Stage 10 Starting Already? Expect Fed To Step Up

Posted by urbandigs

Thu May 28th, 2009 12:23 PM

A: It seems there are rising concerns in the treasury market, marking what I referred to as Stage 10 of this crisis and part of endgame. From a trader standpoint, I define endgame as the final phase of a bigger situation; the end result of actions taken to deal with some sort of event or economic anomaly. There are no free lunches and many, including I, argue that there will be unintended consequences that will come from everything the fed/treasury has done to stem this crisis. I'm sure the fed is watching, but I would not expect them to announce any increase in planned treasury purchases until their next rate decision meeting.

Is the treasury market signaling growth ahead? No, and pimco-elerian.jpgI think PIMCO's CEO Mohammed El-Erian hit it perfectly yesterday:

"Your getting a lot of warning signs about this massive move we had in the 10YR yields, from 2.90% a month ago to 3.50% today, and that's not for good reasons, its for bad reasons. The market is starting to price in the enormous issuance and the fact that the treasury will have to lengthen its average maturity, when it comes to its debt. Secondly, the ratings news last week was worsened. And thirdly, importantly, people are starting to worry about potential inflation. They are starting to worry that the emergency liquidity is not going to b drained on a timely basis, because of political issues. The market is saying this is a very delicate time, and that it is very important that it is navigated well bot by policy makers and by investors."
Spot on. Higher rates could very well be the 'new normal' that we will have to get used to and it is entirely possible that we have already experienced the lowest lending rates we will see in the next decade. This is an unintended consequence of policy actions taken to stem this crisis. In my opinion, this is NOT the treasury market signaling future growth via a sharp economic recovery. Any inflation we see to start, will not be the kind that is associated with higher wages and higher asset prices - a symptom of an overheating economy. Rather, to start, I believe inflation will show up mostly in food, energy, metals, health care, etc., the stuff that shrinks profit margins and squeezes consumers wallets. The question is, what does our fed do next to combat this problem and how does that play a role in crimping growth? And for how long?

Hyperinflationists are screaming that real estate is the place to go to protect yourself from the ginormous piles of money the fed is printing that will eventual send inflation to the roof. I am not in this camp and would rather be in gold to protect against a possibility like this.

Here are my reasons:

1) Deflation will negate some Inflation - people seem to forget that we are experiencing deflation right now, and the damage has been done. Asset vales have fallen, trillions in securitized mortgage bonds losses, stock portfolios have been murdered, unemployment is soaring, debts are rising, bankruptcies are surging, and in general most people have seen a significant hit to their total net worth over the past few years whether it be from equities, falling home values, loss of job, or other form of distress associated with this slowdown. People are saving again and getting frugal after being whacked by a 2x4 by housing market forces. The initial wave of inflation will cancel out the deflation we are currently experiencing, and for all I know this stage may be occurring right now.

2) Government will understate inflation to protect Social Security - people seem to forget the govt's tendency to understate inflation when it seems to be rising and overstating inflation when it seems to be falling. Should inflation become the hyper variety, the cost of living formula for Social Security would have to be adjusted sending higher checks to recipients and putting massive pressure on the new date that the fund will be depleted. Hard to see the gov't releasing inflation data that causes such mass problems on this front, but thats just me.

3) Rates will surge if hyperinflation ensues - umm, if hyperinflation ensues, lending rates will surge. Can you imagine how affordability will be affected if a 30YR mortgage rate is 9% or 10% or higher? It happened before, and those that say it can never happen again, well, I hope your right. But in this new world, unintended consequences may include higher rates for all of us. The question is, how high, and how does the economy/consumers adapt? Do not forget that ZIRP is still in full effect and we only have higher to go from here as the fed figures out an exit strategy.

4) Housing needs credit to boom to see prices skyrocket - umm, we just experienced a parabolic credit bubble that went bust. Among other factors, this played a HUGE role in the housing bubble and bust. We are at now now, just experienced this, and now watching our banks getting nursed back to health. We are about to see regulation come in to make sure this excess doesn't happen again. With underwriting standards much tighter and regulatory watchdogs coming, I don't see a repeat of 2003-2007, when money was just handed out to anybody with a pulse and exotic loan products allowing anyone to buy something way above their means. People seem to forget that we are in store for a new, less sexy normal, and instead they look at housing as a stock that can easily rebound ('V' recovery) after a substantial fall! Me, I think we are adjusting to where we should be had no bubble ever occurred. The problem is a bubble did occur and markets have a tendency of overshooting to the downside as equilibrium is ultimately reached. Many people will never look at housing, in terms of the asset class, the same again!

