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Tom Peterson: Is the Market Expecting Inflation Or Not?


If the market was really worried about inflation, it would show in fixed income markets, wouldn't it?


Editor's note: The following commentary is courtesy of Tom Peterson of Bulls Eye Research.

Consumer Credit:

We've been on the 'reflation watch' for a while. In a debt-laden economy so dependent upon the consumer, we want to see rising incomes and falling debt levels. But since incomes are not rising fast enough to outpace inflation, we would expect to see rising consumer credit levels to take up the slack. On Wednesday the Fed reported that U.S. consumer credit unexpectedly slid by a record $7.20 billion in October, on a big drop in loans taken out to purchase cars and boats. The central bank said total consumer debt outstanding fell 4% to a seasonally adjusted $2.157 trillion, from a revised $2.164 trillion in September. The rate of decline was the steepest since December 1990, and the dollar drop was the largest fall on record. The Fed said non-revolving credit -- made up of closed-end loans for cars, boats, education expenses and holidays -- fell $5.58 billion in October. Revolving credit, which includes credit and charge cards, dipped $1.63 billion. Despite the contraction, consumer debt is still equivalent to almost 20% of GDP now, versus the very high ratio of 13% from only two years ago. Over the past year we have noticed that when revolving credit was rising, according to the surveys a lot of households were dipping into their credit cards to meet ordinary living expenses. This seems to be the trend now. The drop in consumer credit may be seasonal and partly due to Katrina, but overall it still suggests the consumer has hit a wall.

The latest reports from U.S. Industry show rising output, and productivity is still rising, so producers don't need to raise prices. Consumers can't afford it anyway, since net consumer income growth is declining after accounting for inflation. That the consumer is struggling is shown by the consumer credit report mentioned earlier, as well as by slowing housing & retail sales, and also anecdotally by slashed prices at the malls well before Christmas & Hanukkah, (which both take place basically on the same day this year). This indicates disinflationary pressure, pressure that has never really gone away in the past few years despite the Fed's reflationary tactics.

Recent weekly releases from the Federal Reserve detailing Assets and Liabilities of Commercial Banks continue to reveal that beyond shrinking revolving credit, the level of consumer loans is also deflating, even though Commercial and Industrial Loans are expanding again. The implication is that the consumer is soft and retrenching. And we gently remind the reader that the globe relies on the strength of U.S. consumers.

Is the Market Expecting Inflation Or Not?

These days there is a lot of talk about inflation. Many people think gold is busting out because of inflation, but that is too simplistic (we think gold is running due to a combination of a short squeeze, technical buying, disdain for global fiat currencies, plus buying from Russia, China, Japan, India and oil producer countries).

If the market was really worried about inflation, it would show in fixed income markets, wouldn't it? The redoubtable Scott Reamer posted this interesting chart. He notes, "...the implied future inflation premium between the on-the-run 10 year treasury and the 10-year TIPS has FALLEN during this time (while gold has broken out) by a meaningful 20 bps." He thinks inflation expectations are too high (and deflation expectations are too low).

We note this also coincides nicely with our technical view that gold may make an interim peak here over the next few weeks and start a meaningful interim correction after the next tested high is in place.

Bank Changes:

We do not want to bore everyone with a lot of talk about banking on top of this other preceding macro-econ info, but there is an event coming up worth noting. In the near future there will probably be changes to the so-called "Basel Capital Framework". As we understand it, the OCC (Office of the Comptroller of the Currency, the banking system regulators) is set to disclose guidelines regarding bank commercial and residential real estate landing practices prior to year end. Inter-agency discussions about the initial draft of the guidelines has really only just started, so we would not be surprised if the final report is not pushed out into early 2006. Listening to Mr. John C. Dugan, the Comptroller of the Currency himself, he is set to rein-in some banking practices which will affect real estate lending, possibly in a significant way. It seems the OCC is set to reverse itself on lending practices and clamp down meaningfully on the more exotic stuff. Coming at a time when the housing market is already softening, this may not be the most auspicious timing in history, but of course it is entirely consistent with classic Washington practice to close the barn door only after the horse is well departed (the bold emphasis below is mine). At the moment, US banking system exposure to both commercial and residential real estate is approximately 53% of total loans and leases outstanding.

Tom Peterson
BullsEye Research

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