Does it End With the Bang of Inflation? Or the Whimper of Dying Prices?
The Dow resumed its downward slide yesterday. It lost 237 points as the deflation commandos continued their counterattack.
It’s war. And war is hell, as General Sherman said, before burning Atlanta to the ground.
Oil was unchanged in yesterday’s trading. Gold gained $5.
Most of yesterday’s hard fighting took place in the financial sector.
“Fed Sees Turmoil Persisting Deep Into Next Year,” saith the New York Times.
The New York press tells us that Steve & Barry’s, a clothing retailer with 200 stores, has filed for Chapter 11. And Fannie Mae and Freddie Mac got walloped again. The two Mississippi Companies [a reference to the government-chartered company in 18th century France that dominated a huge bubble, went broke and practically bankrupted the nation] desperately need to raise money. But even though the two are backed by the U.S. government and clearly “too big to fail,” investors are being a lot more grudging with their money these days. Fannie had to pay 74 basis points over the Treasury rate to get cash, much more than in the past. Freddie’s stock dropped to $10. Fannie’s hit $15. Both traded as high as $60, if we recall correctly.
IndyMac is in the news too. The big mortgage lender specialized in Alt-A loans – a step up from subprime, but apparently not a very big step. The shares traded at $50 in 2006. Yesterday, they were marked down to 44 cents.
Bloomberg tells us that Wall Street debt is being “downgraded by derivative traders.” They know the stuff better than anyone, of course.
What is surprising – to us, anyway – is that they aren’t downgrading government debt. We believe the credit cycle has turned. After a quarter century of falling yields, it looks to us as though yields have formed a major, triple-bottom. Which is to say, bond prices, (remember, they go up as yields go down) have hit three successive peaks, more or less at the same altitude, in 2003, 2005 and again in 2007.
But if we’re on the downward slope, so far it’s a gentle one. We looked yesterday and found the 10-year T-note yielding all of 3.88%.
We have to pause a minute and draw breath. What are bond buyers thinking? Of safety, surely. They see this latest assault of deflation – with falling stock prices all over the world...with Wall Street collapsing...the Fed nervously holding the key rate at 2%...oil slipping, possibly topping out – and they look for a hole to jump in. What better hole than U.S. Treasuries...dug deep by the full faith and credit of the U.S. government and denominated in the almighty dollar?
Well, ahem...that there is the problem. The hole may be deeper than they think.
Conventional wisdom holds that inflation will not be a lasting threat. The experience of the last quarter century is that short bursts of rising prices are soon replaced by another longish period of stable ones. But this was the period when the Chinese and Wal-Mart were lowering prices on manufactured goods...when labor rates were held down by the influx of millions of people into the modern economy...and before the cycle of commodity prices turned up. This was also the period in which interest rates were falling...and almost infinite amounts of money were available to increase consumer spending and production. That period is over.
Nevertheless, millions of investors expect it to continue. They believe that a cooling world economy will bring the forces of inflation back to their barracks and that they can go on collecting 3.88% coupons without feeling like chumps.
Who knows? Maybe they’re right. Still, we think they are morons. Even if they turn out to be right, the margin of safety on U.S. Treasuries is so razor thin they’re bound to cut a vein.
The real issue for us here at The Daily Reckoning is how the world ends. The world as we know it...Boomland...the world of constantly expanding credit and rising asset prices...is finished, we think. Does it end with a bang or a whimper? Does it end with the bang of inflation? Or the whimper of dying prices?
“Both” is still our best guess.
Bill Bonner
The Daily Reckoning Australia
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About the Author
Best-selling investment author Bill Bonner is the founder and president of Agora Publishing, one of the world's most successful consumer newsletter companies. Owner of both Fleet Street Publications and MoneyWeek magazine in the UK, he is also author of the free daily e-mail The Daily Reckoning.
Comment by GaryB on 12 July 2008:
What a sorry mess US capitalism has created, and not just for themselves. The yanks are bludging off the rest of the world with their Fed's low 2% cash rate, their Govt's phoney 4% inflation rate, and their Treasury's money-depreciating 3.8% yielding 10 year bonds. The yanks could "bring the pain back home", where it belongs, starting with some honesty about inflation - probably more like 8%, and hiking their cash rate.
Comment by Aldo Moneti on 12 July 2008:
Interesting figure that 8% - An economic forecast from a while back has US 10-year bonds hitting a nominal rate of about 8.5% sometime in 2010. I think Australian 10-year bonds will tend to stay below 8% during that time period, based on cycle theory.
That said, after getting the sub-text of Paulson's speech today on Freddie's Fannie, I figured it was a good time to short >20 yr US bonds. With that kind of news, and the ongoing Treasury drain of three or four wars, I can't imagine that US bond bears will stay asleep for much longer. Historically, I don't recall any period of time during or shortly after a war that price levels for non-discretionary goods like food and energy did not rise significantly, especially for those hosting the standing armies.
Comment by Smack MacDougal on 14 July 2008:
Bond Yields never go up or "go down". A bond issue yield rate reflects the difference between what you paid and the face value redemption.
The yield is what it is because of the belief that other bets cannot yield more without a much higher danger of losing all that gets bet.
Prices cannot go up and down simultaneously.
Oh, and there's no such thing as a monolithic, general price level.
Each thing has a price, which derives from the ratio of the amount of the thing and the amount of money swapped for each other.
This swap rate varies in relation to the perceived worth of all things being swapped on the earth.
On any given day, a man can awaken to discover he longer yearns to own his sail boat, so its worth to him falls to nil, yet it can fetch a street price only as high as the next guy who opens his wallet to buy it.
Right now, men with gobs of money are saying this by their acts, "We do not believe in buying capital, hence giving credit to manufacturers of wanted, but unneed things for living. You know, things like iPods, sailboats, inlaid marble countertops.
"Instead, we shall buy future claims on the needed things of life, foodstuffs and energy. For if any man is left standing, he shall need to eat and to power the few things he has aleady.
"Next, we might buy some metals needed for building stuff, making stuff. For if any manufacturer is left standing, he shall need resources to forge the few items he can sell."
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