Nearly $1.4 trillion of today’s massive $2.4 trillion monetary base now consists of excess reserves held at the Fedby shell-shocked financial institutions. Many of these banks are now conservatively positioning their assets afterbeing subjected in recent years to often arbitrary and highly subjective regulatory evaluation. However, as regu-latory and economic sentiment improves, banks may eventually choose once again to lend out these high-poweredexcess reserves, resulting in an inflationary money supply surge as these funds are loaned out time and againthrough our fractional banking system.Excessive Federal Government deficit spending is being facilitated by the Federal Reserve’s multiple programs ofmoney printing, allowing politicians to avoid addressing the bloated federal budget. While the Federal Govern-ment continues on track to spend more than $1.5 trillion more than it receives this year, politicians recently de-clared a shutdown-averting victory with a $38 billion “compromise” cut in the $3.8 trillion federal budget. Whilethe Washington Post hailed the “Biggest Cuts in U.S. History,” anyone with basic math proficiency can understandthe intellectual incoherence of touting a one percent cut in a federal budget in this fashion, particularly giventhat the federal budget has increased by an incredible 40 percent since 2007. The current level of governmentspending is clearly unsustainable.The unprecedented Fed liquidity injections may already be fanning inflationary flames. Since the beginning of2010, oil prices are up nearly 30 percent, and gasoline prices are now exceeding $4 per gallon in some states. TheGoldman Sachs Agricultural Index is up more than 45 percent with corn prices rising more than 60 percent.Wholesale US food prices jumped in February by the largest amount since 1974. Cotton prices in recent monthsreached the highest price since the New York Cotton Exchange opened in 1870. Alarmingly, commodity price in-flation is now working its way through to consumer prices. Wal-Mart CEO Bill Simon recently told USA Today thatcost increases were “starting to come through at a pretty rapid rate,” and that “inflation was going to be seri-ous.”Ironically, Bernanke and other senior Federal Reserve staff appear as of yet unmoved by the potential inflationarythreat, with Atlanta Fed President Dennis Lockhart even suggesting, incredibly, that another round of moneyprinting may be necessary should oil prices continued to climb. With the Fed seemingly on a continuing path ofcurrency debasement, it is difficult to see inflationary pressures subsiding anytime soon. Government inflationstatistics themselves are also suspect, having been subject over the years to changes in calculation methodology,which now include modifications such as hedonic adjustments and substitution effects, all of which appear tomoderate the reported rate of inflation. Reported inflation would have hit an annual rate of 9.6 percent in Feb-ruary, had the reporting methodologies remained consistent with those in place prior to 1980, according to theShadow Government Statistics newsletter.Given our unease with inflation, and our concern over the impact of inflation on interest rates, we continue tokeep the adjusted duration of Aegis High Yield Fund bonds at a short 2.7 years, well beneath the approximately4.6 year adjusted duration of the Barclays HY Very Liquid Index. By keeping our duration short, we hope to avoidthe carnage that is likely to occur as rates move higher to incorporate increased inflationary expectations. We arealso taking other measures to combat rising inflation and interest rates. At quarter-end, we held nearly 7 percentof the portfolio in two variable rate bonds and a REIT that holds primarily variable rate hotel loans, 11 percent inforeign corporate bonds denominated in the currencies of foreign commodity exporting countries, and 6 percent inconvertible securities that should directly benefit from a higher inflation and interest rate environment.In recent months, inflationary fears have begun to push long rates higher, which is remarkable because it is occur-ring despite Federal Reserve purchasing pressure, which acts to drive prices up and yields lower. Yields on 10-year treasuries increased from 3.30 percent to 3.47 percent during the quarter, and are up nearly 100 basis pointsover the last 6 months. As can be seen in
, high yield credit spreads over treasuries continued to compressduring the quarter, with the Barclays Capital High Yield Very Liquid Index interest rate premium over treasuriesdeclining another 57 basis points, to a spread of only 4.01 percent, significantly beneath the 16-year averagespread of 5.42 percent.When credit spreads are low and the yield curve steep with short term rates near zero, fixed income funds haveincreased incentive to borrow money at ultra-low short rates to finance longer-duration bond purchases to“enhance” yield. In this context, it is somewhat disconcerting to note that reported margin debt has now in-creased to $310 billion in February, up a significant 7.2 percent from January and well up from its $200 billionpost-crash low in early 2009. Borrowing in this manner to boost yield is risky behavior that can end badly, as 2008can attest. Rest assured that we do not borrow money to “enhance” yield, as we want to be in a position of fullcontrol over our investments should the markets experience volatility.