The Great Transition?

Submitted by Leo Kolivakis, publisher of Pension Pulse.

TD Economics published a very interesting report this week, The Great Transition. The report begins:

The credit crisis has dominated global market financial trends for almost three years. As we begin 2010, the specter of systemic risk has almost completely disappeared, and we find ourselves reverting to idiosyncratic risk and economic divergences that more typically define market opportunities. In many regards, 2010 will be an underwhelming year for those expecting paradigm shifts. Crises bring opportunity. Recoveries bring banality.

Economic growth will divide along a line separating the 2.7% or so likely in the G3 area, and the almost 6.0% expected in emerging Asia. Economic relegation and promotion dynamics are already defining subtle shifts to policy tack across and between countries in the months ahead.

Monetary policy will not be tightened in a meaningful way globally until 2011, but central banks will continue to tailor interest rates to domestic conditions leading to small but cumulatively important policy differences over the year ahead. The need to hedge against global collapse has gone.

Fiscal policy will not be tightened dramatically anywhere until 2011, but rating agencies will have their say this year on where the dynamics looks untenable. The data flow so far this year is about divergence – regionally, sectorally, and historically – and this is a trend likely to continue so some opportunities will open up even if they are less exciting than the volatile crisis period.

On Thursday, the Financial Post carried an article, Canadian economy will roar 'like a lion,' then fizzle, CIBC says:

But in the biggest change in its forecast, CIBC World Markets now expects the Bank of Canada to boost its benchmark interest rate beginning in the third quarter, by a total of 75 basis points to 1%. Previously, Mr. Shenfeld was among the few analysts arguing the Bank of Canada would remain on the sidelines for all of 2010.

His call that the Fed won’t budge on its funds rate until 2011 remains intact.

The change in the rate forecast is due to the strong first-half growth in Canada. These rate hikes will push the Canadian dollar above parity with its U.S. counterpart, Mr. Shenfeld said, “when resource prices won’t justify that strength.”

So will Canada follow Australia and hike rates? It would be a first since the Bank of Canada always follows the Fed's lead. But as Canada’s red-hot real estate market shows no signs of slowing down in 2010, some economists think the Bank of Canada will have no choice but to hike rates sooner rather than later.

Of course, if the U.S. labor market improves considerably in the first half of 2010, it's possible the Fed will raise rates sooner than what the market currently anticipates, allowing other central banks to follow suit. But not everyone is convinced that jobs are coming back any time soon. My friend, Luc Vallée wrote a comment in the Sceptical Market Observer blog, Where Have All the Jobs Gone?

As I stated before, I am more optimistic on the U.S. labor market. Some jobs are gone forever, but new ones will emerge. The U.S. economy can't go on hemorrhaging jobs forever. Keep an eye on the Conference Board's Leading Economic Index (LEI) for the U.S. economy. From the December report:

Says Ataman Ozyildirim, Economist at The Conference Board: "The Conference Board LEI has been on an uptrend for more than half a year and it is now slightly higher than its latest peak in July 2007. Improving financial conditions, labor market indicators, and housing permits have helped the LEI continue its gains in November. However, its six-month growth rate has slowed somewhat in recent months."

Says Ken Goldstein, Economist at The Conference Board: "The indicators point to a bright new year. The U.S. LEI increased for the eighth consecutive month. Looking ahead, we can expect a slowly improving economy through 2010. The Conference Board Coincident Economic Index™ (CEI) for the U.S. also increased in November. Employment largely held steady, making this the first month since December 2007 that it did not make a negative contribution to the index.

Back to the TD Economics report, The Great Transition. On inflation risks versus expectations:

There is a large divergence in inflation perception versus reality. The spread between various national breakeven inflation rates and actual lagged CPI outturns continues to be wide, even when compared against our forecasts for consumer inflation rates.

The inflation risk premium, rather than just the simple expectation for inflation, has become a strong driver of breakevens. The US five-year, five-year forward break-even now sits at 3.2% compared to about 2.5% prevailing prior to the financial crisis.

