The Yield Curve
John Mauldin
Forecast 2006: On the Gripping Hand
Bretton Woods 2 Keeps on Rolling Along
Things Fall Apart; the Center Cannot Hold
The Bernanke Fed's First Challenge
The Fed Is Targeting the Price of Your House
A Mid-Cycle Slowdown
The Return of Muddle Through
Toronto, New York and London
Once again it's time for me to demonstrate the foolhardy part of my nature by
putting to electronic pen my forecast for 2006. I spend more research time on
this one letter than on any four or five combined, simply reading hundreds of
pages of research, looking at mountains of data all in an effort to try and
catch the gist of the markets. It is a daunting task, but one to which I
actually look forward, as it challenges the mind like few other endeavors.
If I go into as much detail as I usually do on each topic, there is the
potential for this e-letter to be much too long. Therefore I will try and take
the larger picture, make specific and shorter predictions and save the details
and the arguments for later issues. Let's begin by quickly reviewing how we did
last year.
Each year as I do this forecast, I look for a theme. What will be the driving
factor which will set the stage for the economy? In 2001 it was the coming
recession; in 2002 it was a weak recovery and the beginning of the Muddle
Through Economy; in 2003 it was Surprise and Transition. In 2004 it was the
Silver Lining Economy and last year it was the See-Saw Economy. For masochists,
you can go the archives at www.2000wave.com and read those forecasts.
This year, my theme is "On the Gripping Hand." Larry Niven & Jerry Pournelle
wrote a masterful 1993 science fiction novel called "The Gripping Hand" which
involved a species of aliens with three arms. They had a left and right hand
along with their most powerful hand called the gripping hand. They also tended
to find three ways to look at every situation: "On the one had, on the other
hand and on the gripping hand." It was a species bred to be economists. We will
look at a few such situations facing the economy today, and think about what
forces have the world and US economy in their gripping hand.
As I re-read my last year's efforts, it was again not a bad year, but not
perfect. I initially expected the dollar to get weaker against the euro, but by
the end of March I reversed that as facts changed. I said the Fed would tighten
to at least 4% and they did (this was a non-consensus view at the time). I also
expected long rates to rise somewhat, which did not happen, and that was the one
big miss. I suggested that stocks would be flat with the risks to the downside
(again, out of the mainstream). I said gold and oil would be up. I predicted the
economy would grow above trend and it has.
As I look at the coming year, I think it is likely I will not be as successful
in my accuracy. There are a lot of potential variables which could cause any
number of my predictions to be wrong. But chief of my concerns is Fed policy.
When will they stop raising rates? In my mind, I see Ben Bernanke playing Clint
Eastwood, doing the Dirty Harry role, looking into the face of the housing
market and saying, "Do you feel lucky punk? Well, do you?" As we will see, this
is the wild card upon which the economy will turn.
Let me note that this issue probably gets forwarded more than any other weekly
letter I write. For new readers, you can join my 1,000,000 closest friends and
get this free weekly letter sent directly to your email address by going to
www.2000wave.com and simply entering your email address.
Now, let's get into the forecast.
Bretton Woods 2 Keeps on Rolling Along
In 2005 the United States is projected to run a trade deficit of $806 billion,
up from $668 billion in 2004. The International Monetary fund forecasts that the
trade deficit will rise to $890 billion in 2006 and then to what can only be
called a staggering $980 billion in 2007. How in the wide, wide world of global
trading can one country run an almost $1 trillion dollar trade deficit? What is
the rest of the world going to do with all those dollars?
Will central banks really want to buy almost $2 trillion more in US debt in just
the next two years? They own approximately (and at least) $1.5 trillion today,
accumulated over many years. Do they want to own all of our government debt? At
the level of projected trade deficits, that could happen in just a few years. Is
this really sustainable?
The simple answer is no, but the correct answer is that this situation can go on
a lot longer than one would think. And all because of an odd arrangement many
call Bretton Woods 2. I wrote about Bretton Woods 2 last February, but it is
worth going over again briefly, as it is the lynchpin to our global economy.
