Well, the reflation trade has managed to hold on for a few more days and even reached new heights, but the case for a pullback is looking that much better. Precious metals, non-dollar and non-yen currencies, oil and treasury yields have all benefited from what looks like a fairly extreme fear of inflation.
At 3.83%, the 10-year note, and certainly the 5-year at 2.83%, are even approaching levels at which they may be attractive buy-and-hold instruments. In a couple of years, we may look back at this sell-off as a great chance to lock in some respectable yields for a long bout of deflation. These bonds will at the very least vastly outperform the stock market or real estate.
I would be surprised if today’s sell-off in the mid-range of the yield curve doesn’t start to lure people back into longer maturity notes.
Source: Bloomberg.com
Today’s “gap and crap” in the stock market can also be taken as a sign of a top, which would coincide perfectly with a bottom in bonds and turnaround in the dollar. Euro and pound bullishness had been holding at well over 90% by early this week, as had that for precious metals. Silver’s two strong pullbacks from the $16 level were encouraging, as were the nosedives in the euro and pound.
From this juncture, I am still more enthusiastic about the prospects for the dollar, bonds and related commodity shorts than I am about stock market shorts, since the sentiment in the later has not reached the same levels of broad consensus. That said, it would be surprising if we don’t at least stop making new highs for a few weeks, if not fall well under 900 in the S&P.
Still a deflationist, huh?
Why am I so sure that we are stuck in deflation? Simple: the inflation we have experienced for the last 40+ years in the US and most of the world is less related to money printing, digital or otherwise, than credit issuance. This was a great credit bubble, during which families and corporations forgot all the lessons of irresponsible borrowing thanks to compromised central banks that provided cheap money and the promise of bailouts to the bankers who would otherwise be on the hook for extending worse and worse loans.
As credit got cheaper and easier to obtain, people relied more and more on it for everything from houses to cars to clothing purchases and even vacations. With easy credit, prices levitated across the economy until we reached the point where we could just not make debt any easier to get. After 105% loan-to-value, neg-am, teaser rate, no-doc loans, what else could be possibly be done to lure more people to borrow?
Debt is now a burden without a reward
Without the continued expansion of credit, there was no reason for prices to keep going up, but after 2005, without prices going up, there was no reason to borrow. Just like a light switch, in 2006-2007, debt became a burden without a reward, and ever since then the magic of leverage has been working in reverse to the tune of tens of trillions of dollars in lost equity.
Creating a few trillion dollars and simply giving it to banks with (still!) massively upside-down balance sheets does nothing to get the inflation ball rolling again. If the money were dropped from helicopters or spent into circulation by the government hiring tens of millions of people (as in the highly-socialist Weimar Republic, where the government owned factories) or, as is more likely here, in a truly massive war effort like the inflationary WW1 and WW2, we would soon have inflation. But nothing that we have seen so far is remotely capable of spurring inflation until asset prices and incomes have so collapsed that most of the bad debt (tens of trillions) is liquidated through bankruptcy.
Without the bailouts, we would already be most of the way through this recession, as in the short depression in the US after WW1, in which the government did very little except lower taxes. Assets like bank deposits and car factories would be finding their way into responsible hands, where they could be put to productive use. The surviving prudent banks would be lending to the surviving prudent manufacturers and prudent families, who would be acquiring assets from the foolish, who henceforth would be much less foolish. This natural process is exactly how the west achieved such fantastic real growth in incomes, technology and quality of life in the period from the 19th century to WW1.
At the rate we are going, prepare for many years of high unemployment (we’re at 16.4% now) and weak corporate earnings, as the prudent are taxed to prop up the foolish and cynical. This is not a formula for rising prices or a better standard of living. This is a formula for political, moral and economic decline.
This is not the kind of process that societies just can just stop on a dime. Nations can’t be expected to just have epiphanies, throw the bums out and install better governments. The baddies are so in control of the nation’s press, schools and political apparatus that events must run their course, over many generations, unto total collapse. Just ask the French of the 18th century or the Russians and Chinese of the mid-20th. The west has been on this course for nearly 100 years now, since a great civilization was dashed to pieces in the fields and forests of Europe and collectivism gained a foothold.
” Just ask the French of the 18th century or the Russians and Chinese of the mid-20th. The west has been on this course for nearly 100 years now, since a great civilization was dashed to pieces in the fields and forests of Europe and collectivism gained a foothold.”
I do not know what this means specifically. What do you mean a “great civilization?” Do you mean a specific nation state, or “Western Civilization” in general? “Fields and forests of Europe” refers to the events of WWI and WWII, right? I assume “collectivism” could refer to “social democracy, fascism, or socialism” although none of those were specifically singled out.
I do not think the US can embrace the social democracy form of collectivism because successful social democracies require an ethnically homogenous population. I do agree with your earlier blog posts that fascism is a feasible outcome. I do not blame collectivism or the “welfare statists” that Alan Greenspan railed on in “Gold and Economic Freedom” for what happened now (one could legitimately do that for what happen in Sweden in 1992) because the “welfare statists” held little political power in the US after the 1980s. The Great Society was the high water mark of the “welfare statists” in the US.
Regarding my views, I think ethnically homogenous European social democracies (e.g. Germany, Sweden, Norway, Denmark, and Finland) would do relatively well during this deflationary regime. I do not see the current Anglo-Saxon model doing well, and Great Britain and the US will be under significant stress.
I do agree with the market commentary though. It seems that traders are irrational, believing that the Federal Funds Rate would hiked 25-50 basis points because of a “good” jobs report which allegedly signals inflationary fears.
I do not blame collectivism or the “welfare statists” that Alan Greenspan railed on in “Gold and Economic Freedom” for what happened now (one could legitimately do that for what happen in Sweden in 1992) because the “welfare statists” held little political power in the US after the 1980s.