Current inflation, production, and labour hiring drive inflation expectations, but the risk premium is driven by uncertainty and the volatility of each of those measures. When you hit a pothole, the ebb and flow of the shock is only partly dissipated over time. Similarly, the sharp decline and resurgence in inflation rates and economic growth is itself increasing the risk premium around inflation.

This positive feedback loop worked in central banks’ favor in the Great Moderation, but the negative feedback loop will now complicate matters during the Great Transition. We can look to the U.S. economy now tracking a near 5% growth rate for GDP in the fourth quarter of 2009 as yet further evidence that this inflation uncertainty premium will remain sticky.

I was speaking with another buddy of mine who trades bonds today and he told me that if headline inflation comes in as expected on Friday, he expects TIPS to rally strongly. He is long real yields and breakevens, and told me the beta (relative to cash) is higher for real yields.

In Japan, over 18 percent of Japanese expect consumer prices to fall in the coming year, the Bank of Japan said in a survey released on Thursday, up from 10 percent who held that view three months earlier.

In Ireland, prices fell by 4.5 per cent in 2009, the steepest decline seen in the Irish economy in almost 80 years, according to new figures from the Central Statistics Office (CSO).

In England, Jeremy Warner of the Telegraph reports on why the Bank of England will raise interest rates as deflationary threat melts away:

Higher interest rates are on the way back again. The only questions are how quickly they will rise and how far. Admittedly, central bank action in tightening policy has thus far been confined largely to fast-growing emerging markets.

But even in struggling Western economies, long-term rates (the price markets charge governments for their longer-term borrowing) have already shifted markedly higher since their low point last March, despite massive amounts of Quantitative Easing (QE) in both the US and UK. It is surely only a matter of time before short-term rates follow suit. Or so you would assume.

In fact, this is by no means a done deal, and only the brave, among whom I count myself, would unambiguously predict that bank rate in the US and UK will be higher by the end of the year.

At some point, the flood of cheap liquidity created by policymakers to counter the recession will have to be withdrawn, but the operative words are "at some point". Already a lively debate has sprung up in the City on when. At one extreme lie the likes of Ben Broadbent of Goldman Sachs, who believes that UK monetary policy will once more be in tightening mode by the middle of the year. Bolder still is Simon Ward of Henderson New Star, who has suggested that UK rates may rise as soon as March.

He's right to believe that Mervyn King, Governor the Bank of England, would not feel himself at all constrained by the looming general election if he thought such action appropriate. Mr King is said to have formed a gentlemen's agreement with Alistair Darling, the Chancellor, to stop criticising the Government's fiscal policies until after the election, but it seems unlikely this self-denying ordinance stretches to not taking action on rates.

That would defeat the whole purpose of an independently determined monetary policy. In the US, Alan Greenspan was accused of costing President George Bush senior a second term after raising rates prior to the election in 1992. These allegations have instructed an understanding ever since that the Fed should not seek to raise rates in the run up to a presidential election, but the same convention does not exist in Britain.

Luckily for Mr King, it seems quite unlikely that he will be confronted by such a dilemma. In an interview published yesterday, Andrew Sentance, one of four externally appointed members of the Bank of England's Monetary Policy Committee, seemed to hint at higher rates to come.

He saw little chance of the double-dip recession feared by some and felt that enough had already been done to lift the economy out of recession. But this is a long way from saying that the bank rate would be rising within a few months.

At the other extreme are the likes of Roger Bootle of Capital Economics. So worried is he about the private debt overhang that he's gone out on a limb and predicted that the bank rate will remain below 1pc for the next five years. David Owen, chief economist at Jefferies, takes a not dissimilar view, though his prediction that European and UK rates will remain as they are doesn't extend beyond the next year.

As Mr Owen points out, despite the more upbeat data of recent months, the economy is still operating at way below capacity, and he worries that recent buoyancy in retail sales was simply forward spending ahead of the rise in VAT.

Lurking behind most of this bearish analysis are the lessons of past deflationary experiences prompted by financial crises.