Things Fall Apart; the Center Cannot Hold
"Things fall apart; the center cannot hold; mere anarchy is loosed upon the
world, the blood-dimmed tide is loosed, and everywhere the ceremony of innocence
is drowned." - William Butler Yeats
Yeats was not describing what has come to be called Bretton Woods 2, but it
seems apropos to start with that quote. The first Bretton Woods system came
about when representatives of most of the world's leading nations met at Bretton
Woods, New Hampshire, in 1944 to create a new international monetary system.
Because the US at the time accounted for over half of the world's manufacturing
capacity and held most of the world's gold, the leaders decided to tie world
currencies to the dollar, which, in turn, they agreed should be convertible into
gold at $35 per ounce.
Under the Bretton Woods system, central banks of countries other than the US
were given the task of maintaining fixed exchange rates between their currencies
and the dollar. They did this by intervening in foreign exchange markets. If a
country's currency was too high relative to the dollar, its central bank would
sell its currency in exchange for dollars, driving down the value of its
currency. Conversely, if the value of a country's money was too low, the country
would sell dollars and buy its own currency, thereby driving up the price.
The dollar became the world's reserve currency. Yet there were limits. Each
country had to police its own reserves and currency or be forced to revalue. And
the US was constrained because the dollar was fully convertible into gold. This
changed in 1971 when Nixon closed the gold window.
Now we have what many are coming to call a Bretton Woods 2 system. That is where
much of the world, but primarily the Asian countries, has more or less
informally agreed to peg their currencies to the dollar. They do this in order
to maintain their relative competitive ability to sell their products to the
world and specifically to the US.
But this system is inherently more unstable than the first Bretton Woods. There
is no gold conversion constraint upon the reserve currency. The US has few
reasons to protect the value of the currency, and many reasons why they should
want it to drop. And there is no formal agreement among the nations. Any nation
at any time could begin to act unilaterally to change.
Bretton Woods Two is actually a Nash equilibrium. In game theory, the Nash
equilibrium (named after John Nash) is a kind of optimal strategy for games
involving two or more players, whereby the players reach an outcome to mutual
advantage (or often as not mutual disadvantage). If there is a set of strategies
for a game with the property that no player can benefit by changing his strategy
while (if) the other players keep their strategies unchanged, then that set of
strategies and the corresponding payoffs constitute a Nash equilibrium.
Foreign nations, but primarily Asian nations, take our electronic dollars and
send us "stuff." On our side of the equilibrium, American consumers agree to not
save very much and borrow against our rising housing values to hold up our end
of the bargain. We have been very good at holding up our part of the bargain.
They agree to keep prices down. If they tried to get rid of their dollars, their
currencies would rise in value against the dollar, and thus the cost of their
stuff to us. This would make them less competitive against each other. So, to
keep their factories going, they keep their currencies low in a competitive
devaluation.
If there was one "Super-Asian" currency, there would be no incentive for them to
do so. But as it stands, you have a dozen or more countries buying large amounts
of US debt in a form of vendor financing. This happens when Asian company A
sells us $10,000,000 of widgets. They need local currency to pay their bills, so
they trade their dollars into their central banks for local currency (either
directly or indirectly through intermediaries). The central banks then manage
the value of their respective currencies.
But now they have dollars, and need to do something with them. They could buy
stocks or real estate or anything denominated in dollars, but central banks
prefer US debt. This has also had the effect of holding down our interest rates
on the long end of the yield curve. This in turn keeps mortgage rates low which
helps power home values and cash-out refinancing.
Under Bretton Woods 1, Nixon could end the agreement by closing the gold window.
Under Bretton Woods 2, foreign central banks have us in their gripping hand. For
now, they have no incentive to change the rules, as it would hurt them to do so.
Who would buy their widgets and keep their factories going and employment
rising? But at some point, as a small but growing number of foreign central
bankers have pointed out, the deal is going to have to change. You can have too
much if a good thing, especially if you have to swallow a trillion of them a
year.
