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Draw the Yield Curve, Then Plot the Data

Interest-Rates / Inverted Yield Curve Mar 31, 2007 - 12:41 PM GMT

By: John_Mauldin

Interest-Rates

This week we look at something which has far more potential to hurt the economy than subprime loans - the US Congress. We muse on inflation data and why the economy may do better than I think.

Let's start with a question from reader Dr. Rick Simon Associate Professor of Mathematics of the University of La Verne. After some very nice comments, he threw in the zinger:

"That said, however, you've gone far into the 'draw the curve, then plot the data' mentality this time. It wasn't enough to 'spin' the data the way you want it; for example, by citing only the Fed's Moskow and ignoring Bernanke and others. You actually state, 'Fewer buyers and those losing their homes will mean more rentals. That means rent prices will go up.' Please do explain how more rentals on the market will cause rent prices to go up."


The problem, Rick, is not with my logic but with the clarity of my writing. After reading that sentence, I am probably the only one who understands it, because I knew what I meant. So, let's see if I can communicate my thought more clearly, as it makes a good starting point to discuss why I think the Fed is going to be on hold for a lot longer than most market participants think.

The Fed's favorite inflation statistic is the core PCE (personal consumption expenditure), which excludes food and energy. It is computed by the Bureau of Economic Analysis, based on the national income and product accounts. This is somewhat different than the Consumer Price Index (CPI) done by the Bureau of Labor Statistics.

The CPI uses something called "owner's equivalent rent" to account for the rise or fall in the price of housing. The PCE now uses imputed space rent. The methodology is somewhat different and arcane, but the point is that it is not the actual prices of homes but their rental value that is measured in the inflation indexes.

What this means is that during the recent housing price boom, as the prices of housing soared, it did not show up in the inflation indexes because the indexes were tracking rent, which was not rising nearly as fast. One of the reasons rents were staying low is that home ownership was rising, so there were fewer people looking to rent an apartment or home.

Now, the opposite is happening. The rent portion of the inflation measures are rising as fewer people are buying and there are more people looking to rent, either because they have lost their homes due to foreclosure or no longer qualify for the newer, more restrictive mortgages. And even though we are seeing a lot of new apartment construction, the supply of places to rent is still not rising as fast as the demand.

(By the way, one of the reasons that "new home construction" does not appear to be falling very fast is that apartment construction is included in the new home construction statistics. When you break just the new single family home construction out of the index, you find the rapid drop you would expect.)

During the first part of this decade, even though we saw a rapid rise in the cost of a new home (in much of the US), we did not see a corresponding rise in rents and thus inflation did not really reflect the actual costs of housing to the consumer. Now, as housing prices are starting to fall, we will see the opposite. Inflation is going to rise as rents increase.

There is nothing wrong with this methodology as song as you are consistent with your measures. (Europe, for instance, uses actual home prices.) Over the very long term, it will all come out in the wash. But in the near term, it is going to translate as higher statistical inflation.

The Fed is on Hold for a Long Time

The core PCE deflator numbers that came out today were not Fed rate cut friendly. Core PCE has risen by 0.1% each month for the last three months, from a flat 0 in November to 0.3% for February. This puts core CPE at 2.4% over the last year, and the trend suggests that inflation pressures have not gone away.

The full PCE including food and energy came in at an even high 0.4% for the month of February, and will likely be higher in March, as oil and energy prices have risen. And food staples of all kinds have risen on the back of the rise in corn prices based upon the demand for ethanol. That means fewer acres of soybeans and thus higher soybean prices. High grain and bean prices means the cost of feeding cattle, hogs and chicken goes up and thus the price of meat. In short, inflation is still a concern.

Today's Chicago PMI came in at a surprisingly strong 61.7, up from below 50 just the month before. I do not recall ever seeing such a large jump. Given the weak reports from around the country, it is even the more surprising. For instance, US core capital goods orders failed to rebound in February, after having been weak for several months.

Unemployment is low. The parts of the economy that are not related to housing or automobile manufacturing are doing well. There seems to be little that is going to drive a stake in the heart of inflation over the next few quarters. As I have stated since the Fed stopped raising rates, I expect them to be on hold for a lot longer than most market analysts think. I think this late summer is the earliest they could begin cutting rates, and that is only if they see an economy visibly slowing.

