Time to rethink assumptions about interest rates–and income investing strategies

Reality has a nasty way of throwing investors’ assumptions onto the rubbish heap.

Take this one: The massive stimulus packages, central bank interventions, and government budget deficits will lead to a surge of inflation and rising interest rates.

That may still turn out to be true in the long run but the long run is showing a disconcerting tendency to recede into the distance these days.

It’s worth asking if the arrival of higher inflation and higher interest rates is now sufficiently delayed that the period between now and then deserves its own set of investing strategies. What kind of strategy? I’ll try to lay out the general outlines of one in this post.

Inflation is everywhere–except in China’s official consumer inflation numbers

In the first quarter China’s economy grew at an annual rate of 11.9%, according to official statistics released today, April 15. Economists surveyed by Bloomberg were expecting growth of just 11.7%.

Remember the days when investors worried that a 10% growth rate would set inflation on a rampage?

Well, all the evidence except the official inflation numbers says that danger is real.

Inflation at the consumer level in March grew at a 2.4% annual rate. That’s a drop from the 2.7% annual rate in February. Economists had expected that inflation would fall in March since February’s inflation rate was inflated by this year’s late timing of the annual lunar New Year’s holiday. So it’s not at all clear if the 0.3 percentage point drop is good or bad news for consumer inflation.

The message from other inflation measures, on the other hand, was very clear: Inflation is either out of control or threatens to become so.

Brazil joins China on the road to higher inflation–and higher interest rates

China isn’t the only developing economy facing inflation pressures. Economists are projecting that consumer price inflation in Brazil will hit an annual rate of 5.2% this year. That’s well above the government’s target of 4.5%.

The central bank is expected to start raising interest rates as early as its next meeting on April 27. The target overnight interest rate, known as the Selic, is projected to hit 11.25% by the end of the 2010, up from 8.75% now.

All economies have what’s called a speed limit to growth. Growth rates below the speed limit don’t push up inflation at rates faster than the central bank will tolerate. Above the speed limit growth produces dangerously high rates of inflation.

For the United States right now that speed limit is somewhere around 2.5% to 3.5% depending on what economist you talk to.

For Brazil’s developing economy the speed limit for growth seems to be somewhere around 4.5% to 5% right now. The Brazilian economy is on track to grow by 5.5% in 2010. Hence the need to slow growth by raising interest rates.

Why do economists think Brazil is in danger of exceeding its economic speed limit?

Tomorrow’s GDP report will add to fears of inflation in China

Sneak preview on China’s first quarter GDP and March inflation from Reuters today, April 14.

China’s economy grew about 11.9% in the first quarter from a year earlier, unofficial numbers available in Beijing say according to Reuters. That would be above even the whopping 11.7% growth expected by economists surveyed by Bloomberg. China is scheduled to report its official growth and inflation numbers for March and the first quarter on Thursday.

Reuters also reports that March consumer price inflation will come in at 2.4%. That would be down from the 2.7% figure reported for February.

It’s not clear to me how the market will take that inflation report.

China takes another step toward fighting inflation, ending its currency peg

The People’s Bank of China, the country’s central bank, will sell three-year bills for the first time since June 2008. The sale is a likely precursor to either an increase in official interest rates by the central bank or an end to the renminbi/dollar currency peg. In March 2007 the People’s Bank raised interest rates two months after selling three-year bills. The bank hasn’t raised interest rates since December 2007.

Issuing higher yield bills would be one way for the central bank to reduce lending by China’s banks.