Debt and Occupy Wall Steet

I liked this essay's explanation of the zeitgeist behind the Occupy movements.

I think there is a simpler story though to be told about modern economic growth being driven primarily by increased private debt levels.  (Update: my view expressed here is heavily influenced by Steve Keen's writing.)  It is less malevolent than the corruption of politics by money explained by the linked essay and simpler to address.  

My story would be that constantly increasing debt levels of the past 3 decades created false demand that was unsustainable when the debt growth stopped.  The extra demand smoothed out the business cycle while the debt grew creating a self fulfilling "great moderation" of stable dependable economic growth that allowed and incentivising high debt levels.

High debt levels benefit asset owners by driving up prices and lenders by increasing interest payments which also explains the shifts in wealth distribution.  There was also a kicker to the wealth concentration at the end of the debt build up where "the 99%" were convinced to take on large debt loads to purchase houses which, as an un-productive asset, require either the owners salary or price appreciation to enable the interest payments.

Recognising the current imbalances as a debt problem would add "eliminating tax incentives for debt funding" and possibly   add "managing the aggregate debt level" to the responsibilities of the world's central banks.  

I don't think this is a difficult narrative for people to understand and I imagine most are aware of the increased presence of debt in their lives.  While discussion of the government debt level is a popular media topic and the level of education loans is starting to make headlines there is much less discussion of the overall private debt level making me think that the majority of people are still looking for a return to the good old days of steady debt growth.

European Interest Rates

From the FT:

Hints by Jean-Claude Trichet, ECB president, and Otmar Issing, the bank's chief economist, that the possibility had increased of borrowing costs falling have contrasted with comments by several national central bank governors on the committee.
The differences highlight the dilemma faced by the ECB. Economic growth, lacklustre for the past four years, has slowed again, and politicians are increasing the pressure for a further cut in borrowing costs. But excess liquidity and oil price increases are sounding inflationary alarm bells.
The confusion puts pressure on the ECB to clarify its stance at its next rate setting meeting on July 7.

I wrote last week that I doubt U.S. interest rates will plunge like Japanese rates did in the 90's. I am much less convinced that the same can be said for Europe. The U.S. is in a much more attractive position to prevent deflation because lowering U.S. interest rates mostly punishes foreign lenders. Europe's higher savings rates make the ECB's decision tougher. In the end I think they will cut rates (maybe this fall) and I am guessing it will happen while the euro is rising rather than falling. I would also expect the ECB to follow any rate cuts by the U.S. Fed this time around too.

Japan's Impact on the U.S.

There is interesting comparison of of JGB and UST rate paths at the Big Picture and the Skeptical Speculator throws in a look at how the Nikkei performed. While it is an interesting coincidence I have a hard time getting over the idea that it is Japan's current economic troubles that are helping to pull U.S. rates down and not an inevitable reaction to the popping of a stock market bubble.

Also, the most unique part of Japan's history is the 1994-1999 segment where rates fell from a 4 handle to a 1 handle. The policy mistakes (failure to clear out bad loans and banks mostly) in that period led to the long bottoming process we are seeing in that economy. The U.S. rate cuts of 2001-2003 were done specifically to avoid the deflationary trap that Japan fell into and so far it has worked. This comparison of bond yields also ignores the very different saving and fiscal situation of the two countries. Japan's high saving rates bias its policies towards deflation (defending the purchasing power of savers) while the U.S. will lean towards inflating its debts away.

I think JGB yields bottomed in March of '03 which not coincidentally is when U.S. deflation fears peaked. I would rather bet on U.S. interest rates following Japanese rates in the present than in the mid 90's.

The Dressing Room

The leadership if there is any is coming from retail and particularly the teenage apparel sellers. Abercrombie & Fitch (ANF) got the ball rolling with its numbers but is now pulling Urban Outfitters (URBN), American Eagle (AEOS), and Quicksilver (ZQK) along on the ride. While its cloths are not as trendy, the Gap (GPS) stock has a very sassy looking short term pattern going so maybe it will hop in on the rally too.