The reasons for a cut in rates will not be ones that the market is going to like. If the Fed is cutting rates in June it will be because there are visible problems.

A Mere Few Percentage Points

Martin Barnes writes in the month's Bank Credit Analyst that while he thinks the US economy will grow at a below-trend pace, he does not think that we will see a recession. Martin may be one of the best economists around, and the track record of the BCA is certainly one of the best over the last 30 years. I bring that up, because there are a lot of similarities in our views. In a conversation last week, there were quite a number of things we agreed on.

It is just that I think that the economy is going to go into a slight recession because of the housing problems, and Martin thinks that it will simply slow things down. I hope he is right, and based on his track record, he probably will be.

But the difference among our forecasts is not all that much: a percentage point here or there. And I think the main difference is that I see the housing situation ultimately (and finally!) affecting consumer spending, or more accurately, the ability of consumers to borrow to maintain spending. Along with the slowdown in business spending that we are currently experiencing, my guess is that it will be enough to tip us into a recession.

But again, in the long run, it will not make much difference. I fully expect that US GDP in nominal terms will be 25% larger in five years, and sometime in the early 2020s will be double what it is today. We will probably experience at least a couple of recessions in that period, but that is just part of the normal business cycle. I think that would qualify me for reasonably optimistic.

Trading Away

There is only one thing which really gives me reason for concern that the US will not continue on a reasonable growth trajectory, with a few bumps here and there. That is the growing mood in Congress for passing trade protection legislation that could start a series of retaliatory actions around the world that could result in a trade war, a la Smoot Hawley in the 1930s.

Stephen Roach, Chief Economist at Morgan Stanley, writes a rather chilling description of his recent testimony before the Senate Finance committee. He noted that as he entered the room, he looked up and saw a picture of Senator Reed Smoot on the walls, as Smoot was a former chair of the committee and the co-sponsor of the Smoot-Hawley Tariff Act of 1930, largely responsible for the Great Depression.

At the hearing, it was clear that a bi-partisan effort is getting ready to pass legislation that would punish China for the large trade deficit we have with that nation.

Democratic Senators Schumer and Baucus and Republican Senators Graham and Schumer are looking for ways to try and force China to allow the dollar to fall against their currency. They think this would decrease the trade deficit and keep more jobs in the US. They are economic idiots of the first order. But they are smart politicians, which is dangerous.

They know that passing a tariff increase would not be compliant with World Trade Organization rules that the Senate agreed to, so they are working on a way to create a WTO compliant back door.

First, does anyone really think that by increasing dollar costs for labor in China that manufacturing would not go elsewhere? My socks were made in Turkey (which surprised me) and not in Asia. Are we going to pass legislation that would drop the dollar against all currencies? Does Congress really think they can control the price of a currency for any length of time?

The problem is not just in China. The US plays its part by not saving enough and running deficits. As long as the US does not save, we are going to run trade deficits. It is a basic law of economics. If it is not with China, then it will be with someone else.

You have to be careful what you wish for. If (and when) the US consumer saves more, it will naturally be at the cost of increased consumer spending. That would mean a slower US economy.

Roach also accurately notes:

"America's middle-class angst - which is driving the politics of China bashing - reflects a US economy that failed to prepare its workforce for the pressures of an IT-enabled globalization."

Yes, China does need to balance their economy, and float their currency, and they are working on it. The Chinese Yuan is moving from the upper right to the lower left at a very steady pace (see chart below.) This is not fast enough for the Senators, though. They want a much faster pace. Roach thinks that Congress will pass legislation this year that will try and force China to raise the value of the Yuan. Let's examine what might happen if they get their way.

First, let's assume the Yuan drops another 20% in less than a year. That means a 25% increase in the price of goods the American consumer pays on a considerable amount of goods. Can you say inflation, gentle reader?

And it will hit those who make the least the hardest, lower income workers.

"Income inequality grew significantly in 2005, with the top 1 percent of Americans -- those with incomes that year of more than $348,000 -- receiving their largest share of national income since 1928, analysis of newly released tax data shows.

"The top 10 percent, roughly those earning more than $100,000, also reached a level of income share not seen since before the Depression. While total reported income in the United States increased almost 9 percent in 2005, the most recent year for which such data is available, average incomes for those in the bottom 90 percent dipped slightly compared with the year before, dropping $172, or 0.6 percent..." (NY Times)

Second, what message does that send to the world? Protectionism is ok? Free trade does not work? Let's see if we can start a round of protectionist trade wars, with each country responding tit for tat. Let's kill the engine for global economic growth.

