Ignore U.S. Overconfidence, The 2011 Outlook Is Weak

The debate about inflation vs. deflation rages on. In a world where emerging markets have seen double-digit growth by keeping their rates low and their FX quietly pegged driving up real price pressures.  The US and Japan are seeing disinflation and deflation caused by cheap goods from abroad, more flows of money into their bond markets and doubts about longer-term returns.  The capital controls put in place by emerging markets only makes investment in these countries more attractive as its harder to do. 

The break in the cycle of money leaves domestic emerging market savers suffer with little choice but to flood their banks with cash driving up inflationary risks even as US, Japanese and European investors look for growth in their equity markets. Their novelty begets more investors. 

The recycling of money continues apace with deflationary impacts in both US and Japan as a result.  If the US allowed the Chinese and Russian more access to buying strategic companies then perhaps the current account balances would smooth out but this would beget other issues as neither the Chinese or the Russian have allowed US companies access to the core of their markets or businesses. What would happen if the Japanese or US companies interested in rare-earth metals tried to buy out the Chinese miners controlling that market?  

The unequal playing fields for investments complicate the flows of money and have left the FX markets the main shock absorber.  The net result has been to see the BRIC nations on the front lines of FX adjustments.  BRL above 1.70 reflects this battle as the market waits for another IOF move and more extreme quarentine actions for hot money inflows into Brazil.  The rate hikes needed in emerging markets will only add to the pressure to find yields.  This is a negative feedback loop that will break down eventually.


The US existing home sales today was a break point for the market with the EUR and Gold both giving back some of their overnight gains.  The data was significantly better than expected and it’s that good news that drove the reversal.  The Dallas FED October Manufacturing Survey was also up 2.6 from -17.7. But as you dig into the home sale headlines the underlying story remains bearish as prices fell and even with the 10% bounce in sales the yearly sales comparison is still 19.1% lower.  The stability in the US housing markets is not yet back to pre-home buyer tax credit levels.  The deflationary impact of bringing forward demand stems from the risk that consumers will learn to buy only when induced by discounts or tax cuts.  The other issue is that housing will downsize and leave the market bifurcated into those homes that are small and can be afforded by the working class against everything else.

The US September Existing Home Sales rose 10% to 4.53mn annual rate – better than the 4.3 mn expected and up from 4.12mn in August.  The gains were across each region with the Midwest up 14.5%, Northeast up 10.1%, South up 10.6% and West up 5.0%.  Median Prices fell from $177,500 to $171,700 off 2.4% y/y with average also off from $226,000 to $218,200 or 1.7% y/y.  Distressed homes accounted for 35% of the sales in September up from 34% in August and 29% in September 2009.  Total housing inventory fell 1.9% to 4.04mn houses or 10.7 months down from 12 months. First-time buyers purchased 32 per cent of homes in September, almost unchanged from 31 per cent in August. Investors were at an 18 per cent market share in September, down from 21 per cent in August; the balance of purchases were by repeat buyers. All-cash sales were at 29 per cent in September compared with 28 per cent in August.  Full Report on EHS from NAR.

Track Chart 2

The $10bn 5Y TIPS auction brought the first ever negative rates -0.55% high– with 2.84 bid/cover.   Indirects took $3.9bn or 39.4% while directs took 3.2%. The result was as expected given the short duration and the recent demand for inflation protection.  Many used this auction to leg into a 5Y/10Y BE inflation trade. The prior 5-year TIPS sale in April was an original issue sized at $11.0 billion and it set a rate of 0.550% with 3.15 coverage. Awards to Indirects were 23.1%, 63.8% to dealers and to 13% to Directs.

Fed Chairman Bernanke: Evaluating foreclosure problems on housing market and banks.  “I would like to note that we have been concerned about reported irregularities in foreclosure practices at a number of large financial institutions,” said the Fed chairman, who made no reference to monetary policy and took no questions from the audience. “The federal banking agencies are working together to complete an in-depth review of practices at the largest mortgage servicing operations,” he continued. “In addition, Federal Reserve staff members and their counterparts at other federal agencies are evaluating the potential effects of these problems on the real estate market and financial institutions,” he said.

Track Chart 3

The Economic Letter from the San Francisco FED is worth highlighting as it suggests the risk of deflation is low – 5.3% or less.   Here is the conclusion of the report – A refined model of inflation-indexed and non-indexed Treasury bond yields, which captures accurately the possible inflation outcomes perceived by bond investors, suggests that the probability of sustained deflation is just 5.3%. The model accounts accurately for the behaviour of inflation-protected Treasury bond yields during the financial crisis and could prove reliable in evaluating deflation risk.

Conclusion:  The EUR fails at 1.4050 again.  This level is becoming important as a significant road block for the USD downtrend.  Gold consolidates at $1335-$1345 up 0.9% on the day – so clearly still a story of currency doubts and inflation fears for the future.  The US 5Y TIPS auction shows that the market believes that the QE2 policy of the FED will work.  The Existing Home Sales are good enough to suggest we aren’t in a tail spin downward and that the new policy push may be helpful in putting momentum behind the wobbly recovery.  QE2 as insurance against deflation is very different than QE2 as a life-buoy.  The market outlook for 2011 remains weaker than the present except in pockets with the US more prone to believing in growth than other places.  What happens this week in Europe around debt and around the Riksbank/Norges bank rate decisions really does matter.  BOJ meeting and the chance for more explicit intervention including perhaps purchases of foreign assets makes for another volatile event risk.  JPY at 80.80 leaves clear that 80 and 75 are logical outcomes should the FED need to do even more than expected by the markets today.


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