<Any guesses on how much longer the credit/bond/housing bubble(s) can keep inflating? What event could pop them?>
Plenty of catalysts: energy spikes, California govt collapse, the clerks in Beijing and/or Tokyo rethinking their recycling operations specifically on agencies,
bcaresearch.com
the massive and destabilizing hedge fund community trying to preempt the markets by heading for the exit at the same time. I'm sure we could go on all day.
Although I don't like John Mauldin's writing style or especially his conclusions (believes in the muddle through theory), he did write up an interesting piece about the current set up. Note his reference to BCA (listed now on this thread's main page). This at least presents the views of people (as opposed to the deadfish community) that recognize the nature of today's bubble, but apparently think it has legs.
I just come down a little differently on the issue. I think everything but the kitchen sink has been thrown at the situation, and this is about the best they can achieve. It's like the Imperial Guards at Waterloo, Pickett's charge at Gettysburg, and the Panzers at the Battle of the Bulge being thrown in all at once, and they're are now falling on the battlefield in big heaps.
I think the downdraft will come in the dead of the night or over a weekend, and very suddenly. One thing I've learned in markets is that you need to be in position out of the gates even if it means you have to grope for a top (or bottom), because a big part of gains in these moves occurs in the early days.
Poker at the Federal Reserve
Let's Pay the Piper Tomorrow
Dealing the River Card
One or Two More Complications
The Gun to My Head
Paris, Geneva and Inflating My Book
By John Mauldin
July 11, 2003
Is this a critical time in the bond market or are we simply back to where
we were a few months ago before the recent madness? If it was temporary
insanity, what caused it? Why is the dollar rising? Why have the Japanese
sold more foreign bonds in the past few weeks than in the past few years?
Who is buying those bonds? If the money supply is growing at breath-taking
rates, why is gold languishing? If the economic data is so dismal then why
are stocks rising, setting higher highs with each run-up?
This week we will explore these and a few other paradoxes, plus a quick
lesson in poker, bond market style. It's once again time to move back from
looking at the financial data trees and see if we can figure out what kind
of investment forest we are in.
(Yes, I can still hear you asking, "So what are interest rates going to do?
Should I lock in today's mortgage rates? Will rates ever go back down?" The
answer is complex. But since you are holding a gun to my head, I will give
you my guess in this letter.)
Let's Pay the Piper Tomorrow
Last week's letter brought more than a few readers to question my analysis
of the economy. How can I suggest Muddle Through* (even with an asterisk)
given the terrible imbalance in our trade deficit, an over-valued dollar,
debt at record levels, a huge government deficit, rising unemployment,
rising rates which will kill the mortgage and housing markets and so forth?
Aren't we at least close to the End of The World As we Know It?
Of course, a few wrote to point out the rising leading indicators,
improving (albeit modestly) areas of capital spending, a tax cut getting
ready to kick in, record Federal Reserve stimulus, low rates which are
helping consumers, and increased consumer confidence. Plus, isn't the stock
market telling us that the economy is getting ready to grow at 3-4% once
again, just like the Blue Chip economists predict?
Aah, the loneliness of being stuck in the Muddle Through middle with you,
dear reader.
Before we get into the meat of the letter this week, let me discuss the
curious notion that the market is telling us anything. Barry Ritholtz of
the Maxim Group sent me a recent summary of the bear market rallies. The
S&P has rallied over 21% five times since its high in March of 2000,
averaging almost 25% on each of those gains. Four of those times it has
fallen back. The fifth time is the current mini-bull.
The NASDAQ has had 5 rallies of over 37%, with the average being 42%. Four
have failed. We are close to the top of the 5th.
Was the market telling us anything in the last four rallies? Was the market
telling us the economy was getting better as it topped out in May of 2001?
The economy entered a recession only a few months later (I predicted in
August of 2000 that we would see a third quarter 2001 recession). I seem to
remember pundits telling us (and getting a few letters from readers) that
the markets were forecasting that a return to a growing economy was just
around the corner. "Look at all the stimulus the Fed was applying (in the
form of rate cuts)," we were told. "Don't fight the Fed." The market
assured us we were going to avoid a recession.
Each of the previous bear market rallies was touted as the "return of the
bull." This one will fail as did the previous rallies. No secular bull has
ever started from such high valuation levels. I will write more on this
topic in Part Three of our series on markets next week.