What is so uncomfortable about this situation is that we will not know when the
equilibrium equations will change until they have already changed. As Martin
Barnes of Bank Credit Analyst puts it, "Of course, there is a limit to how high
the US current account deficit can get. Unfortunately, we will only know that
limit has been reached when markets start to riot. The dollar's strength argues
against any near-term problem, but markets can be fickle, and we cannot rule out
a marked reversal in sentiment toward the dollar. The crucial assumption is that
Asian central banks would then step in quickly to restore calm to the markets."
It will take two things to happen for the trade deficit to reverse. First, the
dollar will have to go down, and secondly, the US consumer will have to buy less
and save more. We will look later at how likely it may be that those two events
happen this year.
But in 2006, I think Bretton Woods 2 remains the global paradigm. I am still
long-term bearish on the dollar, but do not think the dollar as measured against
Asian currencies will see anything like a major correction this year. You will
see small moves in the Chinese yuan as the Chinese government allows the yuan to
rise just enough to placate US protectionists, and that may give some room for
other nations to slowly shift as well. But the 30% or so correction in the trade
weighted dollar that is needed to bring the current account into something
closer to balance? I do not think it is in the cards this year.
The dollar has been strong for several reasons this year. The Fed has been
raising rates, which is dollar bullish. The government had a one year deal which
allowed companies to repatriate dollars held offshore. By the middle of last
year, everyone and their brother were bearish on the dollar. If there is no one
on the other side of the trade, then a correction is due, and we got it. For the
record, I am still long-term bearish on the dollar, but as I note below, this
correction could take a long time.
Finally, for those who want to play the currency market, I think being long the
yen against the euro is the way to go.
The Bernanke Fed's First Challenge
Where was the hint of inflation that was in the air last year? As I wrote last
quarter, I think the inflation cycle peaked and we are now going to see a period
of lower inflation. Core inflation is low in most countries around the world.
The reigning paradigm in the world is still deflation.
The dual mandates for the US Fed are to hold down inflation and to promote full
employment. The economy is still creating jobs, albeit slowly, and inflation is
slowing. However, it seems that the Fed is going to raise rates at least twice
more - once at the end of January at Greenspan's last meeting and then on March
28 when Bernanke is chairman.
Let's review Greenspan's major speech of last year at Jackson Hole. I wrote
about this last August, but it is so critical that I think we should review it.
Here are a few key paragraphs from that speech.
"The structure of our economy will doubtless change in the years ahead. In
particular, our analysis of economic developments almost surely will need to
deal in greater detail with balance sheet considerations than was the case in
the earlier decades of the postwar period. The determination of global economic
activity in recent years has been influenced importantly by capital gains on
various types of assets, and the liabilities that finance them. Our forecasts
and hence policy are becoming increasingly driven by asset price changes."
Read that last sentence again. I had been writing for months that I thought the
Fed was targeting asset prices, and specifically home prices. They are worried
about a housing bubble creating problems in the economy.
The Fed Is Targeting the Price of Your House
Greenspan says above they are targeting asset prices. Can it be any clearer? You
think they are worried about a stock market bubble? Commodity or gold prices?
What other asset price is driving Fed policy? I think they perceive the greatest
risk to be a continued housing bubble, and they are going to move to do what
they can to let the air out of the bubble. Continuing:
"The steep rise in the ratio of household net worth to disposable income in the
mid-1990s, after a half-century of stability, is a case in point. Although the
ratio fell with the collapse of equity prices in 2000, it has rebounded
noticeably over the past couple of years, reflecting the rise in the prices of
equities and houses. Whether the currently elevated level of the
wealth-to-income ratio will be sustained in the longer run remains to be seen.
But arguably, the growing stability of the world economy over the past decade
may have encouraged investors to accept increasingly lower levels of
compensation for risk. They are exhibiting a seeming willingness to project
stability and commit over an ever more extended time horizon.
