Wednesday, February 3, 2010

Whither Deflation?

Last week, I warned my readers to get ready for more upward growth revisions. I believe that US growth in Q1 2010 will surprise even the most optimistic forecasters.

Why am I so confident? After all, my last call before the December employment report was way off. The bond market didn't go 'boo' back then and more jobs were lost. Today, Bloomberg published a sobering article stating that 824,000 jobs will disappear on February 5th.

No doubt, when all is said and done, and the government bean counters finish tallying up the wreckage, job losses from this recession will be far worse than what was initially thought. And this recession hasn't been gender neutral. By far, men have suffered a lot more than women as cyclical industries got hit harder.

But all that is about to start changing in Q1 2010. Consider the following very carefully:
  • The Conference Board Leading Economic Index™ (LEI) for the U.S. increased 1.1 percent in December, following a 1.0 percent gain in November, and a 0.3 percent rise in October.
  • The January 2010 ISM Manufacturing report showed widespread growth. Importantly, the manufacturing sector grew for a sixth straight month, and both the New Orders and Production Indexes are above 60 percent, indicating strong current and future performance for manufacturing.
  • US real GDP surged 5.7% in the fourth quarter 2009, confirming that the recession is over and the recovery is gaining traction. While the acceleration in real GDP growth in the fourth quarter primarily reflected an acceleration in private inventory investment, there was a pick-up in non-residential investment, exports and investment in equipment & software, a harbinger of future job growth.
In the near term, it is highly likely that US growth will continue to surprise to the upside. Interestingly, Tom Braithwaite of the FT reports that US deflation no longer seen as a risk:

The US has escaped the danger of a Japanese-style deflationary trap, according to James Bullard, a voting member of the Federal Reserve's key policy-setting committee.

Mr Bullard, president of the Federal Reserve Bank of St Louis, told the Financial Times in an interview that his preoccupation throughout 2009 had been deflation, but the risk had "passed".

Last week's Fed meeting produced a dissenting vote for the first time in a year when Thomas Hoenig, president of the Kansas City Fed and a rate hawk, argued that financial conditions no longer warranted a policy of holding rates at "exceptionally low levels . . . for an extended period".

Other members of the Federal Open Markets Committee voted to preserve the "extended period" phrase, generally taken to mean near-zero interest rates will continue for at least six months. But they are also working on an exit strategy from the exceptionally loose policy used to fight the financial crisis.

Mr Bullard, who is considered a centrist member of the FOMC, said he was happy to continue with the current guidance, but he did have some sympathy for Mr Hoenig's argument that "if you come off zero and you move up a little bit, it's still a very easy policy. You've still got a very large balance sheet and you're still at very low interest rates."

He added that, although it was not time to tighten policy, members of the committee would weigh in their decisions factors other than inflation and unemployment. Factors to consider would include asset bubbles.

"I think they're gaining weight with many people because of the bad experience we had in the aftermath of the last recession, the housing bubble and how that really has blown up and caused so many problems," he said.

When the Fed does come to raise rates it may have to switch from its traditional benchmark of targeting the federal funds rate to targeting a repurchase rate because of the upheaval in the two markets over the last two years.

"I think what the operating regime will really look like going forward is an open question and one that the committee is working on," said Mr Bullard, who said the Fed could consider using interest it paid on reserves as the main rate but that it might prefer a market measure such as the repo rate.

The broader post-crisis economy was "on track" with its recovery, he said. "It's not a real strong recovery but that's what we had predicted anyway. But it will be above-average growth for the first half of 2010 and we'll probably see some positive jobs growth in the first part of 2010 here."

He "hoped" that improvement in the labour market would come in the first quarter.

Following harsh criticism of Ben Bernanke in the Senate ahead of his reconfirmation as Fed chairman last week, Mr Bullard warned that political interference with the Fed would be dangerous and he strongly opposed plans to strip banking supervision from the central bank's roster of duties.

"I think it's dangerous for America and dangerous for a global economy to try to divorce this central bank from true understanding of financial markets, and I think that that's the direction we'll be going in if we separated out the central bank from regulation," he said.

"What this crisis has shown is that our understanding of financial mediation and how it can impact on macro economy was not good enough. So what you want is to force the central bank to get better understanding and more information about financial markets as they're making monetary policy decisions."

Not good enough? I'd say the Fed's understanding of how financial mediation impacts the macro economy was downright pathetic pre-crisis and has only marginally improved post-crisis. Who is tracking flows into hedge funds, commodity funds, private equity funds, and flows coming from sovereign wealth and global pension funds?

More importantly, who is tracking leverage being built into the bond market? There too, pension funds are playing an increasingly important role as they leverage up their fixed income holdings to deliver on their required actuarial rates of return.

I urge you to carefully read Niel Jensen's February 2010 letter from Absolute Return Partners, aptly titled If PIIGS Could Fly. Mr. Jensen's conclusion is a stark reminder of the challenges that lie ahead:

As far as the bond market is concerned, as often pointed out by Martin Barnes at BCA Research, if you want to know where the next crisis will be, then look at where the leverage is being created today. And nowhere is there more leverage being created at the moment than on sovereign balance sheets. What is happening is an experiment never undertaken before. As John Mauldin puts it, we are operating on the patient without anaesthesia.

The big challenge will be to get the timing right. These situations can run for longer than most people imagine. Japan’s crisis has been widely predicted for almost a decade now, and the ship appears to be as steady as ever. As I suggested earlier, the key to predicting the timing of Japan’s demise – because there will be one – may very well be embedded in the savings rate, which could quite possibly turn negative in the next few years.

The Dubai crisis taught us that markets are in a forgiving mode at the moment and, before long, Greece could very well find some respite from its current problems. But then again, ultimately, governments will find – just like millions of households have found over the years – that you cannot spend more then you earn in perpetuity. The enormous debt levels being created at the moment will haunt us for many years to come and we may have to wait a long time to see PIIGS fly again.

While I agree with many of the arguments Mr. Jensen puts forward, I am not convinced that the bond market will be the next crisis. You will likely see the short end of the curve getting hit hard in Q1 2010 as the market adjusts its expectations on the Fed's next move, but not a full-fledged crisis in bonds.

Neither am I convinced that deflation is dead. The risks of deflation have subsided but the bigger test will come in the following few years, especially if stimulus programs do not translate into a sustained improvement in US and global labor markets. And that still remains the overarching concern of policymakers across the planet. If they fail to achieve this, a nasty deflationary spiral will ensue, in which case high quality government bonds will look very attractive, even at historic low yields.

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