I am highly suspect of the ability of the market to predict the economy, or
much else for that matter. Eventually, the market will rise from some
future bottom, most likely after (or during) a recession, and a new long
term bull cycle will begin. Pundits in that future world will breathlessly
report to us that the market is telling us the economy is on the mend. When
it happens, they will talk about the wisdom of the market.
Until that time, which I believe is not in our near future, the optimistic
market moves are merely bear market rallies, to be enjoyed while they last,
and are not signs of the incipient wisdom of a stock index. They are to be
appreciated, as they keep the market from sinking too fast and bringing on
a serious recession. It is a blessing that these cycles take so long. I,
for one, am grateful to the optimists who work so hard to avoid a truly
devastating bear market, sacrificing their money in the process. It is a
strange paradox that we should avoid their advice during secular bear
markets, but hope that not everyone else does.
Poker at the Federal Reserve
But where can we find wisdom? Let's turn to the poker game called Texas
Hold'Em, which seems to me might hold some insights into the markets and
the economy.
Texas Hold'Em is a popular poker game. For the uninitiated, this is a game
where every player is dealt two cards, then three cards (called the flop)
are played face up which every player can see. These cards are part of
every player's hand. Then two more cards are dealt face up one at a time
(These cards are called the turn and the river, respectively). The
situation is that every player gets to use the five cards on the table and
combine them into the best possible five card poker hand using the two
cards in his hand. After each deal, there is a round a betting. Ultimately,
the difference is of course the "hole" cards in your hand. The betting
hinges on how good you think your hand is compared to the other players.
When you bet you are saying either 1) "I have the best hand and I'll risk
my money on that belief" or 2) "You have a poor hand, and you will fold if
you are forced to put money on the table."
The current game between the Fed and the bond market is similar. This
spring, as "the flop" came down, everyone in the market, including the Fed,
could read all the data in the cards. The Fed told the bond market that
their "hole cards" were their ability to fight deflation by physically
lowering long bond rates if they needed to.
The bond market response was to believe the Fed and start the process of
lowering long-term rates without the Fed actually having to do anything.
The Fed bluffed the market into doing their work. Like the walls of
Jericho, mortgage rates came tumbling down, mortgage re-financings went
through the roof and deflation was dealt a blow, with nothing more than a
little jaw-boning. (I will resist the comparison with Sampson and the
jawbone of an ass. It would be much too easy.)
Then the turn card (the fourth "up" card) was dealt. That would be at the
last Fed meeting. The bond market, ever an astute observer of gambler
behavior, thought it read some ambivalence in the Fed posture. Was this the
last rate cut? If so, that meant interest rates had no where to go but up.
While the Fed still promised to hold short rates down, would they really
back up their bluff and actively target long rates? If not, then why would
you buy bonds at what would obviously prove to be the lowest interest rates
of the last 50 years? The statement they released did nothing to make the
bond vigilantes think that the Fed was ready to work the long end of the
yield curve.
The response of the bond market was to "call and raise." And raise they
did, by taking interest rates up on the ten year bond by more than one half
percent in just a few weeks.
This rise in interest rates is more than of just academic interest. The
next rise in interest rates is seen as a potential pre-cursor to market and
economic turmoil.
Martin Barnes is one of my favorite analysts. He has certainly been as
right as anyone for over two decades. His work at the Canadian based Bank
Credit Analyst has been the soul of calm and thoughtful analysis. He sees a
period of economic growth in the 3-4% range for the next 12-18 months. (He
is somewhat more optimistic than my Muddle Through prognostication.) Thus
it caught many of us by surprise to read the following from his June
letter:
"The Federal Reserve has implicitly made an extraordinary commitment to
hold short rates at current extremely low levels for an extended period, in
order to hold down long-term rates. This gives a green light for hedge
funds and speculators, but it will be hard to avoid major market turmoil
when the Fed decides it is time to tighten. A long period of low short
rates will feed mini-bubbles in a range of assets, is bearish for the
dollar and bullish for gold and financial sector shares.... Policymakers
will be successful in boosting the economy in the short run, but are
creating even bigger problems down the road in terms of increased leverage,
greater financial excesses and a larger current account deficit.
Eventually, there will be enormous pressure to try and devalue accumulated
debts through increased inflation.