"The lowered risk premiums--the apparent consequence of a long period of
economic stability--coupled with greater productivity growth have propelled
asset prices higher. The rising prices of stocks, bonds and, more recently, of
homes, have engendered a large increase in the market value of claims which,
when converted to cash, are a source of purchasing power. Financial
intermediaries, of course, routinely convert capital gains in stocks, bonds, and
homes into cash for businesses and households to facilitate purchase
transactions. The conversions have been markedly facilitated by the financial
innovation that has greatly reduced the cost of such transactions.
"Thus, this vast increase in the market value of asset claims is in part the
indirect result of investors accepting lower compensation for risk. Such an
increase in market value is too often viewed by market participants as
structural and permanent. To some extent, those higher values may be reflecting
the increased flexibility and resilience of our economy. But what they perceive
as newly abundant liquidity can readily disappear. Any onset of increased
investor caution elevates risk premiums and, as a consequence, lowers asset
values and promotes the liquidation of the debt that supported higher asset
prices. This is the reason that history has not dealt kindly with the aftermath
of protracted periods of low risk premiums."
Again re-read the last paragraph, especially the last three sentences (emphasis
mine). Greenspan is clearly saying that you should reduce your risk in your
investments and business. He is saying that you should not project the current
trend into the future. There is more risk than most investors are assuming. He
is warning, in as clear as possible terms, that housing prices could easily go
down. And in fact, he is all but saying that he intends to help them do just
that, or at the least stop rising.
He and the rest of the Federal Reserve board are intent on raising rates until
the housing market cries uncle. We have had several speeches in the past few
months by Fed governors making that clear. This seems to me like a mindset that
suggests the Fed is going to do what they have historically done in the past.
They raise rates until the economy slows down or the yield curve inverts, or
both!
But at the end of this month the "he" in that paragraph becomes Ben Bernanke.
Does he agree? I think we should assume he does.
One of two things is going to happen. Either the housing market is going to slow
down in terms of price increases, thus signaling the Fed it is time to call a
halt to this cycle of rate increases or the Fed is going to keep raising rates
until the housing market slows down.
Ben Bernanke has your home value in his gripping hand. He is called Gentle Ben.
We may find out just how gentle he is.
The inventory of homes for sale is rising. Housing prices are starting to soften
in a number of markets. Fannie Mae says home sales will be down 6% to 8% in
2006.
The third Fed meeting of the year is scheduled for May 10. In a somewhat ironic
twist, if the economy is still roaring along, the Fed could (and I think would!)
find justification for raising rates again, thus making it all the more likely
there will be a slowdown later on, and a bigger one than we would think today.
But right now, things seem to be slowing down on their own. Wal-Mart just
reported its smallest December sales gain in five years. Auto sales for the Big
Three were all off in December. But the key is mortgage re-finance applications
are down significantly. And that brings us to my next prediction.
A Mid-Cycle Slowdown
Depending on which set of statistics you want to use, mortgage refinancing has
been responsible for at least 2-3% of GDP growth for the last few years. Take
that component out and growth would have been quite dismal. Cash-out mortgage
refinancing has been possible because hone values have been rising at an
extraordinary rate for the last five years.
While I am not suggesting that all mortgage refinancing is going to stop, I
think it is clear it is going to seriously slow down if home values stop rising
and especially if home values start to fall.
The portion of GDP growth from mortgage refinancing is going to drop. By how
much? No one knows, but it could easily be cut in half or more. We have seen
mortgage applications for refinancing decrease by about 25% or so already.
Further, in many parts of the country, homes have been bought as investments.
When prices stop rising, those homes are going to go onto the market, as the
carrying cost of an interest only loan is painful. These "investors" are going
to just want to stop the pain. That is going to exacerbate the housing price
slowdown.
Will the housing market crash? I do not think so today (well, maybe in a few
markets that are simply crazy). Overall, we are just going to see home prices go
flat for what will likely be several years in a reversion to the mean. We have
two references for what happens after a period of significant home prices
increases in England and Australia. Neither of those two housing bubbles popped.
The market just went flat in those countries, and that is the more likely
scenario here.
But "flat" is all that is needed to slow down cash-out refinancing. So, that is
one headwind the economy faces.
