'Titanic Battle' Over Deflation Will Sink Bonds?
Several Federal Reserve officials made clear this week that Chairman Ben Bernanke commands broad support for the Fed's plan to continue stimulating the economy if hiring doesn't pick up.Fisher is in the minority worried about inflation. Most Fed officials are more worried about a protracted period of low growth possibly spiraling into debt deflation.
As Vice Chairman William Dudley put it in a speech: "If you're trying to get a car moving that is stuck in the mud, you don't stop pushing the moment the wheels start turning — you keep pushing until the car is rolling and clearly free."
Last week, the Fed said it would spend $40 billion a month to buy mortgage bonds to try to make home buying more affordable. It left open the possibility of taking other steps. And it signaled that the economy would receive help from the Fed even after the recovery strengthens.
On Friday, Dennis Lockhart, president of the Atlanta Federal Reserve Bank, stressed that the new round of bond purchases would continue until the job market improves, and "if we do not see improvement, more action may be taken."
In a speech Thursday, Eric Rosengren, president of the Boston Federal Reserve Bank, said he was pleased that the Fed's policy committee was "willing to take difficult actions like these rather than accept the possibility of a long, slow recovery turning into a stagnation that someday earns the dubious title of 'Great.' "
Dudley and Rosengren have been leading voices among the officials who favor aggressive intervention to combat chronic high unemployment.
A smaller group of Fed officials have expressed concern that continued stimulative action by the Fed is elevating the risk of high inflation later.
Jeffrey Lacker, president of the Richmond Fed, has been a leader of this group, often described as inflation "hawks." Lacker was the lone dissenter in the Fed's 11-1 vote to launch a bold new stimulative program. He has cast the only dissenting vote at all six Fed meetings this year. Besides expressing concern about inflation, Lacker has argued that the Fed's moves would likely do little to boost growth.
This week, in a potentially significant shift, Narayana Kocherlakota, president of the Minneapolis Fed and long regarded as a hawk, signaled that he has grown more concerned about economic growth. In a speech Thursday, Kocherlakota said the Fed should fight high unemployment with an even more aggressive approach than it announced last week.
The Fed said it planned to keep short-term interest rates at record lows at least through mid-2015. But Kocherlakota said the Fed should keep the record-low rates until unemployment, now at 8.1 percent, falls below 5.5 percent — something he said might take four or more years to achieve.
Laurence Meyer, a former Fed board member and now an economist with Macroeconomic Advisors, said in a research note that Kocherlakota's statement was "one of the most dramatic shifts in policy positions" in Fed history.
Economists saw the Fed officials' remarks this week as an effort to underscore their resolve to combat unemployment. Some of those who spoke out — such as Rosengren and Kocherlakota — are not voting members of the Fed's policy committee this year. But they still take part in committee discussions and can influence other officials.
The policy committee will next meet Oct. 23-24. Most analysts say they don't expect any policy change then, given the major steps the Fed took this month and the fact that the October meeting is so close to the presidential election.
But some say the Fed might decide to do more at its last meeting of the year Dec. 11-12. David Jones, chief economist at DMJ Advisors, thinks that if growth doesn't rise significantly by December, the Fed might decide to buy more than the $40 billion in mortgage bonds it's begun to purchase each month.
Still, Jones cautioned that the Fed would need to avoid intervening too aggressively. If bond investors began to worry about inflation, long-term rates would likely rise. That would mean higher borrowing costs across the economy.
"All of this could have a boomerang effect," Jones said. "It could hurt the Fed's anti-inflation credibility."
Among those who express such concern is Richard Fisher, president of the Dallas Fed and an ally of Lacker's in the anti-inflation camp. Fisher said this week that if he had had a vote on the policy committee this year, he would have opposed the Fed's latest moves.
"I do not see an argument for letting inflation rise to levels where we might scare the market," Fisher said in an interview with Bloomberg radio.
So which is the biggest threat now, inflation or deflation? Is the Fed right to shift its policy so dramatically and do whatever it takes to boost employment growth? The answer is yes.
Harry Dent wrote an article for Forbes, Demographics To Blame For Inescapable Deflation:
Most investors and economic pundits see the greatest money printing operation in history and immediately assume that it must lead to inflation, or hyperinflation, somewhere down the road. We predicted this extended downturn starting back in 1989 as we saw the massive Baby Boom generation peaking in their spending cycle that started in 1983. But we also saw deflation in prices, like the downturn of the 1930s and unlike the inflationary downturn of the 1970s.
