WE HAVE BEEN SUBSTANTIALLY INSULATED FROM THE BOND MARKET PANIC TAKING PLACE IN THE U.S. WE HOLD A LARGE AMOUNT OF CASH FOR THE ACCOUNTS THAT WE MANAGE, AND WE ARE ENJOYING A GOOD PERIOD OF INVESTMENT PERFORMANCE. WE EXPECT THERE TO BE A PERIOD OF ALTERNATING RALLY AND DECLINE FOR A FEW WEEKS WHICH WILL BE FOLLOWED BY A RESUMPTION OF THE UPTREND, ESPECIALLY FOR THE ASIAN MARKETS, ENERGY AND METALS, WHERE WE HAVE BEEN INVESTING.



THE BACKGROUND

The decline in the mortgage bond market has spread, and has begun to affect other bonds, U.S. stocks and commodities. Many commentators in the papers and on TV have pontificated about the events and how they are connected to this typical bond market correction.

Let us look at the problem and see how it will impact various markets. Interest rates fell for 27 years, up until a couple of years ago. This led to euphoric environment for many participants in industries that utilize bank, credit and the bond markets fund their activities. Many have been able to make good (and predictable) returns on borrowed money for decades, and so the prices of assets benefiting from leverage have risen by very large amounts.

We believe the trend of lower interest rates is over. In our letters we have been on record for a while expecting interest rates to rise in coming years. This of course would not be salutary for industries that are major users of credit.

Our argument has been that, although governments are loath to admit it, inflation is currently much higher than the stated 2.5%. In every country inflation is noticeable. This is a normal effect caused by the rise in the standard of living in low wage countries, and by increases in demand. Over time workers demand higher pay and wages rise. As inflation rises, the cost of money rises, banks demand more money for their loans and central banks raise interest rates to bring inflationary psychology under control. Both cost push and demand pull inflation are currently at work, in our opinion.

RECENTLY, SPECULATION ON LEVERAGE IN DEBT INSTRUMENTS HAS BEEN UNPROFITABLE. BANKERS HAD BECOME WAY TOO LAX IN THEIR LENDING STANDARDS. BANKERS HAVE AWAKENED TO THIS. THEY ARE DEMANDING A HIGHER INTEREST RATE TO COMPENSATE THEM FOR THE RISK THEY ARE TAKING.

The bankers have been awakened from their slumber by the failure of some highly levered hedge funds betting on the mortgage bond market. The contagion has gradually spread to the rest of the bond market and there is a re-evaluation of risk taking place. This weekend, I spent a lot of time with a close friend who is a senior mortgage banker. He reminded me that for the last thirty years high quality commercial and industrial real estate loans have yielded about 4% above the 10 year U.S. Treasury bond. Even after the panic of recent week, high quality industrial loans are yielding only 1.8% above 10 year treasuries.

While lenders demands to be paid for risk have risen from less than 1% over U.S. treasuries to about 1.8% over treasuries in one week, they have a long way to go until they reach the approximate 4% premium they have historically demanded. Clearly, lenders want to widen their spread. They are no longer willing to ignore the risk of default even from top quality borrowers.

At the present time, they will not lend to low quality borrowers at all.



THE GOOD NEWS WE DO NOT OWN ANY BONDS OF U.S. ISSUERS. THE ONLY BONDS OUR CLIENTS OWN ARE THE HIGHEST QUALITY SHORT TERM GOVERNMENT BONDS OF FOREIGN GOVERNMENTS LIKE GREAT BRITAIN, AUSTRALIA AND CANADA. ALL THESE BONDS HAVE THE ADDED ADVANTAGE OF BEING DENOMINATED IN THOSE FOREIGN CURRENCIES.

We view the opportunities being created by the debt related sell-off will provide good entry points into some of the markets and industries we have identified as having strong tailwinds.

We hope you are having a pleasant summer, and we encourage you to contact us if we can be of service.

Guild Investment Management, Inc., a registered investment advisor. All material presented herein is believed to be reliable. Investment recommendations and opinions expressed in these reports may change without prior notice.

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