October 17, 2010
Regrettably, I'm leaving Bend soon to return to the land of the dying and infirm and experienced some insominia. Rather than count sheep, I pondered the complex issue of what's next for interest rates.
Certainly, conventional wisdom dictates that interest rates will surely rise. Our Federal Reserve, in contrast to the actions of Paul Volker, has a mission to defeat deflation, the inverse of which is to create inflation. Printing noncollateralized $ and flooding our monetary base is the mechanism of QE2. How can this not be inflationary?
Historically, it doesn't pay to bet against the Fed. Markets are taking note: the price of gold is through the roof, commodities climb higher, the TIPS are climbing and the 30/10 spreads are rising. Since the prices of food and energy are rising, the average American is experiencing a measure of inflation. Seems like a slamdunk but hold on. Remember that the Fed controls M1 but not M2 or M3. To say that it cannot affect the velocity of money in essance means that it cannot force banks to loan or people to borrow.
Contrast the enormous fall in mortgage rates engineered by the buying of 1.25 trillion $ of these securities with the current state of our housing market. Deflation is a real threat. The folks at the Federal Reserve are justifiably worried about this issue. Look at a chart of the core CPI over the past few years; much more descent leaves us around zero. Simplistically, inflation is too much $ chasing too few goods and deflation is too much debt chasing too little cash flow. Following a two decade debt binge, I think the latter scenario most accurately describes our current plight. So the question becomes, will more $ printing reverse this trend. I doubt it. To date, money has recirculated back to the Fed in the form of bank reserves and abroad where growth opportunities exist. Large corporations are flush with cash but they're not spending. This experiment has been tried before in Japan and the inflation rate has become mired at a negative 1% and the ten year JGB yields about 1%.
I know that we're not Japan, but people have been alleging that for the past 5 years despite the progression of the similarities. The critical difference between Japan and the US is that they have savings and a capital surplus that allows them to fund their burgeoning debt. We're dependant on the kindness of strangers. What to make of these opposing forces? I think that the key, independant variable is the $. The last default of US sovereign debt was created by FDR in 1933 when he halved the value of the $ relative to gold. Our government is determined to undermine the value of our currency. The obvious salubrious effects will be an edge to our exports, raising nominal wealth in the financial markets, a perception of inflation. This policy could have untoward effects, however in igniting an allout currency war and an abrupt rather than gradual fall in the value of the $. Once again, the US defaults on its debt via a significant devaluation of the value of its debts.
At some point, the strangers who fund our debt will no longer be friendly. I have maintained for some time that the US Treasury market is the greatest bubble in human history and the issue is not if but when it deflates. Therefore, I am awaiting the appearance of the 2013 options of TBT. In the interim, I am investing in issues which should hold up in a rising interest rate environment: floaters, junk, converts Canadian oil trusts and pipelines.
-Guga
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Showing posts with label Fed. Show all posts
Showing posts with label Fed. Show all posts
Thursday, April 28, 2011
Wednesday, April 27, 2011
OPM (Other's People Money)
July 21, 2010
These are fascinating times for noneconomists to observe the battle of economic philosophies. We love John Maynard Keynes here in the states. No fiscal stimulus, no matter how inept or costly is to be maligned. Deficits don't matter. Markets are erratic and corrupt; trust in your elected politicians and their desgnated hacks, I mean regulators. No pain for the electorate is tolerable. The Europeans and particularly the British have had it with John Maynard. Dutifully following his precepts have lead to insolvency. Screw stimulus! For that matter, screw entittlements. These fools are going to start paying their bills!
Severe austerity is the word on the eastern shores of the Atlantic. Socialism is being decomissioned. As noted previously, Socialism doesn't work; it fails when you run out of other people's money. Horrors say our esteemed Keynsian economists like Paul Krugman. Paying your bills in the face of a recession is countercylical. This deplorable strategy will lead from recession to depression. Instead say they, these brilliant academics, the solution to a debt-induced delevering economic slowdown is to borrow and spend your way to prosperity. I guess we'll see who's right. The US will borrow and spend and the Europeans will cut and save. Interestingly, this is not the only time when countries in distress have adopted different solutions to their problems. In the early 90', Japan was entering it's eternal deflationary depresssion. Non other than our very own Ben Bernanke jetted across the Pacific to tell them exactly what to do: quantitative easing,(money printing), and fiscal stimulus. They followed his advice to the letter, over and over again. Consequence: deflationary depression. The Canadians were in deep dodo at the same time; bad economy and burgeoning public debt. They took the European approach; cut spending, reduced entittlements and endured the subsequent pain. They got a hell of a recession, significant unemployment but inabout 3 years the lights went on and with their fiscal situation solid, have emerged arguably the best economy of the G7.