One wonders, then, why government spending as a share of GDP continues to climb, and massive new entitlements like Medicare prescription drug coverage were added, while welfare benefits have been only moderately pared at the edges. Health care nationalization (somewhat corrupted by corporate interests as it predictably must be in the U.S.) looks to be proceeding with little opposition. Today’s welfare recipients may lean more toward defense contractors, bank bondholders, and mass market home buyers, but the state’s roster of dependent clients continues to grow without apparent limit.
I see this argument made over and over again that, if you’re not as socialist as Europe, you’re not socialist at all. But in this regard the Continent ought to be viewed as more of a high water mark than a minimum hurdle.
I meant western civ in general, the world wars (especially #1), and all flavors of social democracy, fascism and socialism.
I agree with Graphite here. If the welfare statists have been losing power since the ’60s, how come none of their programs have been repealed? Why does 2/3 of the federal budget still go to entitlements, the total discounted cost of which is now approaching 100 trillion dollars?
Also, western Europe is hardly ethnically homogeneous anymore. Muslims are a huge and growing demographic there. In many nations, they are the only people with a birth rate above replacement levels. Even Sweden and Denmark now have large slums and growing violent crime rates.
Evidence that the bond bear has run its course: http://www.financialsense.com/fsu/editorials/sutton/2009/0605.html
See the first chart.
Dear Mike,
What do you mean exactly about France in the 18th century? Do you mean that they had high levels of debt. That is true–along with a poorly managed, inefficient government. And so? All your fearmongering about collectivism and socialism, however, fails to take into account what the Europeans have achieved: greatly efficient economies of scale in large parts of their economy that allows their economy to function: This is true for transportation and health care above all, but also in education, which, though imperfect, still produces more competitiveness and social cohesion per dollar than the US does by far.
I agree with you that inflation is not yet a true danger, and that there are powerful deflationary forces still coursing through all asset classes. That said, the question still remains: where on the spectrum are we? You can look at the long-term charts and say, well, in the 80s, the markets were 50% below where they are now. That doesn’t, however, take into account the fact that we are living in a fundamentally different market and economy.
My best bet: We retest lows within 5-12 months, but don’t go much below S&P600.
European style socialism is headed for worse troubles than the USA due to the demographics of most European countries.
“The problem with socialism is that eventually you run out of other people’s money.” – Margaret Thatcher
There is no question that most of Europe has seemingly created more economically homogeneous societies than the USA, but at what cost? It is difficult to see how the USA could end up with anything similar to European style services, given the nature of the federalist system, the sheer size and geography of the US, and the seeming incompetence of elected representatives. Having socialized services at the state level is a different story though and some states have started doing so (Massachusetts public health care).
“Efficient economies of scale” in relation to the US federal government is almost laughable, but I admit they have managed to get a few things right such as basic utilities.
Only a retest of lows when it appears that only 1/2 of all mortgage loan losses have been written down at this point? The mortgage rate reset problem doesn’t end until late 2011, in fact this so called “green shoots” recovery has occurred at at a lull in the mortgage rate reset cycle. What about all of the European banks which seem to be slow in acknowledging losses? I don’t see it. I think the markets are in for much more pain over the next one to two years.
I find it quite ironic that those who are more averse European “socialism” seem to have no such qualms about China and the way that it has used top-down policy-driven capital allocation not only to buy in to entire industries in which it had no footprint, but to compete successfully in them. Lenovo is just one company that comes to mind, but the recent purchase of Hummer is going to be another example.
Yes, I forgot utilities. France generates something like 80% of its electricity from a very safe nuclear grid–far more efficient and economical management of its resources and capital than anything the US does. The federal paradigm is partly to blame for that, as decision-making is distributed and leads to serious gaps between states–education is the best example…
Re: China. China is hardly a good example of economic efficiency and social equality. They have misallocated huge sums of capital and are only where they are currently because they have had such large inflows of capital from the US. I believe that China has been fixing some past mistakes regarding large excesses in production capacity, but I see no evidence to indicate that China’s model has allocated capital more efficiently than a free market system.
When companies are subsidized with 0% loans (and even free money, no payback “loans”) it is easy to turn a profit, particularly when you are just copying an existing business model.
Speaking as a US Citizen, I am averse to all forms of socialism because it essentially means the destruction of the USA as we know it and either completely disregarding or rewriting the US Constitution. My aversion is driven more by principals of life, liberty and pursuit of happiness (i.e fundamental principals of government) rather than economic success. I think it is also very difficult to argue that system X (any other economic system) produces more prosperity than free market capitalism, but there is far more to life than profits.
I would much rather see state governments take action on some of these issues than the feds. State governments are far closer to the people and thus more accountable. I don’t see any Constitutional authorization for federal government interference with health care, but that certainly hasn’t restrained congress in the past.
Well, I live in New York state, and here, there is no way that the govt is “closer” to the people. They’re corrupt, entirely clueless, and absolutely feckless. That’s pretty much true for most states. I think it’s true that in very small states, where things are “all in the family,” but for large states like NY or CA, which are more like countries, it’s an influence-peddling scam…
I am no longer bearish on the US equity market for the near term… there are simply too many people expecting a pullback, although these people do not expect a retest of the March lows.
I do not expect a plunge (> 5%) in equities in the next two weeks. Perhaps, we will have new highs.
http://online.barrons.com/article/SB124474397599607023.html?page=1#mod=BOL_hpp_highlight
In the long term, see these graphs:
http://pragcap.com/small-investors-are-piling-into-stocks
http://pragcap.com/mutual-funds-inflows-surge
Regarding socialism and Europe, I still agree with Paul.