Minyan Mailbag - House of Sand
Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next discussion with that very intent.
The Dollar Index completed a Triple Top formation and just about the same time the CRB Index completed a multi-year Double Bottom pattern and reached a new high as the Dollar Index made a multi-year low. As many of the commodities are priced in Dollars, this relationship is obvious. Gold and Crude have been on a tear thus far.
If the CRB is making new highs we should have raging Inflation and if that is the case we should be seeing a new low in Bond prices (high in yields). The CRX (also the CRB) bottomed in March 2003 (Just before the Iraq war) and broke out of a one-year base in September of 2003. At the same time the Dollar/Yen broke through 2-year support to test 5-year lows this week. While all this was happening, the Bonds (30yr, 10 and 5yr Notes) were threatening an upside (Triple Top) breakout. This does not make sense.
With the Fed Fund Futures for January and February '05 indicating a high probability for a 25 bips hike at each meeting (FFF05 @ .9775 and FFG05 @ .9753 as of today) that would bring the discount rate to 2.50%. At the same time assuming the Dollar Index catches a bid (it bounced off support today) and starts a small counter trend rally and the Bonds react positively (as they should and did today) and breakout bringing the 5-year Note yield down to 3% or lower, what will be the consequences of the spread between the Discount rate and the 5yr yield being very narrow??? Second, if the yields on the long end also drop (The Long Bond and 10yr note are also within striking distance of a breakout) flattening the yield curve, will the Fed start cutting rates and kill the Dollar rally???
All this is very confusing, not that it affects my day-to-day market activity but ultimately this will have some kind of an impact. I would appreciate if you could throw some light on these issues.
We have commented on the confusing relationships observed for quite some time between asset prices and economic statistics, not the ones necessarily reported, but those we think are real. We think that the nature of the confusion is that what is happening is "not natural".
Bill Gross has written recently about the use of hedonics, as have we, in "under-reporting real inflation. This has definitely occurred, but there has also been a "diverting" of inflation from certain finished goods into financial assets through a conscious and coordinated process by central banks. This process leads to large economic imbalances (there is a cost to everything) that have a minority of us truly worried. Bill Gross actually just said the day before yesterday that S&P should actually downgrade U.S. government debt (S&P immediately said they would not). Why would he say that? What is going on? It seems that the only thing rational thinkers have in common these days is bewilderment.
Since the dollar topped in 2000, the U.S. monetary policy has been extremely loose. The five year growth rate of the money supply has been 50% since that time. To compare, the money supply grew 5% from 1989 to 1994; it grew 60% from 1969 to 1974 (we all remember 1973 to 1974 in stocks don't we?). As the dollar has dropped, bonds have actually rallied while the CRB has rallied: reported inflation has been mild. But perhaps a better look at what has been going on in price inflation is through import prices. Before 2000, import prices were dropping 9% year over year with a strong dollar; today import prices are growing 9.5% year over year (this morning higher than expected import prices were reported). There is inflation in them there hills, it is just not being reported in a way that is recognized by Wall Street, even though everyone on main-street recognizes it. The main difference between import prices and inflation is in the things we can't produce here as well as many finished goods where companies are eating higher costs. Why is this?
Normally when we print dollars to buy goods from let's say Japan (and incurs a trade deficit) here is what would happen. The Japanese business man would take those dollars and sell them for yen at his central bank. The central bank would then sell those dollars back in the open market to buy existing yen; this process would drive the dollar down in price and create inflation in the U.S. At some point the U.S. would have to stop printing those dollars to stop inflation.
But in our current extreme case, central banks are operating a coordinated "printing" policy. Instead of selling those dollars to buy yen, the central bank of Japan prints their own yen to give to the business man and takes the dollars and buys U.S. treasuries with it. Inflation won't go up as much in the U.S. as it normally would because a good deal of inflation that would normally go into goods prices goes into financial assets, a la the stock market rally. Notice that this process also essentially exports labor as well: we borrow more and more to have other countries make our stuff.
This process allowed to go on creates imbalances that normally would not occur: trade deficits and high levels of consumer debt in the U.S. The "lending" countries essentially accept our "checks" no matter the financial condition of the U.S. This is why Bill Gross called out S&P to lower U.S. treasury debt.
In summary, this process has essentially driven inflation into financial asset prices away from real assets other than commodities. It also exports labor and the debt bubble out of the U.S. It theoretically can continue indefinitely as long as other lending countries accept our "checks". I have tried to lay clues as to when they will no longer accept these checks.
In the middle of this process we get confusion because the "coordination" interrupts normal market forces and relationships and begins to offend rational thinkers, for they know it is a house built on sand. At the end of the process we get higher interest rates and sub-par growth in the U.S. if not worse.
As to your last question about the "narrowness" between discount rates and 5 year treasury rates (and also the flatness of the yield curve), it is an environment where financial institutions will have difficulty making money (as they borrow short and lend long).
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