Inflation vs Deflation, with Stats

26Feb17 blog
Inflation vs Deflation

Once upon a time, back in Chicago, I was a boy.  I was sitting with grandfather at the kitchen table. This was during the sixties. I was reading the front page of the newspaper while he was eyes down on the paper’s stock tables.  He had owned and managed a successful freight hauling business through the Great Depression.

I read that several economic authorities were concerned about inflation.  I asked grandfather, “Grandpa, what about inflation?”

Grandfather did not look up from his stock tables, but he cracked a rare smile. Out of the corner of his mouth he said, “You should see Deflation.”

Commodities inflation vs wage deflation.

The central banks are breathing a sigh of relief that all their inflationary tactics, such as QE (printing money), bond buying, and negative interest rates, have rescued us from the downward spiral of deflation.

Does that mean that we have turned the corner into inflation? Hardly.

The recent UK and EU inflation indicators have been driven by the price of oil. Thank you, Saudis, for cutting supply.

On the other hand, the CB’s are concerned that full employment will drive up wage inflation.

Bunk. In a globalised economy there are millions of people chasing jobs, and therefore driving down wages.  For the time being there is no such thing as full employment. Here is an example of economists’ 70’s-80’s thinking.

So the CB’s are concerned about inflation. I agree, but I say don’t do what the CB of Japan did during the nineties, by raising rates at the first sign of inflation. They put their economy into deflation and it still hasn't recovered. Their CB's were oldies, educated in the 70’s-80’s, when interest rates were 14%.

Inflation ain’t gonna happen any time soon, boys and girls.


Inflation Stats and Indicators

This past week, headline, pan-European inflation hit  1.76% Dangerous? No way. Core inflation, ex oil and food, was unch’d at 0.9 %. Relax, EU CB.

However, one telling sign of potential inflation is the price of Comex May Copper, which has risen from  appx 2.23 during Oct16 to appx 2.75 during Feb17. Keep an eye on it.

And Oil may be $50 per barrel, but it’s not $100. Get real.

Another source of inflation is the price of stocks. The P/E of the S&P 500 is now appx 25. Would you buy 25%? What is the cost of investing in stocks? Does anyone remember how to calculate the yield on dividends?

(Idea: create a futures contract based on the P/E level of the S&P 500.)

Raising interest rates may be a solution to control inflation, but it is also a cause of inflation because it raises the cost of borrowing.

Solution for the CBankers, Conclusion

The immediate solution for the CB's - in this era of transition - is for the CBs' to hike rates in order to lag inflation, and not try to anticipate inflation. Get it? These CBankers are stuck in the 70’s-80’s.

Next week

Mon, 27Feb17: US Durables
Tues, 28Feb:  US GDP,  Consumer Confidence, and a new one: S&P annualised index of home values. Was 5.3%.
Wed, 01Mar17: US Car Sales and Beige Book
Fri, 03Mar17: NFP postponed until 10Mar17

Inflation, Taxes, and Government by Goldman Sachs

This past week  Janet Yellen had a few things to say about inflation during her Congressional testimony. Echoed were concerns about the ‘I’ word here in London. First, onto Janet on the subject of tightening:

“As I noted on previous occasions, waiting too long to remove accommodation would be unwise, potentially requiring the FOMC to eventually raise rates rapidly, which could risk disrupting financial markets and pushing the economy into recession.”

Sound familiar? This is the same sort of language that we’ve been hearing since the inflationary 70’s and 80’s during the Volker era.

Not that it’s wrong, but it borders on out-of-date Economics.  Here’s why:

We’re in a new world, Janet. You were educated during the 70’s-80’s when the western economies were being crippled by inflation.

But today, it ain’t so.

DEFLATION

The greatest threat to the Western Economies today is not inflation; it is DEFLATION. Why?

China and other cheap economies pay their workers dirt wages, or bare subsistence.  They import our jobs, and they export a lower standard of living through wage deflation.

The western economies, such as Britain, can solve this problem temporarily by importing cheap labour from Eastern Europe. True, in the short term output will increase, but the trade off is that there are and will be UNFUNDABLE demands on the NHS, the school system, and infrastructure. These demands will only increase as time goes on, and they will increase the UK national debt of £1.5tril.

Meanwhile, the native UK kids are being priced out of the market, leading to them signing on, and increasing the cost to the welfare state. Brilliant.

UK INFLATION

This past week saw THE UK CPI increase from 1.6% to 1.8%. Most of the increase was due to the price of oil, which can fall just as rapidly as it can rise. But the alarmists were clamouring that this level is dangerously close to the BoE’s inflation target of 2%.

Again, this is 70’s-80’s thinking which does not recognise that we are basically in an era of deflation.

I say, let’s move the target to 2.5%.