Was probably a better trade for the morning but I mentioned these stocks a while back so I am flagging them again.

It is difficult to see how this fits into the global inflation or deflation picture other than to say that certainly the mall shopping portion of the population has money.

Thoughts for the New Year

Some analysts are joining me in noticing the bullish pattern in Japan's Nikkei. Japan will probably be the story of the year in several ways next year. If their economy is indeed turned around they will no longer be motivated to sell Yen but will instead begin looking at raising interest rates. This in itself will shake up currency markets as Japanese intervention has kept the dollar artificially weak against floating currencies (the Euro in particular).

The biggest effect though will probably be in interest rate markets. Japanese O/N rates have been at zero for the better part of a decade and in my mind have been pulling global interest rates lower. The world has essentially struggled with the deflationary effects of negative growth in the second largest economy. That struggle may be over. This sort of shift in rates should cause some real pressure on peripheral borrowers and I would expect some spread widening in emerging market and high yield bonds. Many people looked at 1994 to see what might happen when the Fed began raising rates in early 2004 but this year's rate hikes were met with spread tightening. I don't think the same thing will be true when/if Japan begins moving rates up.

I would guess that all this and the development in emerging markets is setting up a pretty strong resurgence in macro trading.

Figuring It Out

I am having a pretty difficult time reconciling the movements in various asset classes today. The strength in bonds coupled with strength in stocks makes the least sense of all. The stock market seems to be okay with that though and the breadth has improved since the open.

My best guess is that one of the Asian countries bought a healthy chunk of bonds last night. This moved the dollar but had a bigger impact on bonds because traders were still wrong footed from the jobs report Friday. Stocks are reacting with relief to the idea that the status quo is going to be maintained a bit longer. And commodities are in their own little world as Asian growth is disappointing and the dollar is not collapsing tomorrow.

There is some talk about deflation today with commodities off and bonds up but that view is tough to accept with stocks going higher. Deflation would be crushing for equity holders and maybe more importantly here, corporate bond holders. I would imagine the movements of a foriegn central bank would make it into the papers eventually if that is really what happened.

Inflation, the Yield Curve, and the Dollar

From Between the Hedges on November 20.

Originally posted with a chart of CPI and PPI.

Bottom Line: While some measures of inflation have spiked recently, due mainly to the effects of the hurricanes, they are not even to levels seen in 2000. As well, it is highly unlikely the CRB index, the broadest measure of commodity prices, will continue to rise near recent rates. The rise in commodity prices has been the main source of inflation thus far. Unit labor costs, which account for more than 70% of inflation, have remained well-contained.

My Comment to Between the Hedges

Difficult to understand the comparison you make between inflation in 2000 and now. The front end of the U.S. interest rate curve was never below 5.50% in 2000 and now we are at 2%.

Inflation is not a problem but without much higher rates I am not sure why it would peak here like it did in 2000.

michael 11.23.04

His reply.

I am not comparing. I am just stating a fact. Inflation was more of a "problem" then, yet we didn't harp on it incessantly. Modest inflation has historically been good for stocks and that is what we have now. Low interest rates now are telling me disinflation is more of a problem than inflation. The CRB is likely to decline over the next 12 months. Commodity price increases have been the main source of inflation worries.

Gary 11.23.04

My follow up thoughts.

I disagree entirely with the idea that people here are worried about inflation. Central banks around the world have learned to tame inflation and there was a risk of deflation last year so I think most people view 2% inflation as a relief. What people are worried about is higher interest rates. That is the only mechanism central banks can use to control inflation. The U.S. economy is more highly levered than at any other point in history and if interest rates move up significantly, from these "accommodative" levels, then it is difficult to see consumer spending and corporate investment being maintained at current levels.

Expecting the trend in inflation to change of its own accord is silly and I trust the Fed's ability and desire to control it. The only issue is where interest rates will be a year from now and if our economy (and the world economy) are prepared for that level of rates.

