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What We Know, What We Can Safely Predict   (June 20, 2006)


Will interest rates rise? Will the economy slip into stagflation (stagnation + inflation)? Will the housing, stock and commodity markets all recover and start heading higher? Will the dollar plummet 40%, as many predict?

A good place to start our analysis of these questions is to sort out what we already know and then build our expectations/predictions on that foundation. Here's what we already know about the U.S. and global economy:

  • Inflation is real, and rising. While the standard line is that the great middle class is untroubled by modest inflation--they still have plenty of money to fill the SUV tank--that is cold comfort to the 50% of Americans whose total net worth makes up a pathetic 2.5% of household wealth.
    • Those of us living on less than yuppie incomes do in fact feel squeezed by higher food and petroleum prices, even if the wealthy can't be bothered to notice. These most pernicious sources of inflation--for growing the food, packaging it and then shipping it to supermarkets requires vast amounts of oil--are conveniently set aside as "too volatile" to count in "core" inflation. Volatile, heck yes. But the direction, despite government massaging, is most assuredly upward.

    Furthermore, one of the fastest-rising drivers of inflation--medical expenses--is rapidly being shifted from employers to their middle-class employees via larger co-payments and deductibles. If the great middle class doesn't notice inflation now, they will certainly notice it when their employer starts making them pay part of the nation's skyrocketing healthcare costs.

    The standard assumption on energy is that it takes a year or two for increases to work their way into prices--and here we are, two years from the start of significant jumps in energy costs. And voila, the Fed is suddenly noticing some inflation it can't quite massage away. Coincidence? Hardly.

    Anyone in business knows inflation is galloping ahead far faster than the government's meager 2.5% "core rate." The list of expenses which have leaped by double digits is long and growing: property taxes (ignored by the CPI); medical (relegated to a tiny percentage of the CPI despite being 15% of the total U.S. GDP), education, shipping, natural gas--exactly how can all these major household expenses be rising by 10% or more and inflation remain 2%?

    We know the answer: "owners equivalent rents," which make up about a third of the CPI, have been dropping for years. Now as housing cools they've stopped dropping and have started rising, albeit modestly. Without that massively deflationary statistic erasing true inflation, now the inflationary chickens are finally coming home to roost.

    China, long the source of deflationary low wages, is now experiencing rapid increases in wages as well as huge run-ups in the prices of commodities such as nickel, copper, steel, oil and cement--not to mention higher shipping costs to bring all those heavy raw materials to China via the sea. The era of ever-cheaper prices for goods from China is over; costs for goods made in Asia will rise unless currencies re-adjust (which they won't, but that's another story: exactly why would China and Japan allow their currencies to bolt 40% higher against the dollar, destroying their farming sector and export business in one fell swoop?)

  • Housing has rolled over just as liquidity is drying up and lending standards are tightening.
    • Globally, central banks in Japan and elsewhere are removing liquidity from their markets, even as they keep interest rates absurdly low. This is "stealth tightening" of credit; rates look the same but there's less money sloshing around to lend.

    At the same time, (as I have described in recent posts) lending standards are slowly being tightened by Federal regulators. ( From the Wall Street Journal: Housing Banks May Be Forced To Cut Dividends.)

  • As housing values (and as a consequence, employment) roll over, the wealth effect is reversing.
    • A quote from a recent Washington Post article says it all: Jobs and income dependent on housing boom:
    Nationally, real-estate-related industries accounted for 74 percent of new jobs over the past five years. At the end of 2005, 11 percent of Washington area jobs were held by real estate brokers, construction workers, mortgage brokers or otherwise tied to real estate, according to an analysis of Labor Department data by Moody's Economy.com. That's the highest level in the 35 years the data go back.

    Economy.com figures that mortgage refinancing put money in Washington area residents' pockets equivalent to 14.5 percent of personal disposable income. That's the 14th-highest rate among major metropolitan areas, behind mostly cities in California and Florida.
    The tiresomely repetitive financial cheerleaders point to charts like this to support their rah-rah thesis that households are wealthy and can handle more debt. Home equity is rising! Stock portfolios are rising! Everyone's richer every year!

    Nice, but they forgot to mention that most of that equity and securities wealth is concentrated in the top 10% of households. But let's let the Wall Street Journal carry this ball: Wealthiest American Families Add To Their Share of U.S. Net Worth:
    The top 1% held 33.4% of the nation's net worth in 2004, up from 32.7% in 2001, but still lower than a peak of 34.6% in 1995. In 2004, the wealthiest 1% percent owned 70% of bonds, 51% of stocks and 62.3% of business assets.

    After the richest 1%, the Fed found that the next wealthiest 9% of families held 36.1% of net worth in 2004, down from 37.1% in 2001. Below them, families in the top 50% to 90% held 27.9% of net worth in 2004, a slight increase from 2001, while families in the bottom half saw their share fall to 2.5% of net worth in 2004 from 2.8% in 2001.
    They also forgot to mention that most households are dependent on housing values rising ever higher. If housing merely stops rising, never mind actually drops, then the borrowing power and net worth of most Americans (other than the golden 1% who own 70% of the bonds and half the stocks) will skid to a screeching halt.

    This chart reveals the absolute dependency of the U.S. economy on the recent (and sadly transitory) rise in housing wealth.

  • Our national debt must be financed by Treasury bonds being auctioned off in the hundreds of billions of dollars annually. There is no Plan B. This is the driver of interest rates, not the Fed.
    • It is a permanent astonishment to me that many smart people continue to assume that the Fed sets interest rates--the rates which they will see on their Adjustable Rate Mortgage re-sets. Alas, the Fed only sets the rate banks can borrow from the Fed; the long-term rates are established by how much bond buyers demand in interest for Treasuries.

    If nobody steps up to pay $100 billion every few weeks for a measly 5% return, then the government must raise the interest rate it is offering buyers. Now if potential buyers keep reading that the dollar is going to plummet 40% and that Warren Buffett has bet big against the dollar, do you reckon that increases their desire to buy a bond which pays a miserable 5%? Why would it?

    So listen up, people; the Fed could frantically drop short-term rates in a pathetic and misguided attempt to reinflate the housing bubble--and mortgage rates could rise dramatically if bond buyers (mostly foreign banks) decide not to risk a dollar drop.

    As this chart shows, bond yields tend to run in cycles of about 20 years. Clearly, the bottom is in and rates will rise--perhaps for as long as the next 20 years.

    To recap: this is what we know:

  • Inflation is real and rising.
  • Housing is rolling over, as is liquidity and loose lending standards; as a result, the "wealth effect" which has powered the housing-dependent U.S. economy is reversing.
  • The national wealth so beloved of rah-rah pundits is concentrated in the hands of a relatively few consumers; as housing prices level off or decline, the majority of American households will suffer a corresponding decline in wealth and the borrowing power they've been living off of via re-financing of their home equity gains.
  • The Fed does not set long-term interest rates; the buyers of Treasury bonds do. If they decide not to indulge in low-yield U.S. bonds (which barely keep ahead of official inflation and which would plummet precipitously should the dollar decline), then the long-term interest rate could rise dramatically, regardless of Fed actions or wishes.


    • Do you bet that inflation is benign and will fall? Do you want to bet that bond yields and therefore interest rates will fall? Do you bet the U.S. economy will prosper even as its primary prop, housing, rolls over? If so, you have to ask yourself: Why?


    For more on this subject and a wide array of other topics, please visit my weblog.

                                                               


    copyright © 2006 Charles Hugh Smith. All rights reserved in all media.

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