Permit me to quote a stat from my column last week. This stat covers the BoE minutes:

“But  more significantly, the Bank revised its equilibrium jobless rate from 5.0 to 4.5, meaning that there is more potential expansion in the labour market than previously thought. Another sign of low inflation.”  [Read: deflation]

They say that Army generals always fight the last war. The same theory now applies to our senior economists.

Janet, wake up. Your 70’s-80’s schooling no longer applies. We’re in a new era, the era of deflation.

SOLUTION FOR THE US and UK

Tie the central bank rate to the index of leading indicators. If the index increases by 0.2%, then increase the Fed rate by 0.25%. Eliminate the guess work,  remove Janet and her colleagues from the decision making process, and then cut their salaries in half.

And provide a similar solution for the UK.

UK BUSINESS RATES TO INCREASE

Needless to say, this is a bad idea, but because we need to move on, I’ll prepare a detailed analysis for next week’s column. Stay tuned.

GOLDMANS AT TRUMP

"I know the guys at Goldman Sachs. They have total, total control over (Ted Cruz). Just like they have total control over Hillary Clinton," DT said during the primaries.

So who has he appointed to his cabinet? The following Goldmans alumni and an associate:

Gary Cohn, Head of Council of Economic Advisors
Steve Bannon, White House Chief Strategist
Steven Mnuchin, Secretary of the Treasury
Jay Clayton, a lawyer who represented GS, now heads the Securities and Exchange Commission

And let’s remind ourselves that Goldmans were largely responsible for putting the financial markets into the crisis of 2008. Again, pardon me for quoting from my column of last week:

‘CDO’s, [Collateralised Debt Obligations]  by the way, were unregulated due to intense lobbying by the financial services industry, spearheaded by Hank Paulson of Goldman Sachs. Paulson also spearheaded an increase in leverage to finance these products. (Leverage is the amount that a bank can borrow based on capital reserves in order to finance dealings.)  Industry wide, leverage rose from single digits upwards to 30 to 1. (The ‘1’ being the amount of capital on reserve.)’

Hmmm...

Meanwhile, the SPX, has, with all the typical bull market disregard for risk, pushed through 2300 to appx 2350. When will this lift off run out of gas? Who knows, but when it does, look for support at 2200.

For the time being, you may wish to buy the VIX @ 11% in anticipation of a SPX sell-off, but I wouldn't. This is because the VIX can languish for months at this level. The problem is that when the SPX breaks, it will come fast and furious, with no time to get in. My best advice is to look for SPX bear market indicators, such as a spike in crude or the CRB index. Then get in.

Regards, LJ

Dodd-Frank to Become History

The big story this past week was the start of DT’s assault on Dodd-Frank, the law passed in 2010, which reregulated the financial services industry after the disaster of 2008. I call it Glass-Steagall Two, and here’s why.

 Background: G-S, passed in 1933, was designed to separate commercial banking, which provided savings and loans, from investment banking, which traded stocks.  Imagine that you enter a bank with your paycheck, and you tell the clerk that you want to save your money in order to buy a house. He takes your money and then he quickly arranges a meeting between you and a stock broker.  Take his proposal or not, the bank has your money which it can use to finance its own stock trading.

The 1929 market crash was in part due to unsustainably low interest rates, which in turn generated low broker call rates, which in turn created low margin rates, or high leverage, which allowed the banks and their clients to freely speculate in the markets.

G-S fulfilled its remit, and between 1933 and 2008 there were no systemic bank crises.

The problems of 2008 originate in the Reagan administration's deregulation of the S&L industry in 1982. Now instead of paying a depositor 2% and then charging him 5% for mortgages or consumer loans, the S&L's were allowed to use their depositor's money to invest in speculative projects. The result was the S&L debacle of the late 80's.

Eventually G-S was abolished in 1999 by the Gramm-Leach-Bliley Act, which allowed banks to use high street depositor’s money to simply play the markets. Sound familiar?

Also, banks were allowed construct Collateralized Debt Obligations, which in many cases were simply bundles of sub-prime mortgages - in other words, repackaged junk. These CDO’s were often given A2 to AAA ratings by the rating agencies, who, coincidentally, were being paid to rate the CDO’s by their customers, the banks. With investment grade ratings, the CDO’s were able to be sold to pension funds.

The CDO’s were then hedged with insurance policies known as Credit Default Swaps.

CDO’s, by the way, were unregulated do to intense lobbying by the financial services industry, spearheaded by Hank Paulson of Goldman Sachs. Paulson also spearheaded an increase in leverage to finance these products. (Leverage is the amount that a bank can borrow based on capital reserves in order to finance dealings.)  Industry wide, leverage rose from single digits upwards to 30 to 1. (The ‘1’ being the amount of capital on reserve.)

