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.
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.