5) Wage inflation needs to occur to see prices rise - probably the most important element in terms of a housing recover. In order for housing to not only stabilize, but to recover and start seeing price increases, you need to see consumers earning more and a stronger jobs market. Now, yes, I think we are in the peak of the monthly job losses right now that will show declining losses going forward as the cycle plays out, but remember that an economy the size of ours should add about 150,000 jobs a month. We are far from that and right now we have millions unemployed. So lets not kid ourselves that wage inflation is a big concern right now. If people aren't earning, and current homeowners lost a ton of equity, where is the purchasing power going to come from to sustain general price appreciation? Yes, you will see savvy deals being done and money being made out of distressed purchases, but certainly nothing in terms of sustainable general increases across the nations local markets.

6) Destruction of wealth in shadow banking system negates most of the fed's money printing - probably the most important element here when looking at the fed's printing. The banks losses were astronomical, and they are the ones that are the biggest beneficiary of all the feds stimulus/printing. People tend to think the feds money printing is just entering the system, and all those dollars chasing too few goods will cause hyperinflation. But the deflationary destruction that hit the shadow banking system, is GREATER than the stimulus/printing the fed has done. So, imagine 2 stacks of money. Under one of these stacks is a deep money pit where the pile of cash falls into. Under the other is no hole at all. Our situation is the first of these scenarios, with most of the money filling the voids left by deflation in the shadow banking system - and not entering the system, at least not yet.

7) Money is being hoarded in excess reserves, which pays interest to banks, instead of flooding the system - (view image at St. Louis Fed) there was a reason the fed started paying interest on excess reserves back in SEPT of last year! Right when that announcement came, the banks started hoarding cash in excess reserves. This was one way the fed sterilized its actions so that money didn't flood the economy. The real question is what happens if/when this money does enter the system via bank loans, bringing the fractional reserve multiplier effect back into full force. This is one thing the fed will have to deal with later on. I would NOT be surprised at all to see the fed raise minimum capital requirements as part of their exit strategy to contain inflationary pressures of massive lending of newly printed dollars.

8) Too much money chasing too few properties? - many define inflation as too much money chasing too few goods. Well, if we are going to see housing fly because of hyperinflation, how does the fact that we have tons of oversupply fit into that equation? Do we expect future supply to stop coming in and future demand to just keep picking up? Lets be real here. The consumer is deleveraging now and this process can last a while to purge the excess and repair balance sheets! Plus, its not like sellers of homes today have so much equity built up that they have a whole new arsenal of buying power - in fact, the opposite occurred and homeowners equity is plunging. Looking at where we came from, we just experienced a parabolic credit / housing boom that saw over investment, overcapacity, overbuilding, whatever you want to call it. We have too much supply! I don't see a housing shortage in the future but I do see a peak in months of supply either being hit already or being very close, especially as short sales and foreclosure sales continue to surge as part of the natural order of markets. We are yet to see the high end jumbo prime problems really hit full force, and I defined this as part of the 'Wave 2' that is ahead of us:
WAVE 2 (yet to come) - perhaps sparked by commercial, prime, jumbo, HELOCs, credit card writedowns. How quickly we forget that the IMF recently upped their total global credit writedowns estimate to $4.1Trln - this assumes total US writedowns of $2.7Trln, up $500Bln from previous estimate (view image).
Hyper-inflation is NOT a good thing! Was the 70s good? Yet I hear people arguing with such emotion, that housing will surge if hyper-inflation kicks in. I just don't see it and I explained why. Why anyone would want hyperinflation is beyond me. Buy a property because you are ready to buy a property and need a home, can afford to buy the property, your job is secure, because your an investor and the numbers make sense, because you are happy with the deal you are getting, etc.; not because you fear hyperinflation. Nevertheless, the voices are out there.

Ben had difficult choices to make: either one, face a modern day repeat of the Great Depression or two, inflate our way out of it and worry later about letting the genie out of the bottle. He picked the latter. Only history will decide what road was the better one to have taken. We are, however, on a path to rising inflation at a time when incomes are not growing and unemployment is high - for now, deflation is still the battle with signs that Ben's inflating is working. Hyperinflation, if it comes, will wipe people of their cash. The cost of living will go through the roof. Business margins will be diminished and may businesses will fail. Unemployment will therefore see increased pressures. This can contribute to the escalating delinquencies in housing, credit cards, car loans, etc.. Banks, however, will benefit from spreads but hurt in potential future losses. Yields in the term markets will be so high and short term rates so low that banks will make a fortune on spreads - part of the plan? If hyperinflation hits, mortgage rates could resemble the deep double digits of the 1970's, great for banks but horrible for housing - again, I don't see this happening but is certainly possible if hyperinflation occurs. Is this why hyperinflation worriers bought real estate to hedge against? Not until the federal reserve steps in to stabilize the dollar by tightening will the long end come down and that is years away.

I know this is a touchy subject, and the following are my thoughts only. Everyone has their opinions, and I would love to hear yours even if it is outright the opposite of mine. We are all in this together!

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