June 16, 2005
DEFLATION, JOE SIXPACK, AND THE GOVERNMENT'S PRINTING PRESS
Forget about inflation, writes Ed Yardeni today in a note to clients. "The next mood swing among investors is likely to be increasing concerns about deflation," writes the chief investment strategist of Oak Associates. BCA Research made a similar point on Tuesday, advising that in 2005 "inflation will surprise on the downside." As a result, "The obvious investment implication is to buy bonds."
For those who agree, there's just one glitch: the bond market in the United States has already rallied, leaving yields at less-than-compelling levels. The 10-year Treasury currently yields around 4.12%. That's up from a quick dip under 3.9% earlier this month, but as recently as March the 10-year Note was changing hands at yields above 4.6%. Then again, if deflation will again be returning to the Public Worry Number One in the markets, there may still be life left in the old fixed-income bull.
But what of the rebound in the consumer price index of recent years? Doesn't that keep the fixed-income set awake at night? The roughly 1% to 2% range for CPI in 2002 has given way more recently to 2.5% to 3.5%. Not to worry, opines Yardeni, who predicts that the cyclical rebound in CPI is kaput. "The CPI core inflation rate is down to 2.2% from February's peak of 2.4%," he writes. "Core prices are up only 1.1% at an annual rate over the past two months. April's core PPI rates also support our disinflation outlook. Intense global competition, cheap technology, and solid productivity growth should keep inflation subdued."
The junk bond market seems to be signaling as much—again. The spread on the KDP High Yield Daily Index relative to the 10-year Treasury has fallen sharply in recent weeks. The rally in junk bonds, and the commensurate fall in the spread, is striking by coming so soon after the high-yield debt market sold off dramatically between mid-March and mid-May. But yesterday's inflation fears have become deflation expectations in some corners. Indeed, as of yesterday's close, the junk spread over the 10-year was roughly 3.2%, down from 4.0% on May 18.
If all of this sounds familiar, you're right; it is. Deflation, you may recall, was all the rage as a topic of concern and fear in 2002 and early 2003. Among the oratorical gems dispensed at the time was the November 2002 "Make Sure 'It' Doesn't Happen Here" speech by Ben Bernanke, a member of the Fed's Board of Governors.
Bernanke's talk was no small weapon in convincing Mr. Market that the central bank could squash deflation virtually at will. To reprise the principal point, we quote the operative passage: "The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost," Bernanke said. "By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services." In case any missed the point, he pulled no punches in summing up the central message: "under a paper-money system, a determined government can always generate higher spending and hence positive inflation."
Not long after Bernanke delivered that timely reminder, the pace of increase in the consumer price index began climbing. CPI's annualized rates of increase, as low as 1.1% in 2002, in time gave way to as much as 3.5%, which was the rate as recently as this past April. But with May's drop to 2.8%, the deflationistas are becoming newly emboldened.
Before you run out and buy bonds, it's instructive to review a less widely quoted portion of Bernanke's infamous talk, in which he explained the deflation's cause is "generally the result of low and falling aggregate demand."
There was a palpable fear that consumer demand would sag in the months after 9.11, thus the deflation worry. In 2005, however, more than a few economists are worried about the opposite, namely, an over-stimulated consumer who keeps buying even in the face of mounting debts. Real estate investing in particular is said by some to be the center of gravity for the current penchant to spend now and ask questions later.
Whether it's homes or SUVs, Joe Sixpack is spending and piling up debt in the process. Indeed, a broad measure of the ratio of debt payments to disposable personal income (financial obligations ratio) published by the Fed depicts the extent of the buying spree and is flashing a warning sign in the eyes of some dismal scientists. Perhaps the ultimate risk is the spending train goes to far and snaps back. In the meantime, the race to Target and Wal-Mart is the only game in town.
Nonetheless, deflation chatter is on the rise, and some corners of the bond market are buying into it. From a short-term trading session, such advice may have merit. Indeed, the buying resumed a bit in the 10-year Note today, with the yield on the benchmark Treasury falling slightly to roughly 4.07%.But for those who're inclined to ride this train, prudence (and an understanding of recent history) suggest keeping an eye open for a new talk by some prominent Fed official on the power of the printing press.
Posted by jp at June 16, 2005 7:18 PM
"Whether it's homes or SUVs, Joe Sixpack is spending and piling up debt in the process."
Nah, not Joe Sixpack. Joe Yuppie, Joe Guppie, and Suzie Q.
Joe Sixpack is already broke.
Posted by: Movie Guy at June 17, 2005 2:59 PM