Gary also raise the point that the yield curve is flattening indicating disinflation. Personally I see the flattening as an anticipation of immediate dollar weakness. During currency events bonds will trade on a price rather than yield basis as the loss to principal overwhelms the gains from interest payments. The currency adjustment punishes all principal equally but a 30 year bond gets to discount the loss over 30 years. A flat curve indicates the currency adjustment is going to come all at once and chop an equal amount off principal at all maturities rather than a steady erosion that inflicts a larger loss on principal payments further in the future.

Page 9 of this paper has a good chart showing the spread inversion of the Brazil IDU bond (2001 maturity) against the spread of the C bond (2014 maturity) back in 1998 (after Russia devalued and the market began to anticipate a Brazilian dollar default and real devaluation). There was also a nice article on Friday which came to a similar conclusion about the message coming from interest rate markets.

Beware the flattening

The U.S. yield curve is definitely trending flatter here. One month ago 5-yr rates were at 3.31% and 30-yr rates were at 4.85%. Now they are at 3.56% and 4.91%, respectively. A 19 basis point (bp) flattening. Most of the shift came on the day of the FOMC meeting and the rest is happening this morning. The markets are changing their expectations for the Fed Fund's rate while keeping their long-term expectations for both the economy and interest rates relatively fixed.

Yesterday Fed Gov. Olson Spoke and the most striking part of his speech to me was the comments he made on real interest rates. After noting that the overnight rate remains accommodative he went on to say, "The nominal federal funds rate is currently 2 percent, a level that, using standard measures of core consumer price inflation, implies a real funds rate that is just above zero--considerably lower than the long-run average of about 2-3/4 percent." Nobody is expecting a Fed Funds rate of 3.75% anytime soon, not the Fed and certainly not the markets but that is the rate his comment implies. I was surprised his remarks did not have more of an impact on bonds yesterday and we may end up with a when-are-they-going-to-stop-hiking-panic in the short-end eventually. Not even close yet but the short-end is definitely reacting.

Even without a panic I think the treasury market will at some point steepen back out as people begin to find a 4% 5-yr rate attractive. Could take a while to play out as the market's belief in a low overnight rate is based in the belief in a weak economy. These Fed comments should be telling markets that they don't perceive the same need for stimulation.

This last point is also the only way to reconcile the strength in stocks with a curve flattening. Flattening is a sign of slowing growth and by keeping the long end low the bond market is not showing the same respect for the economy's strength (or even fear of inflation / stagflation) that the equity market is. In March of '03 the bond market was proven wrong and I think they will be here as well. I have absolutely no doubt that the Fed will avoid deflation and I have a growing faith in the U.S.' ability to export its way back to balance.

Until the Fed starts to give signals that rates are no longer accommodative I think it makes sense to be short bonds. The flattening is making me see the long end as vulnerable to a sharp move higher (yields) like the moves in the Spring of both '03 and '04.

position in TLT options.

Feeling bullish

Woke up this morning and caught a clip on CNBC about the IPO of shopping.com which apparently went very well. I then rode the train into work and basically got more bullish the longer I thought. Today will probably be up but that is not what I am talking about. My points are about a 6 month to 1 year move that is building.

While investors intelligence numbers are skewed bullish (Approximately 80% bulls and 20% bears) the overall news and IMHO most trades still seem bearish. More than bearish I would say they are quite skittish and unwilling to maintain conviction in the face of contrary price moves. Many people express concern that the VXO is still around 16% which it is historically low but I am not sure that anticipating 20% per annum moves in stocks makes sense here. Rates are low, there is over capacity and the economy is taking its time to work these things off. Maybe people are correctly anticipating that economic volatility (both up and down) is falling off.

