The Good, The Bad, The Ugly: Deflation fears...
Bill Bonner & Eric Fry
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*** Deflation fears...
*** Dollar sinks...
*** Wall Street closes...
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Deflation, deflation, deflation.
The word is getting a workout. A few years ago, almost no one had heard of it. Now it seems to come up on every financial page...and even at polite dinner parties. People say the word without embarrassment...and feel no need to apologize after if comes out. They don't even have to explain it. Everyone knows what it is.
"Deflation fears" are driving up bonds (and driving down bond yields) say the news reports. Ten-year treasuries rose on Friday; yields fell to 3.30%. So, if you buy a $10,000 bond you'll earn the handsome sum of $330 dollars each year as your reward for lending the government money. This, by the way, is the same government that is promising to make the $10,000 worth a lot less in the future than it is now. The most recent talk has the Fed "targeting" an inflation rate of around 3%.
Hmmm...you earn 3% in yield while you lose 3% to inflation? And that's if the Fed hits its target. It might just as well end up a little wide of the mark...with inflation, say, at 5% or 10%. Why would anyone who is not a neo-con...that is to say, anyone who is capable of thinking straight...want to buy bonds on those terms? U.S. treasury bonds have become an investment where the risk/reward ratio seems so steeply tilted towards the risk side that only an economist would want them.
Almost everything looks better. Euro bonds pay twice as much...and the euro is rising. Chris Wood of "Fear and Greed" recommends "nearly every traded currency in the world, with the exception maybe of the Philippine peso" over the U.S. dollar.
And yet, to the Japanese, a 3% yield on dollar holdings looks pretty good. The equivalent yield in Japan is just 0.535%. Or 'effectively zero.' But while they earn nothing on the yield, the price of things falls...so they get their profit from deflation.
The Japanese are now buying U.S. bonds. In fact, they're the biggest buyers. They are trying to keep the dollar up against the yen, say the analysts. Even in a slump, Japanese exporters sell 30% of their wares to the U.S. and need to keep Americans buying.
They also hope to make money from their investments in the U.S. "Substantial further disinflation would be an unwelcome development," said Alan Greenspan last week. But that is exactly what the Japanese are betting on.
"Our own situation is strikingly similar in some ways to that of Japan a decade ago," Paul Krugman elaborates. "Like Japan circa 1993 or 1994, the United States is now facing the aftermath of a huge stock market bubble - the Nikkei and the Standard and Poor's 500 both tripled in the five years before their respective peaks.
"Also like Japan, we face a problem not of sharp downturn but of persistent underperformance - an economy that grows, but too slowly to prevent rising unemployment and falling capacity utilization.Whatever reassurances Mr. Greenspan may offer, the staff at the Fed is very worried about a Japanese scenario for the United States."
The effect of persistent underperformance was deflation. Prices have in Japan fallen about 1% per year for the last 7 years. Bond yields have dropped to near zero and stayed there.
If America follows the Japanese example, bonds will rise further and buyers will look like geniuses. If not, they will look like the rest of us.
Over to Eric Fry, back in New York:
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Eric Fry writing from Wall Street...
- US financial markets hung out the "Closed" sign yesterday in observance of Memorial Day.and, like most Americans, we New Yorkers fired up our barbecues, despite the constant "hiss," "hiss," "hiss" of a dreary, cold rain dousing our Weber grills.
- Someday, we imagine, warm weather will return to New York. And someday, we imagine, our economy will again bask in the warm glow of economic growth. But an unseasonable and uncomfortable chill continues to linger over the national economy.
- Happily, the stock market's pyrotechnic display is throwing off a little heat, while also creating an entertaining diversion for the lumpeninvestoriat. As long as share prices rise, investors may indulge in all manner of happy fantasies, like the soothing notion that a weakening dollar is good for the economy.
- It's true, of course, that a little dollar devaluation -- like a little cocaine -- provides a little pick-me-up. But overindulgence is as certain as it is destructive. As the dollar's "manageable" devaluation devolves into something less manageable, the "little pick-me-up" becomes a "big downer." Eventually, foreigners sell their dollar-denominated assets in order to stash their capital in a currency that is not depreciating day after day. Dollar selling begets further dollar weakness, which begets further dollar selling.and that's not a pretty picture. The greenback may be much closer to such a dangerous "tipping point" than most Americans imagine.
- "With America more dependent on the rest of the world for foreign capital than at any time in the past 50 years, any disruption in that supply is cause for concern," the Financial Times reports. "This year both the US current account and the US budget could be in deficit by as much as 5 per cent of gross domestic product, representing a material proportion of the rest of the world's savings. Indeed, foreign investors' willingness to supply America with capital at yields of less than 4 per cent is what has prevented the country from plunging into a big recession." - But how much longer can we expect our foreigner creditors to buy bonds yielding 4%, when those bonds are priced in a currency yielding minus 20%?
- "The non-U.S. portion of the world has a vote on dollar interest rates," Jim Grant observes in a recent Forbes column. "Because the U.S. consumes much more than it produces and owes abroad much more than it owns abroad, torrents of dollars pour into the world's payment system. The holders of these dollars have Bloomberg terminals, too, and some fine day they might wake up and sell bonds. Who could blame them?" - Although we Americans have been running a current account deficit for a decade, and counting, we never seem to lack for willing creditors.
- "But there are a few reasons the deficit could be harder to finance this time around," the Financial Times ominously asserts. "First, the US investment proposition has changed. Three years ago, overseas capital rushed to fund a private- sector, technology-inspired productivity miracle. Now America needs twice as much capital from abroad to fund a large and rising public-sector deficit that has arisen as a result of President George W. Bush's tax cuts and the war on terrorism.At the very least, foreign investors may be keen to change the terms and conditions under which the world supplies America with capital."
- In other words, interest rates may rise to compensate for the ever-present risk that the dollar's value may fall. And it is possible, we imagine, that rising interest rates -- triggered by a falling dollar -- could exert an un-bullish influence on share prices.
Bill Bonner & Eric Fry
28 May 2003
Editor's Note: Bill Bonner is the founder and president of Agora Publishing, one of the world's most successful consumer newsletter publishing companies, and the author of the free daily e-mail The Daily Reckoning (www.dailyreckoning.com).
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