Conventional wisdom has been that Treasuries have been the yet another bubble as cash exited equities and other risky investments, first feeding a commodities spike, then seeking a better home in Treasuries.
But Merrill’s David Rosenberg, who was in a decided minority in seeing deflation as the likely outcome for the US (he has for some time forecast Fed funds at 1% by year end 2008), thinks that Treasuries will go even higher (which means lower yields) as debt deflation takes hold.
We have excerpted his discussion of the interest rate and housing price outlook from his September 29 report. He starts by showing that financial firms, consumers, and non-financial businesses are all shedding assets, which is deflationary.
From Rosenberg:
Barely halfway through the real estate deflation
The data we got yesterday were quite telling. New home sales sank to 460,000 units in August, a fresh 17-year low, and the inventory-to-sales ratio gapped up to 10.9 months’ supply (MS) from 10.3 MS in July. There is no chance that home prices stabilize until this ratio moves convincingly below 8 months. In fact, our models suggest that there is another 15-20% downside in average home prices and they are already down 20% from the peak. So, we are barely past the halfway mark in this real estate deflation.Inventory backlog is proving intractable
As a sign of how difficult it has become for the builders to move product, the median length of time it is taking to make a sale from the time the unit is completed shot up to a record high of over 9 months from 5.7 months last year and the 4 months that typifies a normal market. Sales are down to 460,000 units and yet single-family starts, while down 35% from a year ago, are still running far ahead of demand at 630,000 units. This is why the unsold inventory backlog is proving so intractable this cycle – and this will exert ongoing downward pressure on residential real estate prices in most parts of the country.We can’t grow our way out of this inventory overhang
We are not going to be able to ‘grow’ out way out of this acute inventory overhang via demand because the homeownership rate is still near historic highs of 68% – fully 4 percentage points above the norm. The homebuilders are going to have to work that much harder to work off the excess through a sharper cutback to housing starts, which are very likely to hit new post-WWII lows this cycle (and likely not priced into the HGX index).Policymakers still underestimating the size of the problem
Tack on our view that the unemployment rate looks set to rise above 7%, the output gap to 4%; credit spreads at elevated levels, together with our expectation of continued house price deflation, and our estimate of the expected total losses going forward are close to $1.5 trillion or double the size of the TARP. So, the one problem we have with the TARP as it stands is the size – $700 billion. This tells us that even Bernanke and Paulson, who have been pounding the table to get this plan TARP legislated, continue to underestimate the total size of the problem. So, when you think about it, this entire credit collapse of the past 13 months has reflected one thing and one thing only, which is the unwinding of the greatest asset bubble in modern US history – residential real estate.Still haven’t seen credit effects from consumer recession
We still haven’t seen the normal negative credit cycle that follows on the heels of a consumer recession. That is going to be the next leg of this story; it started this quarter, and likely to last well into 2009. In fact, when we look to the last consumer recession of the early 1990s and see what delinquency rates did for a range of mortgage and personal loan products, what it tells is that much like the real estate deflation story, we are at most 60% of the way though this down cycle in banking sector credit quality. Keep in mind that, based on our macro forecast, estimated total non-mortgage consumer and business losses are going to total roughly $300 billion in the coming year. That alone is more than double the entire loss posted during the S&L fiasco in the early 1990s.Credit collapse is secular and deflationary
So the way to think of this credit collapse is that it is secular in nature, not merely cyclical and also deflationary. Those who believe that we’ve managed, in one day, to switch from a deflationary to an inflationary backdrop because of additional government debt creation are not taking into account the offsetting credit contraction in the private sector, which comes from three sources: asset liquidation, debt repayment and increased savings. The Fed and Treasury are merely cushioning the massive deflationary forces in the financial system.10-year Treasury note yield plunged during RTC experience
If you go back to that 1989-93 experience with RTC, we can tell you that the 10-year Treasury note yield during that prolonged debt deflation period plunged 400 basis points as the inflation rate was cut in half from over 5% to around 2-3/4%. Let’s also remember that even as we look back to the original RTC, and that too was a major intervention at the time, it took a full year for the equity market to bottom, two years for the economy to bottom, three years for the housing market to bottom, and four years for bond yields to bottom.Money supply will increase but money velocity will not
We are getting asked repeatedly these days how it is that the government debt creation we are about to see is not going to be inflationary. After all, aren’t we going to see a boom in the money supply? Well, we’re sure that the money supply is going to increase, but at the same time, we are going to see the turnover rate of that money, or what is called money velocity, decline. This is exactly what happened in that 1989-93 period when the Fed massively reflated. Money velocity contracted 13% and this is the reason why the inflation rate was cut in half that cycle and bond yields rallied 400 basis points, though no doubt that downtrend in yields was punctuated by intermittent corrections – as we’ve seen take place in the Treasury market over the past week.
