Not Enough Juice for Inflation
05/15/09
The stress tests for the major US banks have come out. The test was supposed to clarify the resilience of US banks in case of further economic weakness. This "additional transparency" had been announced by Treasury Secretary Geithner many months ago and the results while being widely analyzed are now criticized by everybody. The bulls say they confirm that the system is not about to disintegrate, the bears claim that the government is lying to you. The one undisputable fact however is that - stress test or not - the market banks continued to rally in May and were able to raise $32 Billion in the secondary market. That is money the taxpayer did not have to put up and that is a real benefit. Lie to me some more, please. While the stock market advanced to the highest level of the year, 30 year T-Bond yields also rose to their highest level since October 2008. Interpretations were again concentrated on both extremes of the spectrum. The bulls (on the economy and on the stock market) interpreted this as good news since they saw asset re-allocation from bonds into riskier assets happening. The bears on the other hand saw inflation rearing its ugly head. On top of it all the media pundits have a hard time keeping the "stock market", "the economy" and "Washington politics" separated. Between Fox on the right, MSNBC on the left and CNBC in the middle, most commentators are making no effort to separate those three concepts. Instead they put all three together in one pot, stir it with emotion and extract their own personal concoction of socio-political investment spin. The result may be an emotionally heated coctail but in most cases can not exactly be called rational investment advice. It becomes sometimes hard to argue with somebody about inflation threats when your counterparty's main argument is: "Washington is printing money like crazy, debases the currency, creates inflation and runs the country into the ground." The conclusion invariably seems to end in "Buy canned food, arm yourself and buy gold so that you can bribe the border guards." The only question I have is which border? Canada or Mexico? By the way: 1st quarter Beretta gun sales were up 66% compared to the 1st quarter of 2008.
As far as inflation is concerned, you know where I stand. Any near term inflation bet is a poor one. Here is why. Let's remember that consumer inflation means that prices of consumer goods go up. In order for this to happen, either the supply of consumer goods must fall or consumer demand, measured in nominal dollars, must go up. Even if the money supply were drastically expanded, (as shown in the first chart above) there is no inflation unless consumers spend that money. In other words, consumer demand, in nominal dollars, must rise for there to be any inflation. The inflation argument is that the combination of deficit spending by the government and credit expansion by the Fed is inflationary. To be sure, we've seen a rapid increase in M1 - the currency in circulation -- and M2 - savings accounts and overnight repo agreements -- in the last year, up 14% and 9% respectively. But M1 and M2 measure money that is floating around in the system, but they do not give you a handle on how much money is available to consumers for transactions. I explained in our Newsletters in June and October that any increase in the monetary base will act as multiplier of 10:1 for the amount of transactions the banking system can support. We used to think of it as the money base being credited to banks as reserves, the banks then lending out any excess reserves, and thus the money gets into the system. Since banks are permitted to leverage their reserves, every dollar added to the base creates several dollars of transactable money. The problem in recent months has been that banks were reluctant to lend and chose to deposit their cash reserves with the Federal Reserve instead, as shown in the second chart above. The monstrous rise in Reserve Balances shows an extreme risk aversion by the banks. These reserves are not available for real economic transactions in the economy, which in turn will not be able to chase goods or create inflation. Only when these $800 billion slosh back into the economy will there be a significant impact on transactions and eventually, with a significant time lag, on inflation.
In the real world, it isn't just banks that are able to create a multiplier effect on transactable money. The rise of securitizations of loans backed by receivables or assets created a multiplier effect that is entirely outside of the banking system and thus can not be measured by the traditional reporting tools. Institutions that PIMCO called the shadow banking system used to invest money in so called asset backed securities. Today, the impact of securitization on the effective money supply is not a multiplier. It is more like a divisor. Above you see the chart on U.S. net issuance of asset-backed securities. Note that the first-quarter 2009 saw the first actual increase (from almost zero) since 2006. The securitizations of cars, credit cards, student loans and mortgages provided financing to the economy in the amount of hundreds of billions of dollars. These funds are no longer available because the securitization markets collapsed and banks prefer to hold their cash with the Federal Reserve rather than make loans to shaky borrowers. The rapid decline in ABS issuance doesn't show up anywhere in money aggregate measures, but the withdrawal of consumer credit obviously affects the ability to purchase goods. The $717 billion increase in M2 over the last year would normally cause inflation expectations to rise, but under the current circumstances, we'll be lucky if monetary stimulus just matches the decline in credit. And this isn't just about credit availability brought about by the liquidity crisis. If it were, programs like TALF would solve the problem. It's about demand for credit. Consumers just don't want to borrow more. They want to pay off debts. Declining demand and availability for credit may increase interest rates on long term and/or risky credits slightly, but it will not result in increased consumer inflation. All government programs combined are just trying to offset the loss of credit the economy has experienced. Those measures in themselves do not mean that inflation expectations should rise. If the programs are indeed successful, they may result in rising economic activity and hopefully pricing power down the road, but we will have to wait for that to become evident, before action is warranted. Last but not least, broad inflation is usually caused by labor inflation, which accounts for some 70% of the process. It will be three to five years before all the jobs that were lost are recovered. It took three years the last two recessions. Bernanke therefore has plenty of time to address the issue. Inflation hawks are recommending being short bonds and short the dollar. I suspect that the better opportunity is being long bonds and being long the dollar.
I will be traveling to Europe in the coming week. The next newsletter will be dated June 15, 2009.
Hermann Vohs
"Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair."
Sam Ewing
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