Both in Japan in the 1990s and the US in the 1930s, the mistake was made of assuming too early that things were on the mend and that the stimulus could therefore be withdrawn. In both cases, the economy plunged back down again.

The phenomenon common to both was debt deflation, where falling prices have the effect of adding to the real value of the debt burden. In such circumstances, the overindebted tend to spend their hard-earned money on debt reduction, rather than consumption or investment.

The problem becomes not that the banks won't lend, which is the accusation hurled at them by the politicians, but that the punters won't borrow. We've already seen this occur throughout the private sector, from banks to companies and households.

Banks have attempted to restore capital impaired by bad debts by substantially reducing their balance sheet size. This process has in effect been mirrored in the corporate and household sectors, where cash accumulation has taken priority over spending. Once this mentality takes hold, it becomes very hard to break.

And there is some evidence that this is indeed occurring. Broad money, in the US, UK and eurozone, is still not growing as it should given the amount of stimulus that has been thrown at the problem.

If the private sector cannot or won't borrow, governments must fill the gap in demand instead, which is why we have seen fiscal deficits spiralling out of control. Governments are only doing what the private sector won't do.

The key issue for policy is to judge when the switch back to private demand is sufficiently robust to remove the public support, for if both horses are charging down the same road at the same time, the deflationary threat will disappear as quickly as snow in summer and it will be back to inflation again.

It seems to me that we are now approaching that tipping point quite fast. The economy looks as if it will be stronger this year than anyone dared hope for even a few months back. The evidence for this is not just in the renewed buoyancy of the capital markets, but in much of the survey evidence too.

But in anticipating a monetary tightening at some stage this year, we shouldn't get carried away. The exceptionally steep "yield curve" – the difference between short, policy-induced rates and longer rates – points to a sharp increase in the bank rate, but to nothing like the sort of level which we were accustomed to in the past.

Just to put this in context, the Bank of England calculates that such is the extent of the

debt overhang that a rise back to 4.5pc would impose the same crushing debt-servicing costs on the economy as ruled during the recession of the early 1990s, when interest rates were in double digits.

Any such regime would pole axe demand. The conclusion that can be drawn from all this is that although the bank rate may rise sooner than generally anticipated, it probably won't rise very far.

David Galland, Managing Director at Casey Research, wrote a comment, What The Deflationists Are Missing. He argues that "Obama and his minions" have political aspirations which pretty much guarantees inflation.

On the other hand, Van R. Hoisington and Lacy Hunt wrote an excellent comment on Ponzi Finance, making a strong case for debt deflation and they do not see rates rising in 2010:

Next year the core GDP deflator will fall to zero, with the possibility of negative levels. Likewise, long-term interest rates, which are highly sensitive to inflation, will continue to move toward lower levels. As stated in previous letters, we see no reason why longer dated Treasury interest rates will not mirror those of Japan, which provides a modern signpost for a deflationary environment. Currently the Japanese ten-year note stands at 1.3% with their thirty-year bond yielding 2.1%.

Finally, Pyramis Global Pension "Pulse" Poll: Leading global pension plans believe future growth to come from active equity management. If you scroll down the article, you will see that deflation concerns were highest amongst plans in the Netherlands (40%). Let's hope the rest of the world doesn't catch a bad case of the Dutch disease.

Comments

[Anonymous]

The next leg down in the decade or longer GLOBAL deflationary depression will result in jaw dropping fall offs in global GDP and a concomitant collapse in the price levels of virtually all asset classes.

Anybody who believes the global elite are actually interested in stimulating growth are not paying attention to the message they are conveying through proposals for carbon use regulation and universal financial transaction taxes. Such proposals are clearly designed to halt economic growth not encourage it.

Without economic growth debt obligations cannot be serviced. Defaults run rampant. Debt deflation is unstoppable.

Just ask anybody who runs a small business in any developed country whether the current or proposed policies of their respective local and national governments are business friendly.

Certain large corporations and co-opted workers unions will prosper in the short run by virtue of their political stature but eventually even they will be thrown under the bus in the name of environmentally friendly and sustainable economic development. Of course, these are simply code words for the current 21st century iteration of the Eugenics movement.

