Merrill: Low Treasury Yields to Go Even Lower

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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26 comments

  1. Richard Kline

    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.

  2. Anonymous

    id go with Richard and add a few (stupid?) remark. because the main cause of growth of credit, has been houses, and that almost everybody agrees now that house prices need to go down to at least to some "fair value" which is probably another 20-30% down, then we have already there the main wealth & debt destruction.
    the massive govt intervention (700bn $ when bill is passed, all the previous stuff, and all the next stuff to come) will be inflationary, and counterbalance the debt destruction. If they keep pumping that money just to help write-off those previous paper debt, throwing it away at insolvent banks, it will do little against the inevitable, just slow it.
    if at the same time, they would let the insolvent banks fail (mostly because of bad mortgages)and the solvent banks find somewhere to lend it in the real economy, then i think that the conclusion would be:
    – for hard Austrian economists, wed still be in deflation, with global credit contracting,
    – BUT
    actually the (almost) only prices still goin down would be those of houses and rents, with the next bubble already started, and most other prices going big time up.
    and the economy kickin…

    – also, the wild card is the dollar, and if confidence in the $ is eroding (from foreigners, but … more importantly from American savers themselves !!!!), then we have capital flight, interest shoots up, and monetisation would accelerate

  3. Anonymous

    Slightly off topic, but pertinent for today. Sadly, overseas, in Australia at least, the controlled press is pushing the notion that markets have gone down because of the failure of the bail-out vote. [Although they technically cover their asses by saying “following” the failure.] The Australian Prime Minister, and the leader of the Opposition (a multimillionaire merchant banker) have both stated that they are speaking to members of Congress to get them to reverse their positions. The government-controlled ABC even managed to find an American economist in favour of the bail-out, and presented him (without a contrary view) as representative of American economists. Therefore it is imperative to keep up the pressure.

  4. Anonymous

    Main Street math: $700 billion divided by 100 million US households = $7,000 each. Fine. We’ll take it in tax rebates.

  5. Anonymous

    Ditto to what Ricardo Kline said. Plus, velocity is one of those derived numbers (like productivity) which in my view is nearly useless. Velocity can’t be measured directly. So it’s little but an idle academic curiosity.

    Inflation forecasting for dummies: IT’S THE WAR, STUPID. The U.S. is embroiled in foreign conflicts which spew dollars overseas. Ergo, we have inflation.

    And, as one would expect, we have fiscal deficits. War is a big reason. Bailing out the financial sector is now a second reason.

    That as talented an economist as Rosenberg can get the most basic attribute — inflation or deflation — wrong shows how primitive is our understanding of fiat-money voodoo, particularly when the voodoo is turning to doodoo. We need some strong hoodoo.

    Repeat after me: “INFLATE OR DIE.”

    — Juan Falcone

  6. Dean

    One of my first comments on Yves’ blog(couple of months back) was exactly that i.e. using deflation as a cover the authorities will undertake infationary policies, claiming with a straight face that such is a sane move, wholly justified as a counter balancing measure.

    When such fine line is crossed and the doctor is killing the patient in the name of saving him/her, you know that something is not right.

  7. stevie b.

    I am an ignoramus and feel I learnt a lot from Richard Kline’s super post.

    Following on from it, I’d like to try and learn a bit more about the consequences of the stated “intensely inflationary” effects of the public interventions. I’ve read elsewhere that a large part of these interventions can be “mopped-up” later as things recover and any severe inflationary effect can be mitigated as a result. Can anyone please confirm this could be the case, or is it cloud-cuckoo-land?

  8. Mike in MT

    House prices need to go down only to the extent that they become affordable for the average worker using reasonable lending standards.

    The quicker we can close the affordability the better. Any effort that aims to prop up housing without addressing the other side of the equation – stagnant wages – is misguided and futile.

    Instead of trying to patch gaping holes in the balance sheets of technically insolvent private banks, the .gov needs to gather up all its firepower and concentrate on getting wages growing in a hurry. I envision this in the form of a massive energy and infrastructure investment.

    Appreciate any thoughts.

