View from the Observation Deck

1. The yield on the benchmark 10-Year T-Note closed the trading session on 6/1/12 at 1.47%. That is a record low (previous record was 1.55% in November 1945).
2. The 10-Year T-Note currently yields less than half of what its rate was on July 25, 2011 (3.00%). That was about two weeks before Standard & Poor’s cut the U.S.’s credit rating to AA+.
3. Treasuries have been a popular safe haven for many investors since the financial crisis began in 2008. It reflects a flight to quality, despite the credit downgrade.
4. The uncertainty surrounding the ongoing sovereign debt crisis in the European Union and some recent softness in key economic indicators in the U.S. has boosted demand for Treasuries, in our opinion.
5. In mid-2007, just prior to the start of the subprime mortgage meltdown, the 10-Year T-Note yielded as much as 5.30%. From 5/31/92-5/31/12, its average yield was 5.06%, according to Bloomberg.
6. Investing in the 10-Year T-Note at today’s historically low yield would result in a 19.0% paper loss if yields were to return to 5.00% by 2014, according to Businessweek.com.
7. On top of the potential downside interest rate risk, investors need to be aware of just how fast rates can rise (see chart). It took only 26 trading days in 2003 for rates to jump 100 bps.
8. The next rise in rates could be even faster, in our opinion. Why? The Fed boosted its balance sheet by $2 trillion to $2.9 trillion since 2008 in an effort to stimulate the economy.
9. We believe it behooves investors to prepare an exit strategy for the day rates turn higher, because the market may not offer much time if we experience a mass exodus.

View from the Observation Deck

1. The Consumer Price Index (CPI) has increased about 3.0% per year, on average, since 1926. The CPI-Headline rate, which measures all items, currently stands at 2.3%.
2. Monetary policy in the U.S. has been very easy for a number of years, in our opinion. The Fed has pumped trillions of dollars of stimulus into the economy to promote growth.
3. Historically, such efforts have resulted in higher levels of inflation. Inflation is the sustained increase in the general level of the prices of goods and services.
4. So long as inflation doesn’t evolve into hyperinflation, higher prices can translate into higher corporate earnings. Corporate earnings are the key driver of equity prices over time, in our opinion.
5. From 1970-2011, there were 20 calendar years where the CPI-Headline rate was greater than 3% but less than 7%.
6. The S&P 500 was up in 15 of those calendar years. The index averaged 9.0% (not compounded) over all 20.
7. The S&P 500 plunged 37.0% in 2008 due to the global financial crisis. The CPI was up only 3.8%. The inflation pressure in 2008 came primarily from the first half’s spike in commodity prices.
8. From 1926-2011, the S&P 500 posted an average total return of 9.8%, according to Ibbotson Associates/Morningstar.