[Anonymous]

We will be in a deflationary depression soon because the fed cant stop that from happening too much longer. Our consumer debt level is too high now to prevent it from happening.

[Leo Kolivakis]

That's why the Fed and central bankers are working feverishly to create another mega asset bubble. The risks are that they screw up, raising rates too fast & too aggressively. If that happens, it's game over.

[Anonymous]

We are surely running out of bubbles, and this one won't take 7 years to go bust!

At that point, the bubble blowing game is over!

[Anonymous]

The greatest trick the house ever played was convincing the world that asset depreciation never existed.
-AoR

[glenlloyd]

The picture painted above is far too rosy for me. I can't believe that we can move forward with any kind of growth given the intervention that now exists. The dynamic has totally changed.

Here's one rub:

If the private sector cannot or won't borrow, governments must fill the gap in demand instead, which is why we have seen fiscal deficits spiralling out of control. Governments are only doing what the private sector won't do.

I hate it when I read this. This is failed Keynesian policy that comes down to this: Because you won't spend, we will spend for you, and later on we'll raise your taxes to cover what we spent for you that you didn't want to.

This is lunacy.

[Anonymous]

And look who gets to spend the money for us.

We passed lunacy in 2006. And we are running on hyperbolic fumes to find the word that does describe it. Malfeasance is an understatement.

[mikla]

+1

[Anonymous]

I agree Kenyesian economics is a fantasy. That's never ever worked.

[Anonymous]

I am by no means an "economist". However in the world I live, deflation is not apparent in my daily life. Sure I see the dramatic deflation in home prices, but I do not buy homes daily, weekly, monthly, or even yearly. Like most people home prices, as far as buying on a regular basis, are not in my perception an indicator of inflation / deflation. Also electronics, I am aware have dropped in price appreciatively, but again I do not buy electronics on any time scale that would effect my life style or budget.

What I can say has affected my life style and budget is the very dramatic increase in the things I do buy daily, weekly, monthly and even annually.

For example, I purchase my groceries and household products from a national chain on a weekly basis. For the most part I buy the exact same products in the exact same quantaties every week from the exact same store I have traded with for years. And even though the CPI says no inflation, my grocery budget has increased 25% in one year.

Another would be gasoline. In the past year gasoline has gone from $1.65 locally to $2.55 per gallon. This is an increase of over 35%, on a national volume so low that refineries are closing due to lack of demand.

From a ordinary person's standpoint inflation is not some distant fantasy, but a hard cold reality. Sure I can save huge on buying a new house so maybe I should buy one every week so I can bank the devuated savings from all the deflation out there. Somehow I just don't think it's going to make my purchasing power, nor my lifestyle any better.

[JR]

The Fed, the government, the economic pundits and Wall Street work 24/7 to get us not to believe our “lying eyes.”  It’s to make us feel isolated, to doubt our senses, to oooh and ahhh over the emperor’s new clothes and his BLS charts and statistics and confidence reports, to make us deny the obvious reality that the emperor wears no clothes, that his numbers do not exist, that all the food is on his table, not ours.

It’s just another aspect of the money monopolists’ protection game. The Fed exists to pull the wool over our lying eyes, as its worldwide banking cartel eliminates competition and concentrates the control of money and credit in its hands.  Have you noticed lately all the new CHASE signs being posted around your town by the Rothschilds and Rockefellers on the new properties they’ve recently confiscated via the “melt-down” robbery they helped pull off? 

And, now, after nearly a century of consolidating corruption, power and wealth, international banking cartel operative, aka U.S. Treasurer, Timothy Geithner, tells us these financial criminals, these money manipulators, need sweeping new powers-- to regulate and police and confiscate the world’s wealth.