Deflation in prices, i.e. a depression, has followed every major debt and asset bubble in history – and this is the largest debt bubble ever and it is global. Why? The deleveraging of debt and the bursting of asset bubbles destroys money leaving fewer dollars to chase goods and services – the very definition of deflation in prices.
There is a new factor unique to this time in history. The rapid aging of wealthier countries also creates deflation as young people are expensive to raise and incorporate into the workforce, and hence, inflationary; while older people downsize spending and everything, and are hence, deflationary.
This is another reason that economists hate us. We explain most of the key trends–booms and busts, inflation and deflation, innovation and the adoption of innovations–in terms of the predictable things people do as they age. The greatest correlation with inflation we have found is simply workforce growth.
Given all of the factors that contribute to inflation in the short run, this correlation is truly remarkable, but there are near-term deviations in times like this when central banks are fighting deflation trends actively or due to economic swings, currency changes, spikes in oil prices, or other factors.
Here’s the simple and basic logic: when higher numbers of younger people are entering around age 20 at average, you get inflation, when higher numbers of older people are retiring around age 63 you get deflation in prices. Why the 2.5-year lag? It takes that long for new workers to become productive and pay off their training, office and equipment investments. Worker productivity rises from just after workforce entry into age 46 – 50 and that drives both economic growth and lower inflation rates. Aging beyond that point drives savings/lower spending and deflation in prices.
So how did we forecast a bust after 2007 back in 1989? We used a simple 46-year lag for the peak in spending of the average household, what we call The Spending Wave (which we covered in a past blog). How did we forecast deflation instead of inflation in this downturn back in 1989? We forecast the number of 20-year-olds that would enter the workforce vs. the number of 63-year-olds that would exit, what we call the Inflation Forecast. It goes out 20 years vs. The Inflation Indicator above that goes out 2.5 years. This indicator would forecast increasing deflation in prices into 2023 before we see the next inflationary period again.
We are seeing mild inflation due to unprecedented Fed stimulus, but that is against a backdrop of deflation that will win in the end as $42 trillion in private debt ultimately deleverages and Baby Boomers continue to age and tip the scales towards deflation.
Deflation is ultimately good for the U.S. dollar (and the UUP fund that tracks it) and safer long term bonds like those in the TLT, but it is devastating for stocks, real estate, commodities and higher yield bonds, or “risk-on” investments.
Watch out in the next year for the next great bubble burst after the last likely round of desperate government stimulus to fight debt deleveraging, slowing demographic growth and deflation finally fails again. Don’t mess with Mother Nature; she always wins in the end!Bears like Harry Dent are convinced that demographics will lead to deflation. Felicity Duncan, looked into this in her article asking Inflation or deflation: What's likely?:
After the US Federal Reserve announced last week that it would be expanding its quantitative easing programme (essentially, its programme of buying assets other than short-term government debt) by purchasing large quantities of mortgage-backed securities (MBS), many commentators expressed concern that this policy would lead to out-of-control inflation in the United States.
At the same time, there are also a number of economists who are concerned that the US may succumb to a bout of deflation as growth remains slow and risk appetite subdued. Which of these groups is correct?
Growth, QE3, and inflation
The Fed announced its new mortgage debt purchasing programme, QE3, in the wake of a disappointing economic performance from the US; unemployment is still running at over 8% and GDP is growing by a tepid 1.7% annualised rate in the second quarter. Chairman Ben Bernanke said that the Fed would take, and keep taking, extraordinary measures to stimulate the economy until the monetary policy committee saw evidence of “broad-based growth in jobs and economic activity that generally signal sustained improvement in labor market conditions and declining unemployment.”
While some observers enthusiastically hailed the Fed’s plan to purchase $23bn worth of mortgage-backed securities by the end of September and to continue purchasing the instruments at a similar rate in months to come as a key step in reviving America’s economy, a vocal group of critics expressed reservations. Specifically, they said that by purchasing the securities and, in effect, printing more money, the Fed is setting the United States up for inflation problems in years to come.
There are arguments for and against this position. For example, currently, consumer price inflation in the US is low by historical standards – it has averaged about 3.8% a year since 1950, but in July was just 1.4% annualised, despite the fact that the Fed has pumped around $2tn into the economy through its various QE programmes over the last four years. Furthermore, as many economists have pointed out, although it’s unusual for the Fed to buy MBS, it’s perfectly normal for the Fed to expand the money supply. Although the current rate of expansion is a little high by historical standards, the country is emerging from a serious economic slump, and stimulus is warranted. Finally, a little inflation could be a good thing, helping indebted Americans and making US exports more competitive (by lowering the value of the dollar).
