If you listen to many of the "smartest guys" you hear the argument that treasury prices will get crushed due to factors including the end of purchases under QE2, the risk of U.S. default due to the debt ceiling political gridlock, risk of contagion impacting U.S. interest rates associated with defaults of Greece, Spain and Portugal, and the bogeyman of the Chinese selling their holdings of treasuries.
Indeed, Bill Gross of PIMCO colorfully argues that investors in treasuries are like frogs slowly boiled to death.
"Much like gradually turning up the temperature on poor froggy’s kettle of water, monetary policy in developed countries has been lowering the temperature and absolute level of yields for the past 2½ years post Lehman Brothers. Teeter-totter yields down, teeter-totter prices up, and froggy’s total return euphoria at present seems to know no bounds. But once the potential for even lower interest rates is minimized by the zero floor, our future frog-legged entrée is left with a rather uncomfortable feeling."
On June 1 Jim Cramer summarized this argument in one very long run-on sentence:
"Stocks got hammered today because your house is dropping in price faster than a popsicle in the hot sun and soon the bank is going to own your drastically underwater mortgage you can’t pay because you are worried about your job or not having a job and you don’t know if they can foreclose on it without getting penalized by judges which gives the banks less money to lend which keeps businesses from expanding so they can’t hire which cuts the federal government’s receipts while it spends causing more inflation including $100 oil and $4 gasoline slowing the economy while building a fire raging with gasoline being shown by Bernanke’s bond program which is about to end which will upset the Chinese and they will dump the bonds because the rates are going as high maybe as Greece which is about to default anyway."
My problem with all of these arguments are the following points: (1) their points (falling stocks, dropping home prices, banks tightening lending, slower hiring, tightening monetary policy, fiscal austerity) are associated with slowing economic growth and deflation (and therefore lower yields), (2) they suggest treasuries are quite risky simply because the yield is low, and (3) most of these arguments end with higher inflation as the final kick in the teeth to treasury prices.
In addition, in most cases it seems like the arguments make a huge leap to economic trends driving inflation. In Cramer's case, inflation is caused by deficit spending policies of the government. But, this is likely about to come to an end either through spending cuts or higher taxes, or both, as both sides of the aisle in Congress agree the deficit spending is unsustainable. Others argue the excess capital infused into the economy by the Fed will drive inflation. Maybe, but I don't believe this argument completely appreciates the fundamental deflationary pressures offsetting the inflationary efforts of the Fed.
Concerning the future direction of treasury prices, here is the core difference between my sagflation theme and dominant arguments in the market:
I believe in the short-term (1-2 years) slower U.S. economic growth, defaults by foreign nations on sovereign debt, and deflation likely trump risks associated with excessive debt levels, the exit of a large buyer in the market and U.S. politicians actually allowing the U.S. to default on debt. Constitutionally, defaulting is a big no-no (see Section 4).
Do high debt levels in the U.S. ultimately force higher interest, most likely yes. However, I believe we have at least one bubble to inflate. The grand-daddy of them all, if I'm correct.
The Treasury Bubble
To start let's re-visit my analysis on April 26 of the deflation versus inflation fundamental trends in the economy. For this analysis, I borrowed a framework from Gary Schilling and broke down economic forces into seven areas, which are commodity, wage-price, financial assets, tangible assets, currency, fiat, and goods and services.
Tangible Assets - Deflation appears to be the over-riding force on tangible assets, as exhibited by the 5.1% y/y decline in house prices. What is likely more concerning than the actual number is the reversal from what appeared to be stabilization to an acceleration downward. The combination of tighter lending standards, high unemployment, and over-supply likely continue to drive prices lower.
Fiat - Yes, the deficit spending by the government over the decade has injected inflationary pressures into the economy. However, austerity is the theme in Washington these days, as well as in many states, and while the details are opaque I believe the country will go through a multi-year belt tightening that will swing these inflationary pressures to deflationary pressures. In addition, the accommodating monetary policy for the past thirty years has inserted inflationary pressures. Now, simply by the Federal Reserve stopping its purchases of treasuries at the end of June, the policy turns less accommodating. If the Fed decides to actually sell any of its holdings, or even signal a rate increase (which I doubt), the deflationary pressures increase even more.
Financial Assets - With the strong rally in the stock market over the past couple years the pressure applied by financial assets has been inflationary. As people see their brokerage balances improve they are more likely to spend a portion of it, driving our consumer economy. However, with valuations well above historical levels it is hard to see how the rally continues. Especially since top-down earnings estimates are likely to come down in the near future as analysts factor in the recent slowing of the economy. With a significant pull-back in the stock market this area could turn deflationary as people rein-in their spending as they feel poorer.
Wage-Price - Wages have remained flattish-to-down as companies have the advantage in labor negotiations. The unemployment rate returned to north of 9% last month and 14 million people remain out of work. Indeed, unit labor costs increased only 0.7% in the first quarter after declining for two years.
Good and Services - In many ways, this is where the "rubber meets the road" on inflation versus deflation. The most significant area of inflationary pressures has been in commodities, which are a cost to most companies. Companies have been trying to pass on these costs to consumers in order to maintain their margins, and thus drive inflationary pressures to consumers. Some have been able to do it successfully, others are unable, and even others view it as an opportunity to take market share. While there is some inflationary pressure here, as exhibited by a 3.2% y/y increase in the CPI during April, the majority of the increase has been driven by higher oil prices, which produced a 33.1% y/y increase in April, as measured in the CPI. Excluding fuel and food the core CPI increased a more modest 1.3% y/y.