Many people are balancing their views between two negatives: deflation and stagflation. I am not so convinced there is not a more positive middle road that allows theU.S. to work through its capacity overhang and eventually become less dependent on low interest rates. My thesis is mainly based on structural changes taking place in emerging economies represented in some part by what we have seen in China. If the developing world begins to shift away from being a source of cheap supply and towards a source of demand that is what will happen. That shift is really all it takes to counter the deflation argument and turn stagflation into simple inflation. Then all that remains is to see that G7 central banks stick to their guns and moderate growth.

The main reason this IPO is bullish is that Wall Street has some overcapacity issues of its own. Hot IPO's like this feed retail interest and that will lead to more money flowing through Wall Street. Right now people on Wall Street seem to be the most bearish of all. The industry has done very little hiring in the last 5 years and any uptick could do a lot to change that morale. All of this will make the trading environment a lot easier.

Lastly, I keep thinking about the interest rate cycle. People were rabidly bullish in Jan 03, and now with markets very near the same levels 6 months later everyone sees us on the brink of a sell off. The rate hikes started in March and will end in November. If you had told me that the market would struggle to go up during the hiking cycle I would have agreed. It always does. I was bearish in Mar and essentially failed to make money because the sell off turned out to only be a side ways grind. This sideways grind made it difficult for everyone to make money and that lack of profitability is translating into a lack of hope. With the interest rate cycle changing I and the market apathetic it just seems that this sideways range will make a great base for a rally.

Getting Started

I am starting this blog, to record my thoughts on the global financial markets and to see if the world has any interest in them and to receive feedback on my thoughts from readers.

Today's news
This morning the news is about India's possible change in foreign reserve policy. India has $120 bn in foreign reserves, most of which is invested in US Treasury bills, and is considering investing them in domestic infrastructure projects instead. This makes good sense in theory because definite need in India for infrastructure improvements (roads!) and the dramatically lower return on investing in the US compared to India. Whether this is good or bad for India will be determined by the specifics of the spending but it is significant to the markets because of the similarities between India, China, and Japan. Since the start of 2002 China and Japan have purchased a combined $240 bn of USD assets while Chinese and Japanese foreign currency reserves total $450 bn and $650 bn respectively.

Will it matter?
If China were to change its reserve policy financial markets would certainly react but right now all we have is India considering changes. My opinion is that it will probably make the dollar trade down against the Yen and the Euro. Not an earth shattering call in here but it is really more an issue of timing than direction. The dollar was already down a bit yesterday and Monday should continue the move. This should also benefit gold and other precious metals but personally I would wait a few days to see if last week's weakness reappears. I also plan to watch Caterpillar (CAT:NYSE) closely in here as it has a bullish chart, a CEO who has "never seen such a strong economy", and the possibility of a ramp up in Asian infrastructure building. China probably has more need of roads than India if they were to follow suit.

Not the end of the world.
Contrary to popular opinion I am not so sure that the repatriation of Chinese or Japanese funds will cause any sort of financial collapse. A strong argument could be made that this repatriation is what the Federal Reserve and US gov't were hoping for by letting the dollar depreciate. Such a policy change would mean that the US consumer is no longer the growth engine of the world and that the US could then be pulled out of its jobless recovery by exporting goods to Asia. Probably some short-term adjusting to be done but I don't think it leads to an inflationary spiral for the US or the world.

Bullish or bearish?
As the above comments reveal, I am leaning a bit bullish on US equities in here. A change in Indian reserve policy would be the second major "bearish" occurrence in two weeks (the first is the FNM restructuring). I believe this Indian policy change (if it actually occurs) will pass relatively quietly and if China should follow suit in 6 months that will be accepted too. The passing of these events without massive US inflation or deflation can only be interpreted as bullish. Obviously I am looking ahead here and am still very open to changing my mind (say if the yen trades below 103/$ in the next month) but to me the global imbalances are showing signs of correcting in an orderly fashion.

Thanks!
Thanks to Google for hosting this and to anyone who takes the time to read my first post.

BTW, I have no positions in any assets mentioned in this post.

mike