How is the federal government funding its massive stimulus programs? By selling short-term Treasuries, of course. Regardless of what you think of TARP, TALF, and PPIP, there is a responsible -- or at least less irresponsible -- way to fund these programs, and so far the government, isn't taking the levelheaded route. The future implications include high inflation and higher taxes; neither is a good thing for investors.
Uncle Sam: fiend for instant gratification
As Allan Sloan points out in a recent Fortune article, the U.S. Treasury has two choices when it comes to deficit financing: Pig out on super-cheap short-term debt by selling near-dated Treasuries, which bear sub-0.5% interest rates; or lock in a higher, but still moderately low, 3.6% annual interest rate by taking the high road and auctioning 30-year bonds. In Sloan's words, the difference is as follows:
So if you're thinking about near-term federal budget deficits, you save $30 billion-plus a year for each $1 trillion you borrow at short rates rather than long rates ... But the problem with short-term borrowings is that you have to keep rolling them over.
In other words, by borrowing short, the government binds itself to the future movements of short-term rates, as debt has to be refinanced at prevailing rates every few months or few years. The problem is that short-term money won’t be free forever. Somewhere down the road, the world becomes less risk-averse, the Fed's deflation worries shift to inflation concerns, and short-term rates rise, perhaps by a lot. At such time, the current 3.6% yield on 30-year Treasuries may look like a long-lost bargain.
Faced with egregiously high debt service costs, the government might choose to meet those expenses by raising taxes, including the levies on your hard-won dividends and capital gains. Alternatively, an extreme situation involves the Fed simply printing money to meet debt obligations. Assuming that economic activity remains constant, that kind of increase in the money supply would likely produce some pretty gnarly inflation.
Taxing inflation ... inflated taxes, what's an investor to do?
Given that commodities, which are priced in dollars, tend to rise in value when inflation strikes, some high-quality commodity names look like a portfolio necessity. Commodity producers that are rated at least 4 out of a possible 5 stars in the Motley Fool's CAPS investing community include Peabody Energy
Investing in master limited partnerships (MLPs) should provide a safe haven from both inflation and taxes. Because the bulk of MLP dividends are normally tax-deferred for the duration that the stock is held, high-yielding MLPs such as Pioneer Southwest Energy Partners
Future tax and inflation developments should always be on investors' radars, but these days, they qualify as red alerts.
More on dodging inflation and fighting taxes:
