Sunday, August 16, 2009

Can The World Avoid The Deflation Trap?


I was recently contacted by Steve Patterson, host of a podcast titled 'Two Beers With Steve', which I added to my blog roll. Steve informed me of a recent podcast featuring Dr. Chris Martenson discussing inflation vs. deflation.

This is an excellent interview and Mr. Martenson is very knowledgeable on the subject. He has his own website, www.ChrisMartenson.com, which I added to my blog under market links and he answers some very tough questions on the inflation/ deflation debate. Again, click here to go directly to the podcast and take the time to listen carefully to the entire interview.

Readers of my blog know this is a topic that I have covered in many posts. I agree with Absolute Return Partners who in their July letter, state: "The most important investment decision you will have to make this year and possibly for years to come is whether to structure your portfolio for deflation or inflation."

Last week, the WSJ reported that Treasurys Up On Decent Demand For 30-Yr Bond Auction,Weak Data:
Treasury prices rose Thursday afternoon on a strong 30-year bond auction following a bout of U.S. data that damped optimism on a quick turnaround in the economy.

Long-dated Treasurys led the gains as they benefited the most from the successful 30-year bond sale with a record size of $15 billion. Treasurys have been well-bid so far this week, with the 10-year note's yield falling more than 25 basis points from the week's peak set on Monday.

Traders said part of the buying Thursday afternoon was a result of the 30-year auction turning out better than expected. Many market participants who had put bets on further declines in bond prices, known as shorts, were caught off-guard and had to buy back Treasurys to cover the shorts on the heels of the auction.

Demand on long-dated Treasurys also picked up after the Federal Reserve reassured investors Wednesday afternoon that inflation pressure remained subdued in the near term. Inflation erodes bonds' fixed interest payments over time, and the longer the maturity, the bigger the potential losses due to a rise in consumer prices.

The 30-year bond auction wrapped up this week's $75 billion Treasury note and bond supply. The $37 billion three-year note supply Tuesday enticed strong demand, while the $23 billion 10-year note auction Wednesday was less well-received, mainly because it came less than two hours before the outcome of the Federal Reserve's monetary-policy meeting.

A proxy of foreign demand, including demand from foreign central banks, was strong throughout all three auctions. That should be a relief to the U.S. government as it is selling record amounts of debt this year to finance programs to get the economy back on track. So far, Treasury auctions have managed to entice investors even as the sizes of the auctions have steadily increased.

"It is a relief to get through another round of supply," said Chris Ahrens, head of U.S. interest rate strategy at UBS Securities LLC in Stamford, Conn. Ahrens said with debt supply still sluggish in the private credit market following the financial crisis, Treasury auctions still drew demand despite the increasing size of the auctions.

In recent trading, the two-year note's price was up 1/32 at 99 25/32 to yield 1.12%, the 10-year note was up 25/32 to 100 3/32 to yield 3.61%, and the 30-year bond was up 1 5/32 at 96 21/32 to yield 4.45%. Bond yields move inversely to prices.

The 30-year bond auction came in at a yield of 4.541%, matching the when-issued paper just before the auction. The bid-to-cover ratio, a main gauge of demand on the auction, was 2.54, compared with 2.36 for the previous auction in July, which was a reopening issue for the June auction, and the average of 2.31 from the past eight auctions.

The indirect bid - demand from domestic and foreign institutions, including foreign central banks - for the 30-year bond auction was 48.05%, compared with 50.2% from the previous auction in July and the average of 35.8% for the last eight auctions.

"This auction was a good capping stone to an overall smooth August refunding. The appetite for 30Y duration was impressive," said George Goncalves, head of fixed-income rates strategy at Cantor Fitzgerald in New York.

With this week's supply out of the way and no supply until the end of the month, Goncalves said longer-dated maturities should be "the best performing sectors on the curve as seasonals carry us to higher prices and lower yields."

In economic data, the Labor Department reported initial claims for jobless benefits rose by 4,000 to 558,000 on a seasonally adjusted basis in the week ended Aug. 8. The four-week average of new claims, which aims to smooth volatility in the data, rose by 8,500 to 565,000 - the highest since July 18.

Retail sales last month dropped 0.1%, the Commerce Department said Thursday. Economists surveyed by Dow Jones Newswires forecast a 0.8% increase in July retail sales. June sales rose 0.8%, revised up from an originally reported 0.6% increase.

So if inflation is in the offing down the road, why is the appetite for 30-year U.S. bonds so strong? They have zero inflation protection. A recent Bloomberg article notes the following:

U.S. government securities have handed investors a loss of 4.3 percent so far this year, according to Merrill Lynch & Co.’s U.S. Treasury Master index, versus a 17 percent return for stocks on the MSCI World Index. U.S. debt has declined amid record government borrowing as investors seek higher yields than those available from government debt.

The difference between rates on 10-year notes and Treasury Inflation Protected Securities, which reflects the outlook among traders for consumer prices, was 1.73 percentage points, the least in a week. The five-year average is 2.20 percentage points.

The Treasury sold $75 billion of 3-, 10-, and 30-year debt this week, the largest so-called quarterly refunding to date. President Barack Obama has pushed the nation’s marketable debt to an unprecedented $6.78 trillion. The U.S. budget deficit reached a record $1.27 trillion for the first 10 months of the fiscal year, the government said this week.

The Fed has more than doubled the size of its balance sheet in the past 12 months to $2.02 trillion by purchasing Treasuries and other securities to thaw credit markets that froze last year. Policy makers decided this week to let a $300 billion program to buy long-term Treasuries expire in October, even as they pledged to keep interest rates near a record low for an “extended period.”

The 10-year note yield surged 37 basis points last week, the most since March 2003, after better-than-forecast employment, home-sales and manufacturing data.

Yields indicate other parts of the credit markets are normalizing.

The London interbank offered rate, or Libor, for three- month dollar loans fell to a record low 0.43 percent. Libor is about 18 basis points more than the upper end of the Fed’s target rate for overnight loans, narrowing from last year’s high of 3.32 percentage points in October.

The spread between what banks and the Treasury pay to borrow money for three months, the so-called TED spread, was 0.26 percentage point, close to the least since March 2007.

The Libor-OIS spread was 24 basis points today. Former Federal Reserve Chairman Alan Greenspan said in a June 2008 interview he wouldn’t consider credit markets back to “normal” until the spread narrowed past the 25 basis-point level.

U.S. 30-year fixed mortgage rates declined to 5.38 percent yesterday from this year’s high of 5.74 percent in June. They were as low as 4.85 percent in April, according to Bankrate.com in North Palm Beach, Florida.

In late July, Bloomberg reported that BlackRock Inc. is buying index- linked bonds in the U.S. and the U.K., betting record-low interest rates and a flood of money into the economies through central-bank asset purchases will fuel inflation:

The company favors U.S. Treasury Inflation Protected Securities with maturities of 10 years or more, and U.K. index- linked gilts due between five and 10 years, said Brian Weinstein, a fund manager based in New York. It’s avoiding euro- region inflation bonds, anticipating the European Central Bank will act to stem any signs of price acceleration. BlackRock, the largest publicly traded U.S. money manager, oversees $1.37 trillion, with $18 billion in index-linked assets.

“Central banks are injecting money until they find the right amount to get the economy growing again,” Weinstein said in an interview. “They might have a hard time pulling it back. The market is overinvested in short-term protection and underinvested in the nuts and bolts of inflation, which is the long end.”

TIPS are the only long-term U.S. government securities to post gains in the worst year for the country’s debt since at least 1978. They handed investors 3.85 percent, while nominal Treasuries slumped 4.87 percent, according to Merrill Lynch & Co. indexes.

So-called U.K. linkers posted a quarterly return ahead of the country’s nominal bonds for the first time in a year in the three months through June, gaining 2.93 percent, compared with a loss of 1.84 percent in the January-March period.

Right now, I would say the conventional wisdom is that that it's only a matter of time before inflation rears its ugly head. As I have written in the past, I am not convinced that there is a bubble in bonds. Moreover, I agree with Henry Liu that liquidity is drowning the meaning of inflation. And let's not forget the excellent commentaries from Hoisington Investment Management who in their second quarter outlook noted the following:
Investments in long term Treasury securities are motivated by inflationary expectations. If fixed income investors believe inflation is headed lower, they will invest in long-dated securities, while they will invest in Treasury bills, or inflation protected securities if they believe inflation is headed higher.