As we all know, in 2008, the market for CDO’s fell like a house of cards, with no firm having the reserves needed to compensate for systemic loan defaults in the sub-prime housing market . Nor were the firms guaranteeing the Credit Default Swaps able to fund their liabilities.

In the end, the tax payer had to fork over $700 billion to bail out the financial services industry. That's appx. $2,300 for every man, woman, and child. Call it corporate welfare.

(For an excellent documentary on the 2008 crisis, view the DVD ‘Inside Job’, by Charles Ferguson.)

In 2010, a new law, the Dodd-Frank Act, was passed, which among other regulations, restricted the bank proprietary trading activities. It included the Volker Rule which prohibits banks from using high street depositors’ money in order to speculate. It also created new regulations to protect consumers. But it also created a costly internal drain on banks’ balance sheets: compliance procedures and staff.

Here’s a personal example. I’ve been lecturing at banks and hedge funds for many years. I have most often been paid on the day or within two weeks. However, it took two and a half months to be paid for my last lecture. I asked my contact at the bank (yes, a bank), ‘What’s holding up my payment?’ He replied, ‘Compliance.’

And as we in London well know, many of the dealing rooms here have been gutted. So if there’s no dealing and no risk taking, what is there to comply about?

By reading my intro above you may think that I’m against the banks speculating in stocks, bonds, commodities, and fx. Not so, I just think that banks should fund these activities from net earnings, after expenses and dividends are paid. I say permit the banks to have separate hedge fund units, with fire walls in place.

But if Dodd-Frank is holding us back - as some people claim - we could, as men of integrity, simply admit our mistakes: Repeal D-F and reinstate Glass Steagall, After all, it worked for 75 years didn't it? Fat chance.

By the way, Mr. Frank was on the radio here two weeks ago. He was not opposed to a revision of    D-F, but maintained that many of its components are essential. Look forward to his testimony during congressional hearings.

Meanwhile, the financial markets will be anxious to know more of Trump’s proposals, and then how they play out.

By the way

The SPX poked its nose above 2300 to 2316.  It could be testing the waters, or it could be doing a head fake. One of my trader's rules is Don't Chase the Trend. Wait for a Retracement before getting in,

Now let’s lighten up.

In a fit of madness, I recently looked for contract work on efinancialcareers. Here are titles for a few sought after jobs:

Option Trader.  Req: Minimum 2 years of experience.  (What? It takes up to 5 years to become a successful options trader.)

Director, Risk and Capital. Requirement: Knowledge of BCBS-IOSCO (Read: justifiable credentials with no, practical experience.)

Night Shift Swaps Trader.  (Read: able to fall asleep at the desk.)

[We are amused.]

Stats, Analyses, and Trade Ideas

     This week’s money market news was dominated by the Stats. I’ll give my assessments from the   viewpoint of a trader.

     The headliner, of course, was NFP, which came in at a whopping 227k. But the question in the dealing rooms in London is,'Is it real?'

     NFP is notoriously volatile, so we need to see the revision next month.  My guess is that if Jan holds above 200k, then it’s real.

     So let’s have a look at the other components in the NFP.

     Unemployment rate to 4.8 from 4.7. Ho hum.

     Workweek unch’d at 34.4 VS hourly earnings to 0.1 from 0.4. These stats tell that Americans are working the same hours for less money. The corollary is that people are working more hours for the same money. Sound familiar? No wage inflation. Bonds should love it. Watch the auctions next week.

     ISM non-manufacturing 56.5 from 57.2. Still, a strong start for 2017.

     PMI manufacturing to 56.0 from 54.5, another strong start for 2017, but note that supplier deliveries rallied to 53.6 from 53.0The latter is a contrary indicator because a higher figure implies that suppliers are delivering more whilst ordering less. Keep an eye on this stat.

     All the above figures bode well for stocks, but the SPX is at a barrier of 2300. I would look for a retracement to 2200 or even 2100, where value could be found, before getting in. And if I were looking for a retracement, then I would go long the VIX here at appx. 10%. It will rally if the index declines.

     On to GB, where the BOE published its minutes. No surprises here, as the rate was left at 0.25. Concern over inflation nudging up was put on the back burner, given that there is little upside momentum  from wages.

     But  more significantly, the Bank revised its equilibrium jobless rate from 5.0 to 4.5, meaning that there is more potential expansion in the labour market than previously thought. Another sign of low inflation.

Next Week

     Tuesday, 07Feb17, watch the US - International  trade figures, expected -44.9 from -45.2. DT’s financial advisers will be watching this one.

     Wednesday, 08Feb17, keep an eye on the US 10-yr auction. The previous bid/cover was 2.58.

GB stats to watch

Friday, 10Feb17, watch the Merchandise Trade Balance, and Industrial Production.

Also to watch 
are DT’s proposals for financial markets’ reforms, esp the Dodd-Frank act.

Regards, LJ