  9. Anonymous

    America has become a .com country. Where are all the steel mills, furniture manufacturers etc. that we used to be so proud of. We have sent all the manufacturing jobs overseas somewhere and now we all just sit and type on computers. Sure computers are needed but so are JOBS that take real work(like back in the 40's & 50's) Just pay attention to the ads on tv. What do you see? Hamburgers, makeup, clothes, movies, more FOOD so we can get fatter and fatter every day. We are a FAT LAZY society, lets face it.
    In the city I live in the property values went up just long enough for the real estate taxes to go sky high. Does anyone think the city will reduce the taxes? I don't think so. Thanks

  10. Yves Smith

    One counter to Richard’s line of thinking: I heard from a hugely well connected source last night that sovereign wealth funds have taken massive hits, and are also stuck in illiquid assets (like private equity deals). They took on major commodities exposure, for instance, and are bigger investors in hedge funds than is widely known.

    The wider world, and not doubt the public in their countries assumed they weren’t taking much risk. That appears to be a myth.

    When word gets out that this pool has shrunken, and you get the backlash at home from the losses, their freewheeling will be curtailed. That is bad news for us.

  11. doc holiday

    Re: “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.”

    Great post there, Richard!

    IMHO, The Bailout Proposal, obviously does not address which casinos get the tsunami of easy taxpayer revenues — and the mechanisms behind this push are discretionary and capricious — except of course, for the immediate bailout of people like buffett or gross, who will be given deals that somehow provide future cash-flow mechanisms which provide quarterly income (for them), while taxpayers are clipped every qtr….

  12. Anonymous

    The complex financial system that has
    grown around financial engineering and created massive credit creation via leverage has been the significant driver of the economy. Credit deflation on the scale we will be experiencing will cause major loss of business/jobs/reduced GDP, which easily trump the inflation influence caused by government spending.

  13. SlimCarlos

    Richard & Juan — both good posts — are correct. We've been terrorized by the deflation bogeyman since the bubble popping began, this as inflation has surged. We will still be hearing about the dangers of deflation when the CPI is running double digits.

    We continue to see fingers pointed at the Great Depression as the only good comp for what's going on today. Yet few point to the measures taken to get out that mess. If you'll remember, they inflated their way out. FDR revalued the dollar from 1/20th an ounce fo gold to 1/35th an ounce of gold. There was an outcry that creditors — who could never be paid back under the original terms anyway — were getting stiffed, and indeed they were. Went all the way to the Supreme Court, who affirmed the measure.

    Why are we inclined to only learn half the lessons of history?

    As a minor point, Rosenberg talks of the 10 year yield coming down 400bps. He neglects to say that FF rates (and presumably very short rates) came down 600 bps. A steepening yield curve is not the hallmark of a deflationary death spiral. A little disengenuous of him.

  14. donna

    Excellent comment, Richard, and the point I keep trying to make. Monetizing the shadow market won’t work and isn’t working. It has to collapse, and whatever assets are in it collapse, too. Nothing is going to change that.

  15. Anonymous

    Nice read Kline.

    Just due to compounding interest we will have inflation, it’s inflate to infinity and die anyway.

    There is a growing bubble of money always looking for a place to park in this banking system. dot.com, housing, commodities, Red China as examples until the bubble finally bursts then reset and start all over again.

    Rationalizing greed can be a full time job.

  16. tompain

    What happens to the velocity of money if the rest of the world loses confidence in the dollar as a reserve currency?

    Inflation is the easiest way out of the debt mess. If the government wants inflation, it will get it. Even if velocity declines, it can only go so far, whereas the ability to print dollars is both unlimited and politically rewarding.

  17. tompain

    Several posters suggest that a weakening economy creates deflationary forces that must be sufficient to offset inflationary pressure. Collapsing economies routinely experience inflation. Look at any instance of hyperinflation. Did they occur in strong economies or weak ones? The economy in Zimbabwe is pretty bad. Inflation is over 1 million percent.

  18. SlimCarlos

    tompain is so right. Most weakening economies are accompanied by inflation. And, indeed, deflation is exceptionally rare in a fiat currency world. Japan is the one, near unqiue, exception. But remember Japan ran (and still does) a huge trade surplus — it was only their domestic economy that sagged.