Gentle Ben hates deflation! Back in 2003, with the CPI at 1.8%, while riding shotgun for Greenspan,(The Maestro), they took the discount rate to 1% for fear of deflation following the busting of the tech bubble. Net result: the housing bubble. Now, the CPI is 1% less than that prior alarming number, you can bet that old Ben is having some sleepless nights. Cann't lower interest rates because they're already zero. What to do? Quantitative easing!
Not so fast say I. Why not? Because it won't work. It won't work because the US has entered a liquidity trap. Remember the IS curve from your Econ 101? A downward sloping curve with interest rates as the independent variable and output as the dependent variable. The point is that declining interest rates lead to rising production. Alas, what happens when interest rates are zero and so is production/employment/housing/etc. At that point, the Fed is pushing on the proverbial string; it's out of bullets. The Japs repeatedly tried it; it didn't work. What's left; more fiscal stimulus from a bankrupt federal government? I say that the bond market has got it right; ever declining yields strongly suggest minimal economic growth and the spectre of deflation. The equity market will join the party, on the downside in time. This country, unfortunately has a flawed economic model. It's based on consumption fueled by credit(debt). We are in a multiyear process of delevering debt, liquidation of bad debt and contraction of credit. We can take the hit quickly or draw it out but wecann't escape it. The Fed controls short term interest rates; the market controls long term rates. The Fed controls the monetary base(M1) but the credit markets control M2 and M3, both of which are shrinking. Galactic levels of bad debt are in essance, the black hole of $.
-Guga
These are fascinating times for noneconomists to observe the battle of economic philosophies. We love John Maynard Keynes here in the states. No fiscal stimulus, no matter how inept or costly is to be maligned. Deficits don't matter. Markets are erratic and corrupt; trust in your elected politicians and their desgnated hacks, I mean regulators. No pain for the electorate is tolerable. The Europeans and particularly the British have had it with John Maynard. Dutifully following his precepts have lead to insolvency. Screw stimulus! For that matter, screw entittlements. These fools are going to start paying their bills!
Severe austerity is the word on the eastern shores of the Atlantic. Socialism is being decomissioned. As noted previously, Socialism doesn't work; it fails when you run out of other people's money. Horrors say our esteemed Keynsian economists like Paul Krugman. Paying your bills in the face of a recession is countercylical. This deplorable strategy will lead from recession to depression. Instead say they, these brilliant academics, the solution to a debt-induced delevering economic slowdown is to borrow and spend your way to prosperity. I guess we'll see who's right. The US will borrow and spend and the Europeans will cut and save. Interestingly, this is not the only time when countries in distress have adopted different solutions to their problems. In the early 90', Japan was entering it's eternal deflationary depresssion. Non other than our very own Ben Bernanke jetted across the Pacific to tell them exactly what to do: quantitative easing,(money printing), and fiscal stimulus. They followed his advice to the letter, over and over again. Consequence: deflationary depression. The Canadians were in deep dodo at the same time; bad economy and burgeoning public debt. They took the European approach; cut spending, reduced entittlements and endured the subsequent pain. They got a hell of a recession, significant unemployment but inabout 3 years the lights went on and with their fiscal situation solid, have emerged arguably the best economy of the G7.
Gentle Ben hates deflation! Back in 2003, with the CPI at 1.8%, while riding shotgun for Greenspan,(The Maestro), they took the discount rate to 1% for fear of deflation following the busting of the tech bubble. Net result: the housing bubble. Now, the CPI is 1% less than that prior alarming number, you can bet that old Ben is having some sleepless nights. Cann't lower interest rates because they're already zero. What to do? Quantitative easing!
Not so fast say I. Why not? Because it won't work. It won't work because the US has entered a liquidity trap. Remember the IS curve from your Econ 101? A downward sloping curve with interest rates as the independent variable and output as the dependent variable. The point is that declining interest rates lead to rising production. Alas, what happens when interest rates are zero and so is production/employment/housing/etc. At that point, the Fed is pushing on the proverbial string; it's out of bullets. The Japs repeatedly tried it; it didn't work. What's left; more fiscal stimulus from a bankrupt federal government? I say that the bond market has got it right; ever declining yields strongly suggest minimal economic growth and the spectre of deflation. The equity market will join the party, on the downside in time. This country, unfortunately has a flawed economic model. It's based on consumption fueled by credit(debt). We are in a multiyear process of delevering debt, liquidation of bad debt and contraction of credit. We can take the hit quickly or draw it out but wecann't escape it. The Fed controls short term interest rates; the market controls long term rates. The Fed controls the monetary base(M1) but the credit markets control M2 and M3, both of which are shrinking. Galactic levels of bad debt are in essance, the black hole of $.
-Guga
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