This scenario also suggests that new home construction will slow. That means job
growth will slow down as well. Today's job number of 108,000 has to be viewed as
disappointing, even if it is tempered by an increase of 71,000 for the two
previous months.
We have seen mid-cycle slowdowns in the US in the last two economic cycles, both
in the 80's and 90's. It now seems we will see yet another replay of that trend
this decade as well.
If the Fed does not do what it has often done in the past and raise rates until
we get a full and serious yield curve inversion and the follow-on recession, I
think we will get a "mere" reduction in growth into the 2-2.5% area.
The consensus of economists is clearly bullish. But then listening to consensus
economists is not very useful. Louis Gave brings this note to me:
"In any case, econometric models, like all mean-reversion techniques, are
notoriously poor at spotting turning-points and detecting trend changes. In
fact, according to a 2002 IMF study, out of 74 identified episodes of recession
in different countries, only four had been correctly predicted by econometric
forecasts published just three months prior the recession year - and in
two-thirds of cases, consensus economists had failed to 'forecast' the recession
even four months after it had started."
The Return of Muddle Through
I define what I call a "Muddle Through Economy" as an economy that grows below
trend. Note that I used the word growth. I think we are in a Muddle Through
Decade. Growth so far this decade has been 2.6%, which is below the trend of
3.6% since 1950. I think we will be lucky to end the decade with a 2.6% number,
as I expect at least one more recession this decade. I think the following
decade could be very strong.
By the end of this year, I think we will see growth slow into Muddle Through
territory. Clearly, a slowdown will not be good for the US stock market. Last
year I said the market would be flat with risk to the downside. This year I
think the market actually ends the year down, and by at least 10% or more during
the year.
That is clearly not consensus. The big majority of those polled by Business Week
are anywhere from mildly bullish to wildly so. Elaine Garzarelli thinks the Dow
will top 14,000. What is she smoking? It reminds me of the George Carlin line in
some forgettable movie listening to someone tell a very improbable wild story
about spies and doomsday drugs. "Wow," he said, "the 60's were sure good to
you." 14,000 would put the P/E ratio back to 1999 territory. And with Ford and
GM in the Dow? Come on.
This market correction is going to put more pressure on the retirement plans of
the baby boomers. The market has been essentially flat since 1998. On March 31,
1999 the S&P 500 was at 1286. Today the market closed at 1285. That is almost
seven years of going nowhere for index investors.
But that is what happens in secular bear market cycles. The market goes nowhere
for long periods of time waiting for valuations to reverse and then go below
trend. When housing values begin to stop rising and stock markets disappoint,
the aging boomer is going to look at his retirement funds and start to really
worry. He is going to have to do something that heretofore he has resisted. He
is going to have to save more.
By the end of the year, consumer spending is going to slow down as the "wealth
effect" from both housing and stocks becomes negative. Enough to put us into
recession? I don't think so, at least not this year. But it will slow the
economy down. Thus, I think it is quite possible that Bernanke actually starts
to lower rates before the end of the year. Yes, I see the irony.
How do we know if my prediction of a slowdown will turn into a recession? We
will watch the yield curve. Typically it will give us a 9-12 month warning. Stay
tuned.
We are already running long, so let's cut to the chase on the rest of the items.
A slowdown will mean that long bond rates will be lower at the end of the year
than they are today. The bear market in bonds is over, says bond king Bill
Gross, and I agree. This will also serve to lower mortgage rates and is one of
the reasons I think we could avoid an outright recession. A little stimulus
here, and little stimulus there.
I should note that Gary Shilling makes a strong case for the housing bubble to
burst, with prices dropping 20% and a major recession as a result. I will use
that part of his last letter as an Outside the Box in coming weeks. For new
readers, I send a second letter on Monday nights to all subscribers of my
regular letter called Outside the Box which is the work of another analyst which
I think is interesting and important, and most of the time it is non-consensus
and thus Outside the Box thinking.