In the normal recessions since 1950, the low in inflation was, on average, 29 months after a complete economic recovery was underway, and bond yields moved in a similar fashion. If this recession were normal, then the low in inflation would be in late 2011, at which time investors would begin to consider shortening the maturity of their Treasury portfolios.

However, because of our highly-indebted circumstances and the movement of private sector resources to the public sector, the trough in inflation will be moved out, meaning that the low in Treasury bond yields is a distant event.

The path there will be bumpy, as it was in the U.S. from 1929 to 1941 and in Japan from 1989 to 2008. Presently the 10-year yield in Japan stands at 1.3%. Ultimately, our yield level may be similar to that of the Japanese.
I also note what is going on in the rest of the world where Japan producer prices slide a record 8.5% amid slump and where Europe and US still at risk from deflation trap:

Consumer prices in America slipped by 2.1pc in the year to July, according to official data released yesterday. It coincided with Eurostat figures showing that the eurozone's consumer price index dropped by 0.7pc in the past year, compared with deflation of 0.1pc in June.

The figures underline concerns that despite the sharp rebound in a variety of economic indicators, and despite news that France and Germany have both now pulled out of recession, the threat posed by deflation has not yet been extinguished. Indeed, the fall in consumer prices over the past year in the US represents the biggest such drop since January 1950, and means that the country has now been in deflation for eight months.

Gabriel Stein, of Lombard Street Research, said: "Ultimately, US consumer prices will not rise on a sustained basis until the negative output gap has closed and a positive output gap opened instead. At some stage, this will happen. But not for some time."

The price figures, which showed that despite the annual fall prices were flat on the month, coincided with data showing that US consumers' confidence has slid yet further amid worries about the state of the jobs market and wages.

The University of Michigan consumer sentiment barometer dropped from 66 points to 63.2 this month – the lowest since March, from 66 in July. The measure reached a three-decade low of 55.3 in November. The Labor Department said its consumer price index was unchanged from June as forecast, and dropped by 2.1pc – the most in six decades – from July 2008. Economists had expected the index to rise to around 69.

Chris Rupkey, of Bank of Tokyo-Mitsubishi UFJ, said: "If consumers are lacking confidence, then they will not be able to help us spend our way out of this long, dark recession. Households are still concerned about the jobs outlook, and certainly, Fed policy is also gearing off of the labour markets as no Fed has lifted interest rates while the unemployment rate is rising."

However, there was brighter news from the manufacturing sector, as separate figures showed that industrial production rose for the first time in nine months. Output rose by 0.5pc last month, following a 0.4pc fall in June. The White House's so-called "cash-for-clunkers" incentive scheme to encourage homeowners to replace their old cars with new models is also thought to have helped.

This brings me to some concluding remarks. The Fed is not going to raise interests rates for a very long time. They will err on the side of inflation because they'd rather this outcome than a protracted period of debt deflation. All the indications are that the global economy has bottomed but this will be the weakest recovery ever and the risks of a W-recovery are high.

That brings me to my final point. Who is buying 30-year Treasury bonds? In that podcast, Chris Martenson said that anyone buying these bonds "deserves what is going to happen to them" and his suspicion is that investors are buying them and hedging inflation risk through credit-default swaps. If that is true, then Mr. Martenson is right, a sudden move in interest rates - say because of a currency crisis - can easily give rise to another systemic crisis in high risk derivatives.

[Note: That end-game is also deflationary! I also wonder if any Canadian pension funds are buying 30-year bonds and hedging inflation risk through the CDS market...YIKES!].

But there is another reason why bonds are being bought. While most global funds are betting on stock market beta to deal with their underfunded status, other more mature plans are buying bonds as they move towards the final end game of offloading pension liabilities and the winding-up of pension schemes.

Importantly, the global pension crisis is highly deflationary and yet very few commentators are discussing this!!!

One thing is for sure, despite stimulative monetary and fiscal stimulus, as well as massive quantitative easing, the world has yet to avoid the deflation trap. Get ready for a hell of a bumpy ride ahead.

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