Deflation Risk is the Bigger Issue
by Rom Badilla, CFA – Bondsquawk.com
May 17, 2010
Many economists and analysts are predicting for higher rates due to increasing inflation expectations along with concerns of massive debt supply. According to Bloomberg’s economic forecasts page, surveys suggest that the Federal Funds rate will increase by 25 basis points starting the fourth quarter of 2010. Furthermore, the yield on the 10-Year will have a four handle by the time we ring in 2011.
JP Morgan’s Client Treasury survey released this morning suggests that 92 percent of total institutional clients are either sitting on the fence and are neutral relative to their benchmarks (74 percent) or short (18 percent), which implies they are expecting higher rates. Keep in mind that not all fixed income portfolio managers make interest rate calls and are willing to pick a side. So no matter how extreme interest rates may be, expect a good portion to always be neutral. However, the survey also looks at clients who are considered “active”. Among those active clients, no one is long their benchmarks despite a seismic shift both in interest rates and sentiment with a debt crisis that threatens a global recovery.
I should add that if you look at JP Morgan’s survey data over the last three years, you will find that the predictive power of future interest rates is poor at best. If you were to follow the herd in trying to determine where interest rates are going, you are better served by sitting on the couch, conserving energy and throwing darts at board. (I’ll show my findings another time)
In any event, I still don’t get it. Investors should be concerned about deflation and lower rates, and not inflation.
The Core Consumer Price Index (CPI) which is an inflation measure and excludes prices on food and energy, is dangerously low. While it is still in positive territory, Core CPI could decline even further regardless of the economy experiencing a recovery or not. Core CPI has collapsed after almost every recession dating back to 1958. Of the eight past recessions (not including this most recent one), Core CPI has declined in seven of them. The one time it did not drop was during the recession in the early 60’s where the inflation index moved from 0.7 percent in February 1961 to a peak of 1.6 percent in March 1962. Suffice to say, core inflation grinded its way back to 1.0 percent by May 1963.
In order to have inflation and to drive prices higher, resources need to be relatively scarce in the face of rising demand. Capacity Utilization, which measures the actual output produced as a percentage of potential output given current resources, continues to hover in the low 70’s, citing idle and slack resources in the manufacturing sector. Typically, during periods of growth, the Capacity Utilization percentage should exceed 80 percent.
Along those same lines, unemployment is still high with an uptick to 9.9 percent and to 17.1 percent in the national rate and the U-6 measure, which includes discouraged workers, respectively . With the slack in employment, wage growth, which would translate to higher demand for goods and service, will be subdued for quite some time.
From the onset of this recession, the U.S. economy lost 8.3 million jobs as non-farm payrolls posted negative numbers in 23 of the 24 months for the period ending December 2009. There is reason for optimism though as non-farm payrolls has posted positive gains in 2010 totaling 573,000 jobs added. Unfortunately, we have a long way to go before getting back to employment levels from before the recession. Assuming this rate of job growth remains stable of adding 143,000 per month (573,000 divided by 4 months), it will take roughly five years and get us to the middle part of the next decade to recover from the 8.3 million jobs lost.
Depressed asset prices certainly are not helping the case for higher inflation. Housing prices are still low and will continue to remain low with some people predicting a double dip. Housing price pressures will persist as “strategic foreclosures” become in vogue, where people who are able to pay their mortgage walk away as the value of their homes are marked below the outstanding loan amount. Furthermore, the bigger issue going forward is the large amount of commercial real estate loans that will be coming due in the next four years. These loans, which many of them are underwater due to the massive decline in prices, will need to be rerolled into new debt. Failure to do so, will result in more defaults which will place even greater pressure on prices and loan growth, which is an ingredient to inflation.
Then, there is the argument of higher future taxes due to reining in federal spending and higher debt loads. Higher taxes, which seem certain here in the US, can cripple spending which in turn, leads to slower economic growth. As we all know from what we may see in Europe, the prospects of slower growth could lead to downward pressure on prices.
I am sure people will point out that surging debt levels will ultimately lead to inflation and higher yields. A case in point could be a country like Greece with high debt levels relative to the rest of Europe. While valid, the issue with Greece is not so much of question of debt load but more so an issue of structural issues with the EU and Greece’s inability to devalue and finding lenders willing to finance them.
Japan is probably a better comparison due to the fact that they suffered through a meltdown but has continued support in the capital markets. The country of the rising sun currently has a public debt to GDP ratio of 190 percent surpassing the United States and Greece. Since the beginning of this decade, Japan has increased its debt burden from 103 percent to its current levels. During that time the yield on 10-Year Japanese Government Bonds started at 1.66 percent and has stayed range bound with an average of around 1.46 percent. Currently, the yield is even lower at 1.30 percent.
While the Japanese situation of financing debt with more debt is of great concern and for the most part unsustainable in the long term, higher debt doesn’t necessarily lead to inflation and higher yields in the short term. With Japan, deflation in the aftermath of an asset bubble meltdown followed by slow growth and productivity, is a lingering problem that has plagued their economy for quite some time. Going forward, that trend may continue even further.
Given where the US stands now coupled with the debt crisis in Europe that could lead to another credit crunch, deflation is a bigger risk that most people are not even considering.