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Deflationary Bust for Treasury Market?


"Irrational" long-bond curve not at all irrational.

Owners' Equivalent Rent (or OER) is the largest component in the government's measure of CPI (Consumer Price Index). OER is a process by which the BEA estimates what it would cost if owners were to rent the homes they own from themselves. I don't believe this to be a valid pricing barometer.

By ignoring housing prices, CPI massively understated inflation for years. The CPI is massively overstating inflation now.

If one substitutes the Case-Shiller Housing index for Owners' Equivalent Rent in the CPI, as in the following chart (courtesy of my friend TC):

Click to enlarge

In spite of massive cuts in the Federal Funds Rate, real interest rates are still positive by 3.1%.

Previously, when rents were in synch with home prices, it didn't matter if one used OER or actual home prices. It's a remarkably different story now. We have just seen the biggest housing bubble in history. At the peak of the insanity, home prices were 3 standard deviations above rental prices, and 3 standard deviations above wage growth.

Now, home prices are crashing, though we still have far to fall before we reach the norm. Housing can therefore be expected to be weak for quite some time.

The Treasury market seems to have figured all this out quite nicely. Those screaming "Treasury bubble" clearly have not.

In the summer of 2005, the chart shows CPI at just over 4%, with the federal funds rate just under 4%. CS-CPI, a better measure of the CPI, was near a whopping 8%.

Notes from TC

1. The relative importance of OER has changed over time - it was 19.10 in 1987, and is now 23.942. I've included the yearly weight within the data.

2. The Case-Shiller 20-City Composites represent sales from several months previous; wthe CPI reflects the previous month.

3. I've modified the CS-CPI to reflect the 20-City Case-Shiller Index vs. the national Case-Shiller Index used in last month's chart. The quarterly national index lags by far too much.

4. For November 2008, the CS-CPI was a whopping negative 3.1% year-over,year, as compared to a positive 1.7% for CPI-U.

5. The divergence between the 2 CPIs is increasing, as the government OER data continues to move higher.

In fact, since the housing market's peak in July 2006, the 20-City Case-Shiller Index has declined over 24%, while the government's OER has increased nearly 7%. Deflation is clearly here, and the Treasury market is responding to it. You just need to know where to look.
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