However, the fact that inflation is under control right now doesn’t mean that it won’t be a problem in the future. Certainly, the steady and continued rise in the gold price suggest that many investors are concerned about inflation, and maintaining rock-bottom interest rates while aggressively expanding the money supply isn’t a recipe for price stability. On balance, though, it seems that inflation is not as immediate or serious a threat as continued economic stagnation.
So much for inflation, what about deflation?
If inflation doesn’t pose a clear and present danger to the sagging US economy, what about the no-less-deadly deflation? Deflation, or falling prices, is a serious problem – just ask Japan, which has struggled to fight its way free of the drag of deflation for years.
While there is, as yet, no concrete reason to worry about deflation in America, this doesn’t mean it’s not a danger. Indeed, an interesting blog from author Harry S. Dent makes the case that deflation poses a very serious medium-term risk to the US economy.
According to Dent, the unfortunate combination of a financial crisis and deep recession with an aging population means that America will inevitably face deflation in years to come. He argues that as the Baby Boomer generation ages and retires, consumer spending in the US will slow, particularly because younger generations have been set back by the recession – home ownership, employment, even marriage are all unusually low among today’s crop of young Americans, which bodes ill for them as consumers.I agree, America's demographics aren't that bad, especially when you compare them to other countries. The US still has open immigration and a very productive workforce working longer than before.
This is an interesting argument. Certainly, it is a major concern that younger Americans are suffering disproportionally in this recession; studies show that failing to launch your career with a bang when you’re young can permanently hobble your economic success. It’s also worrying that such a large batch of Americans is due to start retiring – retirees generally consume savings rather than creating new wealth. This combination could indeed mean deflationary pressures for America.
However, America is not aging as rapidly as certain other countries (including China), and the Fed seems determined to ensure that deflation and sluggish growth are addressed. Deflation also doesn’t seem like an immediate problem.
The only real pressing problem facing America, then, is to get growing again. And the Fed’s latest move is a small step toward making that happen.
In his article, The Fed, Deflation, and the Candyman, Paul Vigna of the Wall Street Journal notes the following:
It’s curious that, again as traditionally measured, there is very little inflation in the economy. Purportedly, this is giving the Fed leeway to act, since what it’s done so far hasn’t created inflation. There’s an entire wing of the intelligentsia that’s been banging its head against a wall, decrying the Fed and predicting either a future that resembles either the Weimar Republic or Zimbabwe. It hasn’t happened, but that in itself is odd.
In 2001, then-chairman Alan Greenspan started an easing campaign that culminated with the fed funds rate sitting at 1% for a year from 2003-2004, and raised them only slowly. That was the spark that lit the fire that resulted in the Panic of 2008 and the modern-day Great Crash.
The Bernanke Fed, by contrast, has gone far beyond Greenspan’s actions. So why no inflationary spiral? Why no great conflagration?Indeed, the downdraft is still there which is why central banks are engaging in quantitative easing throughout the world.
Inflation and Fed policy don’t exist in a vacuum. Indeed, Greenspan himself was afraid of deflation. If the Fed is consciously trying to stoke inflation, and it isn’t working, it makes sense to assume there has to be a counterweight somewhere acting against them.
That counterweight, we humbly submit, is deflation. This is the counterweight, this is what the Fed is still fighting, years after the recession first set in.
It may not be obvious, not with crude oil high, and stock prices rising, and even home prices rising. If there really is deflation, where’s is it? Where’s it coming from? Is it a real thing, or an apparition?
“That’s the whole thing,” said Lawrence McDonald, former Lehman Brothers trader and author of “A Colossal Failure of Common Sense.” Europe, he said, “is extremely deflationary. There’s Lehman-type deflation risk in Spain. It’s massively deflationary.
“They’re trying to fight that,” he said of the Fed. “I don’t see deflation in the U.S. I see deflation hitting the U.S. as a result of Europe.”
Inflation may yet show up. Indeed, the Fed is counting on it. All we’re saying is, the downdraft that swallowed the global economy in 2008 is still surrounding us, whether or not most people realize it.
And the world's largest bond fund manager is taking note. Dan Jamieson of Investment News reports, 'Titanic battle' over deflation about to sink long bonds:
Bll Gross is betting that central banks, including the U.S. Federal Reserve, will be successful in their efforts to ignite some inflation as they print money with the hope of generating economic growth.I think there was a mistake in that last sentence as Pimco manages close to $2 trillion. In any case, the point is Bill Gross is worried about reflation leading to higher inflation, which is why he's publicly advocating a tilt toward stocks, shorter-duration bonds, developing countries, real assets and some gold (privately, I suspect he's still long bonds).
