In his latest missive, Albert Edwards, among other things, touches on two of the most critical drivers in the current economic climate: deflation and Treasury supply. His observations lead him to conclude nothing good about the follow-through for the current bear market, liquidity driven, short squeeze induced equity rally. However, more relevantly than touching merely on what is a unprecedentedly overpriced equity market, Albert will likely spark some newly-heated discussions between inflationists and deflationists (which in this economy where the only fundamental analysis deals with the Fed's balance sheet and Cash Flow statement, which until HR 1207 is instituted, readers have to mostly guess at, is really all that matters).
First, Albert has this very interesting tidbit about GDP, and why the headline indicator is really missing the big picture about the encroaching deflation that has gripped the US economy in all but the acknowledgement by TV talking heads, much to the chagrin of the Fed chairman.
My former colleague Rob Parenteau pointed out something interesting to me the other day. He noted the huge divergence between US economy-wide inflation as measured by the gross domestic product (GDP) deflator and a slight variant of GDP, the deflator for gross domestic purchases (see chart below). The key definitional difference between the two measures is that the latter includes recent savage import deflation (as GDP includes exports and excludes imports). Hence the gross domestic purchases deflator is a better measure of what is going on in the US domestic economy. With import prices down some 19% yoy and even a record 7.3% yoy if one excludes petroleum, no wonder the price of domestic purchases has already fallen into deflation. If anything, domestic purchases inflation leads trends in both GDP and core CPI, so this is significant news.
The media's desire to ignore this metric, which convincingly indicates that deflation is among us, despite the wanton destruction of US Dollars by Chairman Ben, is not surprising: the last thing US consumers need to know is that a dollar today may be worth less than a dollar tomorrow, and thus drive them to save even more, further crippling the Ponzi monster that the US economy has become.
As for the other very relevant topic: why are Treasuries now back to yielding almost record lows, despite trillions of new pieces of paper backed by the declining full faith of the US government, Albert had this observation.
But what about massive supply of government bonds I hear you ask? Won?t that drive yields higher? Well it never did in Japan. But let?s cast our minds back to the early 1990?s US credit crunch (which seems so minor in retrospect!). What happened then is that US commercial banks bought US Treasuries aggressively at the same time as they contracted lending to the private sector (see chart below). This continued well after the end of recession in early 1991.
I note with interest that Swedish Riksbank recently took its target interest rate negative, in an attempt to force banks to remove surplus reserves and resume lending to the private sector. Of course, no such thing will happen as banks are continuing to buy government paper in unlimited quantities - I note here the recent collapse in UK 1 and 2 year yields to new lows. In the US and elsewhere, where commercial bank exposure to government paper is still close to all-time lows, the unwinding of grotesque over-exposure to bubble sectors like real estate (see chart below) will continue to underpin the secular bull market in government bonds.
The last is quite an interesting observation, which brings the confusion full circle: as Rosie notes constantly, his thesis is buy Treasuries on the deflation threat. Yet the real issue may be that banks, stuck with record excess reserves, and even more record holdings of toxic real estate paper, will sooner rather than later, realize that they can not rely on the Fed's backing in perpetuity and gradually start offloading the toxicity that currently passes for bank assets, and move into a safer class, especially as leveragability falls off, and banks once again become banks, instead of glorified, backstopped hedge funds, a prime example of which always is Goldman Sachs.