In 1913, the same year that the Federal Reserve Act was passed, a subcommittee of the House Committee on Currency and Banking, under the chairmanship of Arsene Pujo of Louisiana, investigated the concentration of financial power in the United States in the hands of the few world bankers who conceived the Fed.  It said:

"Under our system of issuing and distributing corporate securities the investing public does not buy directly from the corporation. The securities travel from the issuing house through middlemen to the investor.  It is only the great banks or bankers with access to the mainsprings of the concentrated resources made up of other people’s money, in the banks, trust companies, and life insurance companies, and with control of the machinery for creating markets and distributing securities, who have had the power to underwrite or guarantee the sale of large-scale security issues.  The men who through their control over the funds of our railroad and industrial companies are able to direct where such funds shall be kept, and thus to create these great reservoirs for the ventures in which they are interested and to prevent their being tapped for purposes which they no not approve.  The latter is quite as important a factor as the former.  It is a controlling consideration in its effect on competition in the railroad and industrial world.

“When we consider, also, in this connection that into these reservoirs of money and credit there flow a large part of the reserves of the banks of the country, that they are also the agents and correspondents of the out-of-town banks in the loaning of their surplus funds in the only public money market of the country, and that a small group of men and their partners and associates have now further strengthened their hold upon the resources of these institutions by acquiring large stock holdings therein, by representation on their boards and through valuable patronage, we begin to realize something of the extent to which this practical and effective domination and control over our greatest financial, railroad and industrial corporations has developed, largely within the past five years, and that it is fraught with peril to the welfare of the country.”*

As to bailout--bailout enables the Fed to manufacture whatever money might be necessary to cover the losses of the cartel.

*Herman E. Krooss, ed, Documentary History of Currency and Banking in the United States (New York: Chelsea House, 1983), Vol. III, “Final Report from the Pujo Committee, February 28, 1913, pp.222-24

[Anonymous]

Here here. The other thing I notice is that food containers are getting smaller. For example a jar of spaghetti sauce went from 28 to 24 ounces, and I'm pretty sure the price didn't go down accordingly.

[Anonymous]

"Sure I see the dramatic deflation in home prices, but I do not buy homes daily, weekly, monthly, or even yearly. Like most people home prices, as far as buying on a regular basis, are not in my perception an indicator of inflation / deflation."

Shortsighted. Think of the total effect in all areas of the financial world of falling house prices, and you will see that it does effect your daily expenditures. Just the fact that you cannot now get a HELOC and access to money like before means lower prices overall in the economy, and a lower standard of living for you (potentially, unless, like me, you are half Scottish and a big saver).

[Winisk]

Agree.  The only thing that matters is the quality of life.  It boils down to this for me.  For the past ten years, I've had to work more to maintain my standard of living which is not lavish.  Wages have been static while prices of almost everything has gone up.    I will consider myself fortunate to have the ability to stay even because new construction is slowing down and everyone around me relies on that to continue.  Whereas in the past, contractors were booked a year or two in advance, most are living job to job at the moment.  I don't see how this will change any time soon.  Carpenters, plumbers, electricians, painters, furniture stores, lumber stores, etc. etc. and all the businesses that serve these people are all feeling the pinch.  Seriously, how will the economy replace these jobs when everyone who wants a house, and can afford one, has one?  I can't shake the feeling we are all living on fumes here. 

[Mrmojorisin515]

"The U.S. economy can't go on hemorrhaging jobs forever."

Housing prices always go up!

[Madcow]

Government spending, intervention, stimulus, high taxes, subsidies, etc etc will keep prices of food and energy high in a deflationary environment.

Its like feeding a stripper more and more cocaine - when what she really needs is a long sleep. 

Prices of stuff will fall, but prices of assets will fall faster.

[Anonymous]

Let us not lose sight of the forest for the trees....

Look...there is only ONE TRUE SOLUTION....

KEY WORD.....SUSTAINABILITY

Here is a list of the SUSTAINABLE GOVT. SOLUTIONS TO DATE :

1)

2)

3)

...................................

That is correct....NOTHING....

...................................

What WOULD BE a SOLUTION....

1) Business friendliness....

0 taxes

2) Tax structure change....

0 Individual taxes

Replaced by a 15% Consumption tax only

3) Enhanced markets

All markets must be defragmented...