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Rosenberg has several excellent points. I am not convinced, however, that he has thought through their implications because his assessments of their impact strike me as fitted to the near-term rather than to the mid- to long-term impacts of some of these issues.
His final point regarding a decrease in the velocity of money is very important for gauging the outcome of the bubble’s collapse, and is an issue seldom discussed at all. He is correct that, left to itself, velocity of money will decline substantially, and that this outcome is profoundly deflationary. If. If, that is, velocity is left to itself. It won’t be. The public authorities clearly want money to be lent. If they depend upon the private sector, we get the velocity decline. If they lend directly, we may well get a different deflection point from recent money hyper-velocity than Rosenberg factors in.
One of the real gains in knowledge which came in the later 30s as a response to the deflationary impacts of the Great Depression was that public lending must take up the slack to get money moving again. That was the real purpose and function of the public home ownership and agricultural lending firms of the time, for example. Ben Bernanke’s great, indeed colossal failure at present is that he is bent upon saving damaged _private_ lenders in order to keep lending going: this is folly, and will fail in the cases of those firms which are materially insolvent. What we need are funded _public_ lenders to get the muni markets, home mortgages, and a FEW other targeted financial sectors perhaps like small businesses funded and working. As long as we have Bernanke around, then yes, we will get Rosenberg’s projected collapse of money velocity or something close to it. Ben is a neoliberal to his core, and rejects the idea that public lending has a place in either economy or society. (Dufus.) I strongly suspect that we will have calls for _public lending_ from the inception of Congress 09, which may lead to a different outcome. (Which, public lending, to be clear I firmly support if it is directed away from the financial economy and toward the real economy.) Obviously, Rosenberg projects the context we have now; he has to, and there’s nothing wrong with that—but the context can change in a hurry, and I suspect that it will. Once Paulson, Bernanke, and Dubya are excused from further public failures.
Rosenberg also makes very concisely a point which has received insufficient discussion to the present, that the patently inflationary impacts of the Fed’s present huge fund injections are, for the present, offset by the robustly deflationary impacts of declines in lending and even more so declines in _borrowing_. But. But we haven’t really seen _major_ declines in borrowing yet IN THE REAL ECONOMY. And we know that there is substantial private capital sitting out the panic, waiting for a chance to acquire assets and lending shops, thence to lend. What we really have, pace Rosenberg, is a massively inflationary Fed injection offset by credit HOARDING combined with actual credit contraction by actually insolvent firms within the ‘transmission’ of the financial economies engine. In a phrase, we have a partially compartmentalized credit contraction, where Rosenberg and most others see this contraction in a unitary perspective.
Something that Rosenberg and most others do not take fully into consideration in my view, is that what we presently have is a massive contraction of hyper-expanded faux credit. All this gearing by the shadow wankers didn’t go into the real economy, it went on spinning prices in financial space. This is a large part of why the tremendous credit hoarding we have seen hasn’t totally frozen the real economy in the US. It can, it can—but it hasn’t. What has been frozen is the money-whirling motions of the vapor credit economy. This is why the banks are seized up, but Walmart still has full shelves and container ships pulling into port every day. It is not like the vapor economy and the financial economy are partitioned from each other, no; far from it. But they are not the same, and this is not adequately weighted in the ‘balancing’ spoken of by Rosenberg and others. Yes, we have a decline in consumption: that is manifestly recessionary. Not to be too fine, but we may get a Depression on Wall Street while only getting a Recession on Main Street.
—But the funds the Fed is injecting aren’t going to magically vanish. Their debt doesn’t just go *spung* like matter when some hypothetically compensatory particle of asset price anti-matter elsewhere in financial-space goes *gnups*. The Treasuries we put in motion, and their claims will be hanging around _for years_. They will be churning around the financial system well after we bounce off the deflationary bottom. What we will get, in my view, is a hyperbolic from the Fed’s moves. This is, BTW, what happened in Russia or Argentina: Go look at the graphs, sharp down, then sharper up as the currency and debt boil out.
The US financial and real economies are _not_ equivalent to those of Russia or Argentina in relationship to the global financial system; I do understand that. I cannot detail the hyperbolic ‘model’ I suggest above, or anticipate precisely when we will get a great swing around. But I think it all but certain that we WILL get one, because we are injecting volume into the financial system, and their is also a substantial amount of private capital sitting on the sidelines, more volume, and a very substantial portion of overseas capital which efforts will be made to attract into US assets at or near some presumed deflationary bottom, yet more volume.
All that is to say that the effects of the deleveraging are credit contractive and deccelerative, and so deflationary, but the public interventions are intensely inflationary with mid-term and longer overhangs. So which do you think will win? I think global central banks will keep injecting until they inflate, but that the turnaround will come faster than they can plan for, and be more nearly vertical in its upswing.
I’ll leave it at that for now, I’m bushed.