The Household Driven Deflation?
In his daily report yesterday, David Rosenberg had some pertinent things to say about deflation, not the least of which was debunking Melissa Francis' preconception that inflation is equivalent to commodity price increases. The key issue is the differential between absolute and relative price increases: in many ways the current inflation scare is even less moot than the panic in the summer of last year, when it became painfully obvious that neither retailers nor final-state manufacturers have pricing power (think excess capacity: if the manufacturing ISM is any indication, this pricing power is only going to get further obliterated in the coming months, eating away directly at the bottom line, and making the forward EPS ramp up even more of a mirage in the manufacturing sector; also worth pointing out that non-manufacturing ISM actually fell by 2.6% to 44.4%). For a full discussion of this topic, we refer readers to Rosie's June 5 "Breakfast With Dave" piece.
A more relevant observation is Rosenberg's presentation of the Household Debt-To-Net Worth ratio (chart below), which is currently at an all time high of 26%. Rosenberg estimates that depending on where this ratio normalizes (either the pre-bubble 20% level, or the long term average of 16%), it would involve a debt elimination of $3-5 trillion. This delta is simply too big to be absorbed by taxpayers: "A goodly chunk of this excess debt — bringing credit into realignment with the permanently new and lower level of household net worth — is going to have to be paid down (or defaulted on). This is the lingering deflation risk that the bond bears have yet to factor in."
But what about all the excess cash flooding the system? As has been discussed on numerous occasions, even with the Quantitative Easing cash factored in, we are now in a much worse place from a mortgage interest perspective, and with every incremental increase in far maturity yields, consumers lose additional household value in the form of home equity (if you couldn't sell your half a million dollar house when mortgages were 4.5%, good luck trying to do so at the same price at 5.5%). On the other hand, the stimulus spending focus on infrastructure projects (and an ungodly amount of pork spending) has little hope of creating absolute inflation pressures: rebuilding highways and bridges by retaining minimum wage contractors does nothing to facilitate wage increases, and the unemployment number rising ever higher simply indicates that anyone harboring thought of a raise in this employment-supply glutted environment will be sorely disappointed for a long, long time.
As for the money multiplier effect - just take a look at the latest excess deposit reserve number. That's right: $838 billion in cash which nobody has any interest borrowing. In fact, the latest consumer credit number jives perfectly with a reversion to the mean as expected by the chart above. The bottom line - the U.S. consumer does not buy Bernanke's belief (nor Wall Street's consensus of almost 50% who say that the Fed Funds rate will be higher than 0% in three months).
One last point worth noting out is the amusing lose-lose situation (as Rosenberg presents it) which the Fed has painted itself with regard to Treasuries: "if the Fed doesn’t step in and buy more government bonds, investors are going to conclude that there is not enough demand to absorb all of the new supply coming on stream. Yet, if the Fed were indeed open to the idea of expanding its bloated balance sheet further, then the ‘monetization of debt’ would cause the inflation-phobes to panic and sell their long-duration paper."
So yes, all in all an admirable effort by the fed to give the impression that debt is deflating, happily gobbled up by the equity market. Of course it all occurred on the back of a plummeting dollar. It is inevitable that this trend will reverse promptly once the U.S. finds itself in an increasingly more problematic trade vacuum, as Japan and Europe realize they actually need to export products. In the prisoner's dilemma game of monetizing debt, Bernanke and Obama have defected against every single player, without repercussions yet, and have already lost any potential benefit from this action. It is our belief, that the next round will see defections by all those who have realized the Fed is now acting purely for its own, unitary interest. Politically destabilizing events like the parliamentary crisis in the UK, the IMF bailout of Eastern Europe, and others will only accelerate a wave of monetary backlash against the US. Then at some point the coincident dollar revaluation combined with the increasingly more trigger-happy bond vigilantes, and the consistently deleveraging consumer will expose the debt deflation for the mirage it was, and the equity market which has been in its own little world for way too long will finally get reacquainted with gravity.
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