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Posted 2/28/2005
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Dress rehearsal for a dollar deluge
Tuesday's sell-off was a test run of the problems that will erupt when foreign investors refuse to finance our debt binge and home owners stop their own binge.
By Bill Fleckenstein
This week I'd like to put into perspective a few recent developments: Problems in the housing-ATM food chain, inflation concerns and news that the South Korean central bank planned to diversify its dollar reserves.
Prerequisite to current events: Bubble 101
To do so, it's important to take a step back and recognize that in the wake of the biggest mania in the history of the world, which ended in March 2000, it would have been reasonable to expect a fairly severe recession and a radical decline in many asset markets. That occurred in the stock market, to some degree (principally Nasdaq stocks). But the bear market was temporarily arrested, as was the recession, by the fact that 13 interest-rate cuts (plus a couple of tax cuts) jumpstarted the housing market -- and ultimately created a new bubble as I noted on June 28, 2004.
As housing prices rose, lending standards dropped along with the decline in interest rates. The ensuing boom in refinancing and the serial extraction of equity from homes allowed folks to live way beyond their means. This process has put many people in the position of now owing far more than they ever have, using the increased value of their home as collateral. That, in a nutshell, is what I have meant in repeated discussions about the housing ATM.
Does Fannie major in financial engineering?
Meanwhile, even as insanity in the housing market has continued in some locales, cracks have been appearing in the dike for the last couple months in the form of the well-publicized problems at Fannie Mae (FNM, news, msgs), where it is no longer financial business as it used to be. Problems there definitely matter, since Fannie is the 800-pound gorilla of home finance.
In another turn for the worse, Fannie's regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), last Wednesday stated that it has "identified (additional) policies that it believes appear inconsistent with generally accepted accounting principles." When I read the OFHEO headline (concerning Fannie's "held for sale" loans and hedge accounting), I thought it smelled like Enron, ergo my new nickname for Fannie: Fanron.
Warts also have sprouted in various facets of consumer lending, such as Capital One (COF, news, msgs), New Century Financial (NEW, news, msgs), Countrywide Financial (CFC, news, msgs), and Novastar Financial (NFI, news, msgs). I expect the sector to see more trouble, which will disable the housing ATM as a vehicle for consumers to spend beyond their means.
Awaiting an inflation epiphany
Further weighing on the housing-finance arm and consumers generically has been the recent rise in long rates that has finally accompanied the year-long rise in short rates. A week ago Friday, the bond market was hit pretty hard and managed to complete a reversal on its chart (signifying the end of a move) after the producer price index was reported to be up 0.8%. When I wrote about those results in my daily column, I said that it was not yet knowable if this is the start of real inflation concerns or just transitory noise. I felt that how the markets reacted to the Consumer Price Index data, released last Wednesday, would give us more information.
Not the CPI itself, mind you, because, as I noted last February, the CPI will never show inflation of any consequence. The CPI has been engineered specifically not to. Housing-price increases have essentially been removed, via the way in which owner-equivalent rents are calculated, and they cannot possibly reflect what's happened to house prices. Then, when one adds in hedonics (which strips out many price increases by assuming they are quality improvements) and factors in the substitution allowances in the data, it is clear that the CPI is not going to ring any sort of alarm bells.
A statistic unfriendly to finagling
The PPI is a little more untamed; it's harder to apply a hedonic adjustment to producer prices for copper or zinc, etc. Also, those prices are more directly impacted by a drop in the dollar. So, while a PPI might show some inflation, I repeat, the CPI never will show inflation of any consequence. My belief is that inflation in this country is running at 4% to 5% a year, at a minimum, and yet the CPI chugs along at 2% to 3%, depending on whether the government concludes we had a 0.1%, 0.2% or 0.3% increase in any given month.
I have believed that so long as asset prices were marching higher and folks felt better off, they would never come to the conclusion that the CPI is a charade. Consequently, I think that to expect the public to look through the CPI at this moment in time is perhaps a bridge too far. That doesn't mean, however, the bond market won't see through the CPI.
In any case, it will be interesting to see how the bond market behaves in the next few weeks. If the markets determine that the Fed is behind the curve, then the Fed will have to raise rates irrespective of what's going on in the economy. That will not be pleasant for the stock market. And, if the Fed chooses not to continue down that path, at some point, the bond market and currency market won't like that outcome.
The Oscar for worst performance by a Central Bank
Speaking of the currency market, the South Koreans appeared to yell fire there last Monday night, when they announced plans to diversify their foreign-reserve holdings away from dollars. (They are not the first to do so, as the Indians, the Russians and others have said the same thing.) Then the following night, they said "you misread us," as they tried to cover their tracks.
The real news, of course, was the foreign-currency market's reaction last Tuesday -- as the announcement itself was really just evolutionary, not revolutionary. What we saw was a dress rehearsal for the day when everyone realizes that they might be the rotten egg stuck holding a currency in serious decline. That the decline in the dollar has been upgraded to "noteworthy" (via the South Koreans) and that inflation may be a topic of conversation increases the risks interest rates will go higher. That, of course, will further pressure the housing ATM. Interest rates and the housing ATM are inextricably intertwined. So, if inflation or dollar concerns push interest rates higher, that will only exacerbate the problems already under way.
Trouble binds a variegated quilt
Given the fact that the housing ATM has allowed the consumers to live beyond their means, as I have described, and that they are already showing signs of reining in spending, we may be at an ominous juncture. I have made no secret of my belief that 2005 was going to be a year of trouble. The catalysts that could set those troubles into play are now either in place or lurking beneath the surface. These problems affect not just the housing market but also the economy and the stock market, which are of course interrelated.
I think it's important for folks to think about this and realize that finally, after about as much speculation as any economy could ever endure, our asset markets and economy might finally be ready to "revert to the mean."
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