    A lot of the analysis we see suffers from a perspective deficit. For some reason we in the western world feel that we are exceptional and the normal rules of economic forces do not apply to us. If one presented the vital signs of the American economy — massive debts, consumption-oriented candy-floss economy, massive trade deficits — and showed it to Rosenberg without naming the country, would he predict deflation? I think not.

    This is just another case of a false belief in American Exceptionalism.

  19. Anonymous

    The money on the side waiting to buy up all the financial bargins seems much like the SS trust fund or the Airline Trust fund, more IOU’s rather then cash. The Flow of Funds report has showed a remarkable growth in mortgage credit from 02 thru 07 to the tune of 5 trillion dollars. Very little capital backs up that mortgage credit creation and it that does not cover all the credit card, LBO, student loan, auto etc that was up dumped on the every growing pile. Those that view credit deflation as some type of minor bump along the inflation road may be correct based on historical information but then again the speed at which assets value is being destroyed should be a warning that credit defation is a far larger problem then anybody can imagine.

  20. SlimCarlos

    >> The Flow of Funds report has showed a remarkable growth in mortgage credit from 02 thru 07 to the tune of 5 trillion dollars.

    Five trillion over five years — a trillion per year — isn't too shabby, but the Fed has created, including TARP, between one and two trillion in less than two months. There has never been a printing press that couldn't keep up.

  21. Anonymous

    So, if we’re entering a deflationary environment, where do I invest??

    Treasuries seem incredibly expensive, I’m not brave enough to take on corporate debt in this environment. So where do I park my money for the next year ir two?

  22. Anonymous

    “”So, if we’re entering a deflationary environment, where do I invest??””

    Hold on cowboy!

    I think most people would say park it and be friggin thankful you have it!

    This market has defied all thinking previous to this point. One used to say “0 coupon bonds”… or utilities.

    Maybe someone else can help you out more than I.

  23. Anonymous

    Is the argument really inflation or deflation? Why not both at once…I am no economist but the combination together seems far scarier.

    Asset price deflation (delveraging), goods inflation (central bank cash pumping – transmitted through lower US dollar/higher commodity prices) – whilst wages are stagnant..ouch.

    Is this possible?

  24. Richard Kline

    So Yves, that is good if worrisome content to hear, re: sovereign wealth fund losses. I can’t say I’m surprised, and particularly not with regard to the kinds of exposures mentioned in by your contact, commodities and hush-hush hedge fund placements. Well, sovereign wealth will _not_ ride to the reflation in the US quickly. I didn’t particularly think this was going to happen, to be frank, but included the possibility in my leading comment here because to ignore the potential would have been a significant omission.

    But let’s extend this insight then: What has been the _response_ from the backers of those sovereign wealth funds to ‘instability in the financial system,’ including presumably their unstated losses? Well, China lowered rates and loosened reserve requirements, actions of far more import than their concurrent rollback of fuel subsidies. Faced with losses, they are sur-flating. No one, but no one, at the sovereign level is going to accept deflation while they have computers to post pixels. If overseas wealth doesn’t flow into the US, we will only balloon our own balance sheets more to cover the slack, in my view.

    So Juan, I agree with you that derived figures (such as Rosenberg’s) for the nominal level of the velocity of money are an academic exercise, and cannot be considered firm readings. But velocity IS a real component of financial system process and behavior, whose first order impacts can be broadly represented. Yeah, any actual number is suspect, but if money is hard or easy to get the system acts quite differently in aggregate. So velocity is not a moot concept, to me, only it’s measurement. . . . You’ll notice that I didn’t put any ‘number’ on my own surmises there.

  25. Richard Kline

    And SlimCarlos, I agree with you completely that most economic analysis suffers severely from perspectivistic distortions—and virtually all American analysis. Comparable parties are view differently, and also durations of effects are routinely compressed to make situations which are not truly comparable appear so. I didn’t mention the latter problem in the context of discussing whether mid-term inflationary moves purportedly offset against near-term price movements, but this deserves deeper consideration.

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