Page 1 of 4 CREDIT BUBBLE BULLETIN
Good inflation?
Commentary and weekly watch by Doug Noland
And the essential fact right now is that the American economy needs an
inflation rate above the Fed's comfort zone. Paul McCulley, "A Kind
Word for Inflation", Pimco website, June 16, 2008
I have
elevated the status of my old "analytical nemesis" to that of the most
dangerous monetary analyst in the US. McCulley (managing director of
fixed-income manager Pimco and head of its short-term desk) has been preaching
inflationism for years now, and the more obvious the flaws in his framework the
more creative he becomes in crafting his sermons. He's become so
adept at this game that many might actually buy into his flawed yet seductive
logic.
Essentially, if I am reading McCulley correctly, he is arguing that because of
an unusual "trade shock" from rapidly escalating energy costs, the Fed must
employ negative real interest rates to avoid a "modern-day depression". I will
continue to espouse the view that today's ridiculously low interest rates are
part of the problem rather than the solution.
Back in 2001/2002, the inflationists were keen to monetize the wreckage from
the technology bust through the inflation of mortgage credit. Not
uncharacteristically from a historical perspective, this inflation ran out of
control and amuck. Now, with much greater and generalized financial and
economic post-bubble wreckage, the unbowed Inflationists are subscribing to
more generalized consumer price inflation as part of the medicine to ensure
asset prices and the real economy avoid sinking into a deflationary spiral.
A book could be written explaining why the inflationists are so wrong. Here,
I'm limited to the briefest synopsis.
Today's inflationary forces have been developing over a period of many years.
Importantly, the key dynamic is one of a highly unusual strain of acute global
inflation. The impetus for this inflationary backdrop has been the massive
inflation of dollar financial claims, in particular a bubble in Wall Street
asset-based lending that spawned unprecedented distortions to both the US
credit system and underlying "bubble economy" (and, increasingly, the global
economy). This massive dollar credit inflation ("currency" debasement) opened a
Pandora's Box for similar unfettered expansions in domestic credit systems
across the globe.
Oil is inarguably the most important commodity in the world. The massive
ongoing inflation in energy prices is and will continue to have momentous
economic, financial and geopolitical consequences. Comparisons with the 1970s
and 1970s-style inflation, however, miss key aspects of today's inflationary
dilemma.
There are three interrelated dynamics that are driving current inflationary
forces. First, there is the massive flow of dollar liquidity inundating the
world. Despite huge dollar devaluation, a major credit crisis, and economic
downturn, our system is on track for yet another year of US$700 billion plus
current account deficits (and this doesn't include the massive speculative
outflows to participate in the global inflation). Global economies, especially
booming Asia, are awash in dollar liquidity to use to bid up the prices of oil
and other strategic resources.
Second, today's massive dollar flows have increasingly gravitated to
speculative endeavors (hedge funds, sovereign wealth funds, commodities
speculation and so forth), each year ballooning the global pool of speculative
finance that by its very nature chases rising prices (liquidity loves
inflation). Third, the confluence of the flood of global liquidity and
unfettered domestic credit systems has exerted its greatest stimulatory effect
upon the highly populated countries of China, India, and Asia generally. This,
then, has created a historic inflationary bias throughout the energy, food and
commodities complexes.
McCulley and others prefer to "monetize" the current oil price "shock" through
ongoing artificially low interest rates, arguing that recent price effects are
a temporary phenomenon. This short-term jump in inflation is said to be, in the
words of Mr McCulley, "good inflation". Supposedly, it will help buttress the
general prices level and generally help support asset prices, while tepid wage
growth ensures that a 1970s-style wage price inflationary spiral will be
avoided. Yet such analysis seems oblivious to the nature of the underlying
risks associated with the current inflation.
As should be obvious by now, the current hyper-inflation in energy and food
prices risks global chaos. There is today such a robust inflationary bias in
globally priced necessities that spectacular (NASDAQ 1999) price moves have
become the norm rather than the exception. As such, US monetary policy that
accommodates $700 billion current account deficits and massive speculative
outflows to the world is courting monetary disorder disaster. To be sure, the
current trajectory of US financial outflows ensures an acute inflation problem
for key things everyone wants and needs. Or written differently, efforts to
"monetize" mortgage losses and energy inflation here at home will be
invalidated by a global push to exchange excess dollar (and other currencies)
liquidity for real things of necessity and tangible value.
A major flaw in the "good inflation" argument is that surging fuel, food and
other costs in reality are administering a further crippling blow to the
over-indebted US consumer. Grossly inappropriate short-term US interest-rates
are today directly stoking serious price inflation, in the process reducing
consumer discretionary incomes and the capacity to service enormous debt loads.
The collapse in prices for vehicles such as SUVs and trucks (see Bursting
Bubble Economy Watch below) - and the resulting huge "negative equity" in auto
loans - is the most obvious example of household sector creditworthiness taking
a direct inflationary hit. This has created a major additional burden for
millions that bought the big new home out in suburbia. And because of the
worsening credit backdrop, mortgage and consumer-debt borrowing costs are
rising in spite of Fed rate cuts. Moreover, households are suffering further
from the sharp reduction in returns on their savings, not to mention the
inflation-related decline in many stock prices.
The inflation of the 1970s saw consumer prices rise, incomes rise, home and
asset prices rise, and wage-based inflation spiral higher. The current
inflation dynamic is a different beast. Sinking home prices and surging energy
and food prices are causing bloody havoc on general creditworthiness, a huge
dilemma for the faltering financial sector and the finance/consumption-driven
bubble economy.