Do the Senators deliberately want to create problems in China by a precipitous change in our trade relations which will have a major affect on world commerce?

I am well aware that global free trade is not a one way ticket to prosperity for all. If it is your job that goes to another country, that affects you deeply. But the US as a whole has benefited tremendously from globalization, as has the world. And yes, some benefit more than others, but that is the nature of free market economics combined with technological change.

The one thing that worries me more than anything else, from an economic point of view, is the drive on the part of politicians to pander to those who want to be protected from change. We should help them, certainly. Education, reform and transitional help should be encouraged.

And then today, the Bush administration announces that it will pursue action against certain Chinese paper producers that the paper industry maintains is subsidized by the Chinese government, reversing a 20 year policy. I can see a case for this, in that it is unfair competition on one level. But it now means that every industry is going to come to Washington crying for protection from competition not just from Chinese companies, but any company that has a government connected with it. That is a potential trend that concerns me.

President Bush would probably veto a bash-China currency bill that would pass the House and Senate, but it is not clear that there would be enough votes to uphold his veto. Two-thirds of Senators voted for a tariff bill that they knew was viable. Maybe cooler heads will prevail. Let us hope so.

But the worrisome prospect is that the economy starts to slow and unemployment starts to rise just as the legislation gets to the floor and up for debate. It will give politicians the appearance of "doing" something, when in fact it will make things worse.

Baseball, Ringing a Bell, and My Conference in La Jolla

April 2 is the last day you can sign up for my Strategic Investment Conference in La Jolla April 19-21. There are just a few slots left. To learn more, or to sign up, you can go to https://hedge-fund-conference.com/invitation.aspx . If you have any problems, let me know.

Next week is the start of baseball season. Opening game for the Texas Rangers is on Good Friday in the afternoon. That seems like a good reason not to write a letter next week to me, as I am going to have some friends over to watch the game from my office balcony. We play the Red Sox, who look good this year, so the Rangers have a good chance to start disappointing me early this spring. In what is an annual rite here in Texas, we start the year with questionable pitching.

A few years ago (2005) some subprime mortgage outfit named Ameriquest purchased the naming rights for the Ballpark in Arlington for $2,000,000 a year, and got signs all over the place, as well as a big bell in center field that rang with each Ranger home run. (Fans did not like the name change, but nobody asked us.) I said at the time that this was probably a sign of the top of the mortgage industry. This last week, they took down the big Ameriquest bell in the outfield and are changing the name back to the Rangers Ballpark in Arlington. Sometimes they do ring a bell, and then cart it off.

I am starting to get excited about my move to uptown in Dallas. The commute is about the same (25 minutes), but the view from the high rise is a lot different. I like mountains and oceans, but I have always enjoyed looking at a cityscape at night. I will be quite near my two older daughters, which should be fun.

Some have asked is if I finally broke down and bought a home, thinking that would be a sign of the top, but the answer is on, I am leasing. I want to make sure I like urban living first. I may run screaming back to the suburbs this time next year.

And tonight is a Dallas Mavericks game, so it is time to hit the send button and see if I can make it to the tip-off. It will be interesting to see if the Mavs can set an NBA record by having four double digit winning game streaks. Tonight is #9, and then the 10th will have to be against the second best team in basketball, the Phoenix Suns. It is fitting that to get that record, they have to do it against a great team and not some weak sister. Have a great week.

My young assistant Micah Davis is leaving soon to go full time in an entrepreneurial venture (and I wish him the best), which means I will be in need of an assistant. The duties are varied. You get to be the one to read my emails from readers first (and we get a lot, which I do try and read as many as possible), help me with formatting various letters, research and some writing (writing skills are very helpful). Micah has been working a little more than half a day recently as he has been starting his new enterprise, but there are other things that could be added to the list of duties depending on the talent of the person. This is not an analyst position, although we do some. This could be a person just graduating from college. If you know of someone, have them drop me a resume.

Your ready to watch some baseball analyst,

By John Mauldin
Frontlinethoughts.com

John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staff at Millennium Wave Advisors, LLC may or may not have investments in any funds cited above. Mauldin can be reached at 800-829-7273.

This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities and is provided for general information purposes only.


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