“What I sense is a titanic battle of the ages, a battle between deflation and reflation,” the manager of the world’s largest bond fund said Thursday.
Mr. Gross, co-founder and co-chief investment officer of Pacific Investment Management Co. LLC, gives the reflation effort a 70% to 75% chance of succeeding, versus a 20% to 25% chance of deflation taking hold.
“So you should naturally tilt your portfolios to reflation,” he told an audience of about 400 advisers and ETF providers at the IndexUniverse Inside Fixed Income Conference in Newport Beach, Calif.
Even if central banks were to begin moving interest rates up, it wouldn’t trigger 1970s-style inflation of 12% or 13%, with gold tripling in value, Mr. Gross said.
“We’re not looking to that, but we see inflation moving to perhaps 3.5%,” he said.
That scenario “tilts you toward the equity side, I suppose,” Mr. Gross said. “Tilt toward [Treasury inflation-protected bonds], shorter-duration [bonds], tilt to developing countries, tilt to real assets. I’m not a gold bug … but if the Fed prints another trillion or two, they will have debased the currency relative to gold [or to] assets that can’t be produced at that rate.”
Mr. Gross addressed the question that he indicated was on everyone’s mind: How could the Pimco Total Return Exchange-Traded Fund, an ETF best known by its trading symbol BOND, do so much better than its broad-based bond benchmark?
“I ask myself that everyday,” he said, noting that the ETF has produced a 700 basis point return advantage over the Barclays U.S. Aggregate Bond Index over the past seven months.
“It’s an appreciation rate that can’t be continued,” he said. “The target is 100 to 200 basis points over [the index].”
So how has it happened? “Because we work like dogs,” Mr. Gross said. “I get in at 5:30 a.m. and follow BOND obsessively, every five minutes. It’s sort of ridiculous, but I really care.”
In addition, Mr. Gross said it was easier to manage “a fund that’s all cash flow” coming in. “It gives you an open range of choices.”
With $2.7 billion in assets now, though, “it’s a little harder. But it is still an achievable objective to beat the [bond] index funds,” Mr. Gross said.
Bill Gross isn't alone. Bill Fleckenstein of FleckensteinCapital.com, wrote a comment, the Fed pulls out the bazooka explaining why he's cautiously shorting bonds:
Given the fact that I feel strongly that a (long-awaited) inflection point for the bond market may be at hand, this week I initiated a small short position in the U.S. 10-year Treasury bond.
From a tactical standpoint my goal was to take advantage of the current bounce in the bond market, but I have no idea if this is going to work (anyone who claims to be sure is delusional).
For one thing, when the Fed is in buying as much paper as it is, it could make it difficult for a bond short to work. On the other hand, the bond market is even bigger than the Fed, so if I'm right about the shift away from deflation psychology, then I could have a winning position for quite some time to come.
At any rate, this is a very modest position, and I have no huge expectations. Thus, I won't hesitate to throw in the towel if I think my timing is not right, but I also probably will add to it if I think it is working, and then figure out how I want to manage my risk along the way.
In summary, I am in essence trying to capture the idea that the bond bull market has ended. But these things take time. I just want to test the market with a bit of a position. While this is the sort of tactic that works for me, no one should follow suit without doing his or her own research and carefully assessing the risks.
As a final note, regarding precious metals (my favorite long idea), and in which I do have a big position, I think the tendency for everyone will be to fight the last battle. So many people were so wounded, shocked and beat up mentally during the gold correction and slaughtering of gold stocks over the past year that they are going to be inclined to sell too soon rather than buy enough and net-net put a bid under the metals complex for some time.
However, if it weren't for the fact that we have an election coming up, which could theoretically upset the macro apple cart in some way, I would say the metals are almost a layup to close 2012 "high and last."
I'm far from convinced that the bond bull market has ended and see this 'titanic battle over deflation' playing out for several more years, leading to more volatility in the stock market.
On that note, take the time to read Michael Gayed's latest on why Fed action makes metals a buy and watch a CNBC interview with Bridgewater's Ray Dalio below discussing how too much monetization could trigger inflation and a possible downturn in the US. Also, Mohamed El-Erian, Pimco's co-CIO and CEO, weighs in with his thoughts on the outlook on the US economy.