I am still bullish on gold, although I think we should see a correction to the
recent powerful run-up. Gold is now rising not just against the dollar but
against all currencies. It is not rising due to supposed inflation worries. If
that were true, bond yields would also be rising. It is part demand from Asia
and the Middle East, part momentum and investment driven and partly as a way to
protect oneself from paper currencies. But it all adds up to a bull market in
gold. It will be interesting to see if it becomes a bubble, although that is a
long way off.
I am still bullish on energy. Demand is going to increase so much over the next
ten years that prices are going to be pushed to new highs. Plus, I get very
nervous that so much of our world supply of oil is in places like Nigeria,
Venezuela and the Middle East which could see serious supply disruption due to
local politics. An oil spike caused by a disruption in supply (as opposed to
demand driven) could have a very negative impact on my mid-cycle slowdown
prediction.
The global economy should do well, in spite of a US slowdown. Japan is starting
to show signs of life. I do not expect China to have a hard landing as some
predict. In fact, I am still quite positive about China and think growth is
going to be quite good. There are a lot of positive things happening in China,
and I am going to write about them in the coming weeks.
Let me give you one reason. Those "communists" understand something that our
politicians don't. Last year, they simply did away with all rural taxes. In
2006, the threshold for income taxes has been doubled. Imagine, tax cuts
designed to produce growth. Caveat: If Congress does not extend the dividend tax
cut, watch the market get killed. It will be ugly.
Given my view, I am not all that excited about long only commodity funds. I
think copper could be in for a serious correction this year. Funds which can
benefit from volatility will have the potential to do well in this environment.
Toronto, New York and London
I will be in Toronto November 18-19 speaking at a private conference, but my
friends and partners at Pro-Hedge will be setting up a speaking event one
evening. If you are interested in coming, just drop me a note and I will get you
details. I will be speaking at the "Hedge Fund Incubation and Seeding
Conference" on January 30-31 in New York put on by Financial Research
Associates. You can get more info at www.frallc.com. It is a subject I am quite
interested in. I will be in London the week of 12-15th of February working with
my London partners, Absolute Return Partners.
If you are an accredited investor (net worth of $1,000,000 or more), I might
suggest you go to www.accreditedinvestor.ws. In conjunction with partners in the
US (Altegris Investments) and around the world, we research and offer a variety
of private offerings, commodity funds and hedge funds. (In this regard, I am
president of and a registered representative of Millennium Wave Securities,
LLC., member NASD. Be sure and read the risk disclosures below on the web site
about hedge funds and private offerings.)
And speaking of Altegris Investments, I will be at their office in La Jolla next
week for our annual planning meeting. I am looking forward to some new and
exciting things we will be able to announce soon.
This is going to be a very busy year for me. I have committed to write another
book called The Millennium Wave which is due in the fall. I have been thinking
about this topic for 6 years. We will be starting a new service which will
recommend money managers to regular investors (no net worth requirements) in
February. I am quite excited about that. There are managers who understand the
concepts of absolute returns about which I write so often, and I look forward to
introducing them to you. We will be adding partner firms in various parts of the
world to be able to serve more of my international readers. Those announcements
will come soon!
We are having perfect weather in Texas. It is unseasonably warm for winter. We
had a very mild summer as well. If our weather were really like this every year,
California housing prices would plummet as everyone there would come here to get
houses for 25% of what they are in California. There is no housing bubble in
Texas.
It's time to hit the send button. Enjoy your week and year. Here's to a year
where our bodies weigh less and our investment portfolios weigh more!
Note: John Mauldin is president of Millennium Wave Advisors, LLC, (MWA) a
registered investment advisor. All material presented herein is believed to be
reliable but we cannot attest to its accuracy. Investment recommendations may
change and readers are urged to check with their investment counselors before
making any investment decisions. Opinions expressed in these reports may change
without prior notice. John Mauldin and/or the staff at Millennium Wave Advisors,
LLC may or may not have investments in any funds cited above. Mauldin can be
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Your always excited at the beginning of a year analyst,
John Mauldin
JohnMauldin@InvestorsInsight.com
www.2000wave.com
January 7, 2006
Copyright 2005 John Mauldin. All Rights Reserved.
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John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.
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