backtracking as much as they dare.

The Fed only sets short rates.  Currently the yield curve has short rates
higher than long rates.  They will lower the shorts rates but they actually
do this by increasing the money supply (they don't really set rates, they
set a target for rates and then pump out money--or suck it up-- until the
targets are met).  The increasing money supply gives inflation a little
nudge and the bond markets tend to give long rates a corresponding boost.
So the effect of their action is to lower short rates and raise long rates
as I said.

Now I admit this is all much more complicated than my description of
it--I've tried to keep it simple and understandable (to me and to anyone
reading it--I'm only an amateur economist as you know).  But it really does
work pretty much that way.

I just don't think the Fed is going to take any action specifically based on
the size of the surplus.  It's more the other way around.  If there is a
large surplus, this tends to be counter-inflationary because it means the
government is sucking money out of the economy to pay off debt.  That allows
the Fed more room to lower rates (by pumping out money).  If the government
spends the surplus or gives it back in tax reductions, that might (emphasize
MIGHT) constrain the Fed from lowering rates as much as they otherwise
would have.   In this case, the Fed actions alone would tend to mean higher
short rates and lower long rates, but the effect on long rates might well be
more than counterbalanced by the much greater supply of long bonds available
because of the larger debt and thus the lower price of such bonds in the
market.  The net effect might be to just raise the entire yield curve.

I think I've given my understanding of this above.  But here's the real
bottom line.  Long rates right now are very, very low.  They are almost as
low as their nadir a couple of years ago.  A 30-year mortgage can be had now
for just over 7%.  The low point for such mortgages was around 6.5% a couple
of years ago.  But the inflation rate for the last 12 months was around 3.2%
whereas when rates were at their low it was more like 1.4% or less.  So real
long-term interest rates now are amazingly low.  That mortgage is deductible
so if you are in a 28% bracket you are paying only about 1.8% for it:
(.72 x 7) - 3.2 = 1.8 .   I don't believe they'll stay this low and, more
importantly, neither do most experts.  Did you happen to catch Abbey Joseph
Cohen on Wall Street Week?  She specifically said her boss, Morgan Stanley
is recommending people switch out of treasury bonds and into "lower quality"
(meaning "junk") bonds.

B.. i did hear Abbey Cohen speaking of your corp junk bonds.. thought of you
immediately :>))

I still do not understand why the hike in ST rates would cause a lowering of
LT rates.. (outside of surplus issues).

Also.. your explanations make me feel that sometimes the horse is going
before the cart and sometimes the cart before the horse..  and that the
economy and the rest of the world play are not being taken into
consideration.. oh well.

Like I said, I'm an "amateur economist".  Also, there are often forces at
work that have opposite effects.  And  monetarist doctrine (which I think AG
largely follows) says that the economy and the rest of the world really
don't matter and that all that matters is the money supply and maintaining a
stable domestic purchasing power of the currency.

Let me try one more time, though.  What the long-term bond market mainly
cares about is what their money will be worth in today's terms when they get
it back in 30 years.  If there's more inflation, it will be worth less so
they'll demand higher interest on the bonds they buy to compensate.  The
gyrations in long term rates are mainly the result of factors which suggest
more or less inflation during that time.  Higher short rates mean and a
tougher stance by the fed against inflation and hence most likely lower
inflation.  Lower inflation means lower long rates.

Also consider this.  Over time, the "real interest rate" on long term
treasury bonds has been fairly constant at around 3-4%.  "Real interest
rates" are the "nominal" rates minus inflation.  So if real rates are nearly
a constant, long rates depend mostly on inflation or perceptions of
inflation, not directly on Fed actions vis a vis short rates.  And, also,
the economy and world markets only effect long rates secondarily by
affecting perceptions of inflation risk.

Finally, we have had a unique situation recently.  Never before, at least
since 1900, have we had the prospect that all the Federal debt could be
eliminated and, hence, the Treasury bond market dry up.  Remember--no
Federal debt, no treasury bonds.  Some people like Treasury bonds because
they are one of the few investments with almost no risk of default or
bankruptcy.  These people and institutions want to own them even if they
have to pay more for them than they normally would compared with other types
of bonds.  So they have bid up the price (and bid down the yield) of longer
term treasury bonds much more than probably would have been the case had we
not had talk of paying off the debt.  Of course, that talk is a result of
the surplus--no surplus, no paying off the debt.  So for this reason also I
think long treasury rates are unusually high and not likely to stay there
(based on my belief that the debt won't get paid off or at least won't get
paid off as soon as the Clinton Administration has suggested).

Bernardissimo.. MD turned Bond University Professor.. (or is it Bond U Prof
turned MD?).. i got it finally.. thanx so much.. i was not paying attention
to the inflation and LT rates relationship.. DA!

Have you noticed i try to eliminate my double exclams so your spam kicker
will let me in? Thanx again.

news:B67C966E.3778%bsthomas@ix.netcom.com...

The spam kicker only effects my personal email, not the group.  You can
exclaim all you want to the group and I'll still see it.\

I use Outlook Express to read newsgroups and Eurdora for personal email.  I
was using Eurdora for email before Outlook was available for Mac and when I
started using it (instead of Netscape) I didn't want to switch over all the
email stuff.