Until the supply of retailers is rationalized through acquisitions, attrition, and store closings, I believe there is simply too much competition to allow inflation to build in goods and services. The fundamental problem is one of demand since wages are flat and consumers can no longer tap equity in their homes after taking almost $3 trillion out of the equity in their homes for purchases from 2004-2006. Now 40% of homeowners with second mortgages are underwater, so where is the money going to come from for these "zombie consumers?"
Currency - The decline of the U.S. dollar due to accommodating monetary policies and weak economic growth has encouraged to inflation. As the dollar declines goods and services imported from foreign countries appear more expensive. In addition, foreigners visiting the U.S. find goods and services within the country relatively less expensive and therefore are encouraged to spend more. With my outlook of declining interest rates, it is difficult to argue why the dollar should strengthen on its own accord. However, as other regions of the world weaken, including the potential for debt defaults by sovereign nations, the US dollar may look increasingly attractive, sparking a rally.
Commodities - Commodities have been the primary reason most people have started to worry about inflation. After the strong rally in prices for most commodities something has to give, either businesses passing on cost increases, cutting costs like labor to offset the increases, or a willingness to sacrifice margin. The last scenario is that commodity prices reverse and begin to slow due to an economic slowdown, additional supply, or changes in speculators outlooks. If commodity prices, especially oil, begins to decline, I would expect most investors to view it as a positive since it relieves cost pressures. In my view, it would signal the final piece driving deflation.
Thus the breakdown has two clear deflationary trends in the future (fiat and tangible assets), three market-related items that have been inflationary but could swing deflationary quickly (financial assets, commodities and currency), and two fundamental items that have great potential to turn deflationary due to excessive debt and over-supply (wage-price, and goods and services). Because of this analysis, I am less concerned about accelerating inflation hurting economic growth next year than I am about accelerating deflation taking the legs out of the economy.
One Way It Possibly Steps Forward
So how does this go down? I think a critical mistake many of the experts are making is jumping to the final outcome, or endgame as some have put it. That is, high levels of outstanding debt force interest rates higher, which in turn hurts the economy and boils all the "frogs" invested in treasuries. Will this outcome eventually be the case, quite possibly, but I think we have a few steps to walk through over the next couple years before Bill Gross is dining on frog legs.
The following steps are one possible path in the future, and possibly one of the dire pathways. I lay them out to illustrate how some of the market dynamics could play on one another. That said, the future is obviously unpredictable and as one of my teachers use to say, "What if aliens landed in the parking lot?"
Step One - Economic Growth Slows as Deflation Pressures Mount, Pushing Yields Down
This step likely unfolds over the remainder of 2011. A slowing U.S. economy due to weak consumer demand is the primary driver of deflationary pressures. We could see slow U.S. economic growth coupled with rising commodity prices due multiple factors, including (1) weakness of the US dollar, (2) poor inventory tracking and controls in developing countries that continue to manufacture products, (3) continued healthy growth in developing countries, and (4) bubble dynamics within the commodity markets themselves. As growth continues to slow the pressure on treasury yields to move lower likely increases.
Step Two - The Weak Fall, Causing Anxiety and Raising Demand for Safety
Greece is on the verge of defaulting on its debt, Portugal is beginning to face up to its challenges, Spain has yet to get its arms around its obligations, and state and local governments with high debt loads and obligations are cutting significantly. These governments are likely the canary in the coal mine as others we do not know about are probably under stress as well. This step likely produces a strengthening dollar, further encouraging deflation and hurting efforts to reduce debt in the U.S., as currencies like the Euro falter.
Step Three - A Giant Unexpectedly Falters, Causing Investors to Panic
By definition, it is the unexpected that causes the most volatility in markets. With a slowing world economy, potentially volatile currency and commodity prices, and pockets of the world less sensitive to market changes, it is quite possible a large economy like Brazil or even China could suddenly get thrown into a crisis. A scary fact is that China does a poor job of collecting and reporting economic statistics, probably due to the significant growth, politically centralized control of the economy, and the lack of a significant economic crisis recently. Of course no one knows the extent of this issue, but if the steel industry provides any indication of the economy, an inventory build-up could happen without the understanding of the markets and cause a rapid slowdown in the economy to work off. If the slowdown is in a commodity-intensive industry, like steel, the country supplying the commodity could suddenly see their demand fall off a cliff. If the commodity accounts for a significant portion of the economic growth, the country has a problem. The point is that developing countries have relatively opaque reporting of economic and business statistics, increasing the potential for imbalances to develop.
Step Four - The Fed Reacts
Bernanke spoke on June 7 of his expectation (hope) of the scenario in which "hiring picks up from last month’s pace as growth strengthens in the second half of the year." The Fed really wants QE2 to produce enough stimulus to enable self perpetuating growth. However, I believe deflation and external shocks may force the Fed's hand into QE3 sometime in the next 6-12 months due to the ending the current monetary stimulus, more supply coming on line for commodities, and the previously discussed deflationary pressures. This likely results in additional massive purchases of treasuries.
If the Fed's actions are large enough and communicated well enough to convince the markets the actions can stimulate the economy, then I believe treasury yields likely rise in anticipation of an improving economy. If the Fed's action are not large enough, then yields likely fall as the market anticipates a large buyer entering the market, driving up prices.
Step Four - Hammered Investors Chase a Dream
All bubbles start with a good story, or dream. If the expectation of long-term deflation takes hold in the economy investors are likely to flock to treasuries to both escape poor performance in equities, realize some real return (even if the nominal yield is below 1%), and in expectation of future price appreciation as deflation worsens.
Step Five - "Bubble, Bubble, Toil and Trouble..."
Not sure I really want to think about the final step, especially after a bubble in treasuries pops, but then we get into forced deleveraging on multiple levels with likely much higher interest rates. Finding a place to hide will be hard.
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