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Five Things for Wednesday, May 13


Point of Recognition: Deflation and real rate shock hits CEOs, why real interest rates matter and more.


1) Point of Recognition: Deflation and Real Rate Shock Hits CEOs

"The point of recognition will soon be upon us. And this means people will begin to wake up to declining prices, increased savings and reduced consumption, which will only further reinforce the deflationary debt unwind we are experiencing."

This morning I ran across a Bloomberg piece that illustrates exactly what the coming point of recognition entails, "Real Rate Shock Hits CEOS From Airgas to Sara Lee as Costs Crimp Recovery."

Real investment-grade corporate borrowing costs are running north of 8 percent, the highest level since 1985, according to Bloomberg data. Why so high? Two main factors: annualized consumer prices are declining - consumer prices fell by 0.4 percent in March, the first decline in 54 years - and Treasury yields have quietly moved to a five-month high.

Some key takeaways from the article:

  • Customers of Airgas Inc. (ARG) are reducing purchases of industrial gases such as nitrogen and acetylene because of rising real interest rates.

  • The climb in rates "really reflects a risk aversion," David Rickard, chief financial officer of CVS Caremark Corp. (CVS) told Bloomberg. "People are afraid to lend."

  • Hertz Global Holdings Inc. (HTZ) expects its interest expense to jump by $100 million to $150 million a year and is operating fewer vehicles to conserve cash.

2) But Aren't Interest Rates Near Record Lows?

What's the big deal, some may ask. Just this morning we learned that the average 30-year mortgage rate fell 0.3 percentage points to a near record low of 4.76 percent, only barely above the record low set in March of 4.61 percent. Money is cheap right? No. In fact, to understand whether money is cheap or expensive, we must understand real interest rates.

This is how it works. During a deflationary debt unwind, nominal interest rates, such as a "record low" 30-year mortgage rate of 4.61 percent, are virtually meaningless. If the rate of inflation is declining, which it is, then your real rate is much higher.

Let's look at an example. If we buy a one-year bond for $100 with a nominal interest rate of 2%, then at the end of the one-year holding period we'll get back $102. If the rate of inflation is 2%, however, then our $102 return reflects a "real" interest rate of 0%. That's how inflation saps purchasing power. You began the year "investing" $100. Even though you received $102 back at the end of the year, an apparent return of $2, the rate of inflation absorbed that $2 and put you in the break-even position because your $102 purchases the same amount of goods that $100 at the beginning of the year purchased.

3) Why Real Interest Rates Matter

Ok, so we know real interest rates are high, that's actually good news for savers, right? And with a personal savings rate that has jumped from near 0% as recently as January 2008 to above 4% now, we are rapidly becoming a nation of savers. (More on the personal savings rate in Number 4).

So why is this bad? It's not bad, in and of itself. That's a myth perpetuated by the Federal Reserve and government. However, it is "bad" for current monetary and fiscal policy because rising real yields deter companies from borrowing - in an economy that has become dependent on increasing amounts of debt in order just to maintain the velocity of transactions in the economy (velocity which continues to decline even as monetary policy is trying desperately to keep up).

Meanwhile, deflation erodes cash flow and make it harder for companies and individuals to service existing debt. In short, deflation hurts borrowers and rewards savers.

So in the "real world" of real interest rates, despite assurances from the Fed and Treasury and federal government that credit is becoming unfrozen, borrowing costs remain impossibly high, infinitely high in some cases. It is technically true that a 30-year mortgage rate below 5% means nominal borrowing costs are low. But context is everything. Which is cheaper? A 30-year mortgage at 6.5% interest with inflation running at about 2% and down payment requirements at 5% of the listed house price? Or 5% with inflation at 0% and down payment requirements at 20% of the listed house price? See what I mean?

Anyway, this is all simply a fancy way of saying credit is tight, and in some cases completely unavailable for consumers and businesses.

Americans are accustomed to the three-step economic improvement plan, which is as follows: Step 1. Fix. Step 2. It. Step 3. Fix it.

So, how do we "fix it?" The key to understanding this is to recognize that deflation is a psychological shift among consumers and businesses in time preferences and risk appetites. The Fed can make credit available, but they cannot make lenders lend, or potential borrowers take on more debt even when borrowing costs truly are inexpensive and it makes economic sense to take on more debt.

Real lending and economic activity will only begin when real savers see real value at the right risk. That will only occur in the short-run with vastly lower prices, or in the long-run with stagnant prices and the benefit of time.

4) A Note on Personal Savings

I ran across an interesting piece over at The Atlantic's Business blog, a very nice site, taking a look at the Personal Savings Rate, "America: Not Now, Or Ever, A Thrifty Country." The post built upon a chart that had appeared earlier on the Calculated Risk blog, another great site.

See below:

Click to enlarge

The Atlantic post made an observations that I disagree with and which is closely related to what we've just discussed about deflation and real interest rates.

"[A]n increase in the savings rate from somewhere around 0% (in 2005) to somewhere around 4% (where it is now) can be described as thrifty only because a 0% savings rate is an impressively terrible accomplishment by any standard."

Looked at in nominal terms, an increase in the personal savings rate to 4% from 0% seems like no big deal. But in the context of deflation and with real interest rates close to a 25-year high, a rising personal savings rate of this magnitude is an enormous economic shock. Moreover, while it may be true over the course of the 1982-2000 secular bull market that America was never a thrifty country, now that we are nearing the point of recognition described above, the heart of a secular bear market driven by a deep and profound socionomic shift, that is most certainly changing.

Again, this is not a cyclical pullback in risk appetites, consumption and time preferences. This is a structural change. Companies that fail to recognize this and plan accordingly will risk failure.

5) News & Weirdness

Morning Headline Most Likely to be From the 16th Century:
King Predicts 'Protracted' British Recovery, Inflation Below 2% Until 2012 - Bloomberg
Bank of England Governor Mervyn King says "pretty solid reasons" to question whether a recovery can be sustained and "inflation is more likely to be below the target than above."

Morning Headline That Could Only be From the 21st Century: Bernanke Sees Start of Recovery - Bloomberg

Miller Wrestles Whitney in Showdown Over Bank Stocks - Bloomberg
Get it? Miller likes banks stocks. Whitney hates them. Her husband's a professional wrestler. Man, woman, man, wrestling? Thanks, Bloomberg.

Fed Views Jump in Yields as Sign of Better Outlook - Bloomberg
Which, if true, must mean the Fed doesn't understand that the market is circumventing their efforts, forcing real interest rates higher in order to allow deflation to run its course. (See also, today's Five Things Numbers 1 & 2).

Why Markets, Not the Treasury, Determine Bank Capital - Economix (NYT)
Useful educational reading for Federal Reserve and Treasury officials... if they are actually interested in the consequences of their actions... as opposed to simply allowing elite economic interests to loot from the system while it still exists.

Obama Administration Considering Financial Pay Rules - NYT
This is a broad move to link pay to performance targeting not just TARP banks but the financial services industry as a whole.
Linking pay to performance is a great idea. And by intervening in a private industry's compensation practices the government will be able to successfully bring pay (and performance) back in line with other government-run programs, and agencies; namely, by guaranteeing that the performance is horrible.

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