"The U.S. policy environment has never been more stimulative. All of the
policy levers are at maximum thrust and, unusually, are working in the same
direction. The sheer force of this reflation should pull the U.S. economy
out of its recent doldrums, rewarding those investors who have added some
risk to their portfolio. However, markets could be very turbulent when the
Federal Reserve is eventually forced to start raising interest rates to
more normal levels. Moreover, while aggressive reflation will help the
near-term economic outlook, problems are being stored up for the future via
increased consumer leverage, a rapidly deteriorating fiscal outlook, and a
widening trade gap.
"....The dark side of current reflationary efforts is that they are leading
to increased financial imbalances that will cause problems down the road.
Consumers are taking on more leverage, government finances are
deteriorating dramatically and the bloated current account deficit is
continuing to increase. None of these trends are sustainable over the long
term." (The Bank Credit Analyst, June 2003, www.bcaresearch.com)
For our purposes today, the key sentence in those words were: "However,
markets could be very turbulent when the Federal Reserve is eventually
forced to start raising interest rates to more normal levels."
If long term interest rates rise beyond a certain point (more later), that
will create a different set of issues, but it will be very problematic
nonetheless. If capital spending has not rebounded from its current
doldrums and if the economy is not producing net new jobs when the interest
rate rise begins, as it inevitably will, the turbulence will be more than
merely "very."
Today, the interest rate rise has merely taken us back to where we were a
few months ago. I do not think this will affect the housing market all that
much in the near future, as rates this low were good for the markets only a
few months ago, and they did not dip into the 5% mortgage rate range for
more than a few weeks.
If rates were to rise to much higher levels, this would change. The lower
the mortgage rate, the higher the loan you can qualify for. Since the
tendency of much of the US market is to buy as much house (in terms of
dollars) as you can afford, the lowering of rates over the years has helped
push the rise in home values.
When rates go back up, the pressure is in the opposite direction. Since
home values are the Wealth Effect that is most closely tied with consumer
confidence and spending, there is some point at which increasing mortgage
rates become a serious drag on the economy if business spending and job
growth are not on a roll to offset this.
Mortgage re-financing dropped 21% last week as rates rose. That sounds bad.
But when you look at a long term chart of mortgage re-financings, we are
still at very high levels. I know that borrowers take out a lot of money
when they re-finance and that has been a big part of consumer spending, but
rates are not so high today as to preclude continued borrowing. But it is
not about today that we should beam concerned. It is the future about which
we all obsess.
The only seeming agreement among observers is this: there is a point at
which if mortgage rates were to rise in the current economic climate that
the higher rates would precipitate a recession.
At what point do rates get too high and begin to pull down the economy? No
one seems to know. There are just too many variables to factor in. There is
a lot of disagreement or scratching of the head. Is it 6% mortgage rates?
6.5%? Can we go back to 7% in today's economy without any problems?
Bonds hate uncertainty. And right now they are not certain as to what the
Fed is saying. Have rates been cut for the last time? Is deflation no
longer a concern? If deflation is not a concern, then should we worry about
that ancient enemy of bonds: deflation? Thus rates rise.
Dealing the River Card
And now we come to the river card - the last card to be played before the
final round of betting. The river card will be dealt next week as Greenspan
speaks. This may be one of his most important speeches of his career. It
will certainly be one of the most watched. Every riverboat gambler that
calls himself a bond trader will be watching for any signs of perspiration
or nervousness as he looks at his cards.
With due regard for Greenspan, he has a tough assignment. It is a delicate
game. The Fed has been telling us for some time they will work to hold long
rates down to combat deflation if necessary. That "bluff" has helped bring
rates down.
If he leads traders to believe that the Fed is no longer worried about
deflation then rates will rise as the bond vigilantes will begin to worry
about inflation. Why buy long bonds at today's low rates when the Fed is
going to allow long rates to rise, thus making your bonds worth less?
If he talks about concerns of deflation, will the market believe him if he
does not commit to action? Most observers I read believe the Fed will work
to lower long rates if a recession or deflation appears at the front door.
It is also widely believed that the Fed is loathe to do anything of that
nature unless absolutely forced to. That is a very drastic action, and
would be admitting that the economy is in serious shape.
If the Fed can talk rates down without actually having to do anything, it
is the best of all worlds. The bond market seems to be calling the bluff.