No taxes of anykind on any securities globally....

Enhanced RETAIL direct access electronic exchanges.

Lower transaction costs....

Lower bid/ask spreads....

All securities MUST transact on the exchange....

No outside matching....No dark pools ....etc...

........................................

Here's the reason....

Cumulative valuations and tax take .....would dwarf the current system....DWARF IT....

Other reason ....

THE CURRENT SYSTEM WILL NOT WORK....

[kathy.chamberli...]

Ø

[crzyhun]

Interesting thoughts...there are a few straws in the wind that may matter. Census workers will boost econ. ST. Biz cap ex build too, witness INTC. So mayber better BUT the countervailing is still to be watched.

[Anonymous]

Conversely, he said, “if you’re sitting on a pile of cash and looking to move into the real estate market, it would almost be a no-brainer to just wait for lower prices.”

Notes of caution simmered to the surface this week after realtor Royal LePage forecast home prices would continue to “appreciate significantly” during the early months of the year. Already in 2009, they’re up 19%, according to the Canadian Real Estate Association.

The trouble is that while prices are rising, incomes are not.
~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~
Leo;
Anyone who doesn't see this as inflation is an IDIOT. And that includes Ben Bernanke our very own Princeton idiot. Inflation was starring him in the face and the brakes should have been applied in 04. Housing is a consumable to leave that and gasoline out of the CPI is just plain stupid.

You have an inflationary housing bubble ready to pop. Have fun with that when it explodes this summer.

[Anonymous]

NO - This is EXACTLY wrong.

When some isolated good or isolated group of goods -- oil, homes, internet stocks -- is going UP, UP, UP. This is NOT inflation.

See cuz the prices of everything else are not higher. People can live just fine... food, services, cars, clothing, are not up. How can it be inflation?

Inflation is not narrowly selective. Thats a bubble. It will pop of its own accord and in the end is deflationary.

[Anonymous]

>Both in Japan in the 1990s and the US in the 1930s, the mistake was made of assuming too early that things were on the mend and that the stimulus could therefore be withdrawn. In both cases, the economy plunged back down again<

I'm now rooting for the rah-rah crowd (of which Leo
is a charter member) so that the central bankers will
will once again make the error of raising rates prematurely here in the new normal and snuff out any chance of a
"real" global recovery, thus having fooled themselves with
the current "fake" one. Given the cast of characters
involved and their total myopia (look at their track record), chances of this are very high. That will be the
time to short this mess.

[jm]

Very nice work.  Thanks for it.

I actually believe that T yields are driven at leats in part by hightened credit risk (horrible technicals and fundamentals), and less by inflation premia. 

Watch that tried and true workhorse, EUR/USD... its broke 100 day, may be testing 200 day a third time soon.  That may signal a reverse in credit risk perception. 

Real yields are very high coming out of what everyone thinks is a past recession.

[Anonymous]

"Governments are only doing what the private sector won't do."

Perhaps you don't see this as a fundamental problem, but I do. There are reasons that people do not want to increase their debt burden, and the government doing so by force - which deficit creation amounts to - looks to me to be a very unwise policy.

[Chopshop]

very nice piece, Leo.  thanks for it.

only bone to pick is with Galland's piece from Casey, which is rife with analytic / historic / technical inadequacy and reads like a poorly researched college term paper on inflation.

Prechter's latest Theorist (released yesterday) is a masterful antidote to such lazy / ill-informed anal-ysis.

[Leo Kolivakis]

Chopshop,

I didn't think much of Galland's article either. Very superficial arguments, but it's still worth reading to see how some inflationists think where we are heading. Thanks for commenting.

[Comrade de Chaos]

I think that the producers price index will increase more than the CPI ex gasoline, and it will translate itself into lower margins and price wars in a number of industries. 

[ATG]

"The need to hedge against global collapse

has gone."

Just about time for Act II of the Great

Default Deflation from Jobs to Gold to

Greece to California.

Rising interest rates due to credit risk may

gobble up economic productivity, the

Big Government PacMan...

http://www.jubileeprosperity.com/