The bust in Wall Street finance is driving a major shift in economy-wide
spending patterns, putting downward pressure on wages, incomes and profits in
some sectors, while other sectors enjoy huge inflationary boosts. The breakdown
in Wall Street "alchemy" has ensured that this round of Fed-orchestrated
reflation bypasses home prices as it hastens problematic inflation elsewhere. A
very strong case can be made that the nature of the Wall Street finance and
asset-based lending boom nurtured a degree of financial and economic imbalance
and vulnerability unlike the wage-based inflation of the 1970s.
And while headline inflation numbers today may not be approaching the 1970s'
double-digits rates, I would argue that an even more problematic economic
adjustment is in the offing. I simply see no way around the necessity of
sharply reducing the amount of new credit and imports required to sustain the
US economy. I see no alternative than a long and wrenching adjustment period
while the household balance sheet is repaired, financial sector stability is
restored, and some semblance of economic balance is achieved.
Students of the sordid history of massive inflations are familiar with the
inevitable pleas for just a little bit more inflation and a little more and a
then lot more ... McCulley wants us to believe the Fed is doing the right thing
by providing us some "good inflation." This really upsets me. I've repeated
over a number of years a lesson learned repeatedly throughout history:
Inflationism is a road to ruin. This road has become all too visible.
WEEKLY WATCH
For the week, the Dow was clobbered for 3.8% (down 10.7% y-t-d) and the
S&P500 was hit for 3.1% (down 10.2%). The Transports rose 1%, increasing
2008 gains to 13.6%. The Utilities declined 1.2% (down 4.8%). The Morgan
Stanley Cyclicals were hit for 3.7% (down 9.2%), and the Morgan Stanley
Consumer index fell 3.3% (down 9.4%). The broader market was in better shape.
The small cap Russell 2000 declined 1.1% (down 5.3%), and the S&P400
Mid-Caps fell 1.3% (down 0.4%). The NASDAQ100 declined 1.9% (down 7.5%) and the
Morgan Stanley High Tech index 2.2% (down 6.4%). The Semiconductors fell 2.7%
(down 6.1%), the Street.com Internet Index 2.8% (down 5.5%), and the NASDAQ
Telecommunications index 2.3% (down 0.3%). The Broker/Dealers were hit for 3.0%
(down 23.9%), and the Banks were slammed for 5.9% (down 29.2%). With Bullion
rallying $31, the HUI Gold index rose 4.3% (up 1.5%)
One-month Treasury bill rates sank 41 bps this week to 1.48%, and 3-month
yields fell 17 bps to 1.85%. Two-year government yields declined 13 bps to
2.89%. Five-year T-note yields fell 13 bps to 3.59% and 10-year yields 9 bps to
4.17%. Long-bond yields declined 6 bps to 4.72%. The 2yr/10yr spread widened to
128 bps. The implied yield on 3-month December '09 Eurodollars sank 21 bps to
4.335%. Benchmark Fannie MBS yields declined 11 bps to 5.95%. The spread
between benchmark MBS and 10-year Treasuries narrowed 2 bps to 178. The spread
on Fannie's 5% 2017 note widened one basis point to 71 bps, and the spread on
Freddie's 5% 2017 note widened narrowed 2 bps to 70 bps. The 10-year dollar
swap spread declined 1.25 to 69.25. Corporate bond spreads were mostly wider.
An index of investment grade bond spreads widened 8 to 120 bps, while an index
of junk bond spreads narrowed 16 to 549bps.
Investment grade issuance included Time Warner Cable $5.0bn, Johnson &
Johnson $1.6bn, Thomson Reuters $1.75bn, Vulcan Materials $650 million,
Tennessee Valley Authority $500 million, and South Carolina E&G $360
million.
Junk issuers included Source Interlink $465 million, Lender Process Services
$375 million, and Visteon $206 million.
Convert issuance this week included Petrohawk Energy $800 million, Energy
Conversion Device $275 million and MF Global $150 million.
International dollar bond issuance included Indonesia $2.3bn and Jamaica $350
million.
German 10-year bund yields dipped 2 bps to 4.62%. The German DAX equities index
dropped 2.8% (down 18.5% y-t-d). Japanese 10-year "JGB" yields dropped 10 bps
to 1.755%. The Nikkei 225 slipped 0.2% (down 8.9% y-t-d and 23.4% y-o-y).
Emerging markets were mostly under pressure. Brazil's benchmark dollar bond
yields jumped 15 bps to 6.64%. Brazil's Bovespa equities index sank 3.9% (up
1.1% y-t-d and 19.6% y-o-y). The Mexican Bolsa fell 2.9% (unchanged y-t-d).
Mexico's 10-year $ yields declined 2 bps to 5.29%. Russia's RTS equities index
gained 1.2% (up 4.1% y-t-d). India's Sensex equities index dropped 4.1%,
boosting y-t-d losses to 28.2%. China's Shanghai Exchange index declined
another 1.3%, pushing 2008 losses to 46.2%.
June 20 - Bloomberg (Shelley Smith): "Companies in Europe borrowed more
money from bond investors in the past three months than in any second quarter
on record, paying the highest interest costs in a decade on concern credit
conditions may deteriorate further. Sales jumped to 252 billion euros ($391
billion)
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