July 13, 2010
Deflation, not inflation, is the current threat
In addition to a weak stock market, another key feature of the recent trading environment has been sharply declining Treasury bond yields. During the last week of June, the 10-year Treasury bond yield pierced the key 3 percent level for the first time since the financial crisis.
This is a result of a combination of a flight to safety and growing deflationary fears. As illustrated in Graph 1, inflation is dormant if not dead for the moment and the near-term environment is decidedly deflationary. As Christopher Wood notes in the July 1, 2010 issue of his indispensable GREED & fear, the rally in the Treasury market is sending a strong deflationary signal to the equity market. Based on current trends, HCM expects the 10-year Treasury yield to end the year much closer to 2.50 percent than 3.0 percent. Think how remarkable these low Treasury yields are in view of the monumental volume of government debt that the United States must issue to fund its annual trillion-and-a-half dollar deficits. As noted above, however, the 10-year Treasury yield is no longer simply a risk-avoidance trade (a matter of dancing with the least ugliest girl or boy); it is also an important deflationary signal based on the fact that governments in Europe and the United States (particularly states and municipalities) are cutting spending by dramatic amounts in the coming months and years, which will suck enormous amounts of money out of the global economy and undoubtedly have a significantly deflationary impact on prices.
The growing frustration with fiscal policy makers is evident in the words of Societe Generale’s Albert Edwards, who writes: “The clowns pulling the levers of fiscal and monetary policy will take us back into recession. But this time outright deflation beckons and we will all be turning Japanese. Yet the fiscal hawks are right to say that the fiscal situation is unsustainable. Our view is that governments are indeed insolvent. But the doves are also right that current tightening will take us back into recession and drive the deficits even higher. There is no ‘good’ way to end this. Ultimately central banks will be forced to print for fear of the alternative. And maybe 20%+ inflation will indeed prove to be the ‘best’ (or least bad) way out of this mess.”6 Mr. Edwards is correct that inflation may ultimately be the solution to this mess, but that day currently appears to be far away. Right now investors need to be prepared for a prolonged period (3 years at least) of deflation.
Further support for this deflation thesis is provided by the sharp drop in the money supply, as shown in Graph 2 (again, like Graph 1, borrowed from Christopher Wood’s GREED & fear, June 10, 2010).
Shrinking Money Supply Is Only Part of the Picture
Suffice it to say that just as inflation is driven by increasing money supply, deflation is driven by the withdrawal of liquidity from the system. In addition to the shrinkage in M2 (the Federal Reserve no longer publishes M3 for reasons best known to itself), other liquidity engines such as securitization have also departed the scene. Accordingly, Graph 2 only shows a partial view of the withdrawal of liquidity from the financial system. The overall picture is actually worse than this, although such a phenomenon is ultimately what will be needed to purge the excesses of the past and return the global economy to greater stability. Unfortunately, the interregnum period will involve a great deal of pain, as the markets appear to be acknowledging.
Liberal pundits and administration supporters are talking about how President Obama is about to declare victory on financial reform. Nothing could be further from the truth. The financial reform bill that is emerging from Congress leaves so much essential work undone, and is so obviously a sell-out to special interests and expensive Wall Street lobbying efforts, that it can only be considered the latest example of all that is wrong with the American political system. In addition to leaving untouched the single biggest threat to financial stability – naked credit default swaps – it also fails to address the bleeding ulcers of Fannie Mae and Freddie Mac, ignores the deficiencies of the credit rating agencies7 and leaves most of the details of financial reform to be filled in by regulators, whose track record in effectively doing their jobs is, to put it more politely than it deserves, pathetic.
Putting an exclamation point on the poverty of leaving the regulators in charge was the United States Supreme Court’s wholesale rejection of the “theft of services” doctrine in the cases of Jeffrey Skilling and Conrad Black, which were issued at the same time the final brushstrokes were being painted on the financial reform bill. The Supremes once again reminded prosecutors that the threshold for holding businessmen criminally liable is extremely high, and that business conduct cannot be criminalized after-the-fact by the politically ambitious even if they are justifiably disgusted by greedy and immoral behavior.
And as if these rulings weren’t sufficient repudiation of the current regulatory apparatus, U.S. District Judge John Koeltl rejected the SEC’s first attempt to bring insider trading charges involving credit default swaps against a Deutsche Bank AG salesman and a hedge fund manager. Not to put too fine a point on it, but the judge rejected every aspect of the SEC’s theory, including the fact that the alleged confidential information wasn’t “material” and the allegation that the defendants violated any duty to Deutsche Bank to keep the information confidential. The press report did not disclose what the judge had to say about the SEC’s attempt to create a fiduciary duty with respect to an insurance product, a concept that is itself a legal absurdity. The meager quality of lawyering at the SEC has become an embarrassment not only to the government but to lawyers in general, a profession that is not easily shamed.
In view of these rulings, HCM would strongly recommend that Goldman Sachs reconsider any efforts it is making to settle the suit brought against it regarding the ABACUS transaction. It would do far better to spend its time figuring out how to treat its clients better than succumbing to an ill-founded and politically motivated lawsuit by an agency that can’t get out of its own way when it comes to regulating the financial markets. HCM has little doubt that Goldman would easily trounce the SEC on the merits before any federal judge hearing the case. Having already suffered untold reputational damage, Goldman would be much better served by pursuing an easy court victory (how many more ugly emails can the prosecutors dig up that weren’t already aired in Congressional hearings – everybody already knows that Goldman did some shitty deals) than being forced into a settlement in order to mollify the torch and pitchfork brigade.Of course, if you listen to the individuals called to testify before the Financial Crisis Inquiry Commission, the financial crisis wasn’t anybody’s fault and everybody should skate. The latest financial innocent to appear before the commission was former AIG employee Joseph Cassano, who believed that it was prudent to insure AAA-rated subprime securities for a mere 7 basis points of annual premium ($7,000 per $1,000,000 of insurance). Despite evidence to the contrary in the form of the $180 billion of taxpayer money that was required to bail out Mr. Cassano’s prudence, Mr. Cassano had the gall to tell the Commission not only that he didn’t misjudge the risks of the financial instruments that he was insuring (many of which defaulted), but that “I think I would have negotiated a much better deal for the taxpayer than what the taxpayer got.” (He may actually be correct on this last point, but the standard he says he could have beaten was set very low by Geithner & Co.) He managed to blame Goldman Sachs and everybody but himself for his errors of judgment (which he refused to acknowledge despite tens of billions of taxpayer dollars of evidence to the contrary). Mr. Cassano escaped criminal prosecution only because being criminally stupid is not yet indictable, although we can only hope that in the next world he will be suitably punished for his fecklessness and arrogance. In this world, as far as we can tell, he is still enjoying the $280 million he was paid for losing more money than anybody in history. But his performance in front of the Commission, following others such as Robert Rubin (who also denied any responsibility) has helped to make the commission another source of public anger at Wall Street and distrust of the financial markets, which is the opposite of the Commission’s intended goal. We certainly don’t need the Commission to tell us what caused the crisis – as outlined in The Death of Capital (and many other excellent books on the topic); it was the result of years of flawed fiscal and monetary policies, lax regulation, and a failure to understand the true nature of capital.
6 Albert Edwards, Societe Generale, Global Strategy Weekly, “We are now walking on the deflationary quicksand,” June 24, 2010.
7 In the latest example of “the pot calling the kettle black,” the following headline was flashed on CNBC on June 30, 2010: “S&P Places Moody’s on CreditWatch Negative.” It’s not that you can’t make this stuff up, it‘s that you wouldn’t want to waste the energy doing so.
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