Next week we see what the last card reveals, and how the market reacts.
One or Two More Complications
Let's see if I can cloudy the picture even more. The Japanese bond market
is in revolt. Greg Weldon reports that Japanese investors have sold more
foreign bonds in the last four weeks than they have in total for years. It
seems they are buying the Nikkei (Japanese stocks). This is a huge shift.
This has put pressure on US rates. This started just a few days before the
recent Fed meeting. Perhaps it precipitated the US rise in rates, but the
bond market surely followed the lead.
This should also put pressure on the yen, making it rise. This is something
the Japanese government does not want. They have been working to keep the
yen from rising during this period, which is what the yen would normally do
when investors start selling foreign bonds. (As an aside, Dennis Gartman
points out the Chinese are the main buyers of these bonds. But that is for
another time and another letter.)
Will the Japanese central bank help out a fellow central banker in need
(Dr. Greenspan) by buying long US bonds, which will help the US (their
important customer) and also lower the yen? Or will they decide that a
rising Nikkei will be enough to offset the problems at home that would
result from a rising yen? Will a rising stock market be enough to trigger a
reflation in their economy, or will they need to use their last bullet and
devalue the yen?
Greg Weldon also did an entire letter on what gold looks like to the rest
of the world. (Greg's web site for his outstanding letter is
www.macro-strategies.com. You can get a free 30 day subscription.) In country
after country, gold is NOT in a bull market. It is signaling deflation. The
worldwide wave of deflation has not subsided.
Korea is now in recession. Germany is either in recession or soon will be.
German Chancellor Schroeder has called for the European Central Bank to
work to bring down the value of the euro. Numerous Asian countries are
working to bring their currency down against the dollar, even as we run
huge trade deficits.
It is simply not possible for every country to devalue their currency
simultaneously. The end result of this much government manipulation of the
markets will not be good. Thus, even as gold tells us deflation is
possible, gold is the one "currency" which cannot be inflated by a
government. I was bearish on gold for all of the 90's and turned bullish in
February of 2002. I expect I will be bullish for a long time. As Bill
Bonner wrote today in today's Daily Reckoning, "Buy gold when it falls
below $340. When it rises above $340, buy some more." A steady accumulation
plan for gold is a wise move.
The Gun to My Head
But I can still hear you asking, "So what are interest rates going to do?
Should I lock in today's mortgage rates? Will rates ever go back down?"
The answer is complex. But since you are holding a gun to my head, I will
give you a simple guess.
If we have a recession within the next 18-24 months, and if inflation has
not reared its ugly head, then there is the real chance we will see long
bond rates drop. That will be the primary card (perhaps the only real one)
the Fed has left to play to try and jump start the economy. A recession is
by nature deflationary. I believe if the Fed is forced by either a shock to
the market (which will cause a recession) or the rising of rates too high
so as to create the probability of a recession, they will work to lower
rates.
My guess (and it is only that) is that we will see lower rates one more
time during the next recession which is not yet on the horizon. The Fed
will work to postpone that day for as long as it can. I expect that will be
the final bottom of the bond market.
What should you do today? If it makes sense to refinance your home today
and lock in low rates, I would do it. If my guess is right, then you will
get another chance to refinance again. If I am wrong, then you will be
happy with your rate in the years to come.
Paris, Geneva and Inflating My Book
This time next week I will be with my friend Bill Bonner at his chateau
(otherwise known as a money pit) in Ouzilly, France. He has promised good
wine and there is always interesting conversation. His book on Japan and
its implications will soon be out, and it promises to be good, from the
drafts I have seen. He has also asked how I feel about a workout of moving
stones, but I think my back is going to somehow not be up to such. I will
report to you of our conversations. Sunday back to Paris and then Monday
night on to Geneva. It will be a very full schedule, with a few media
moments, I am told. I will be back in the office on the next Friday,
writing to you of what I learn. With the wonder of the internet, I can stay
connected, and hopefully will not find myself to far behind. We will see.
It is now very hot in Texas. In an effort to remain married, I have
promised my bride to take her from the Texas heat when I get back. We will
go to Halifax for the cool of the Canadian summer, where I intend to finish
my book, which keeps inflating on me. It seems there is always one more
important idea. It is shaping up nicely, though, and I think it is going to
be a very useful tome to help you with your investment decisions. |
