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Posted 4/5/2004
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Where are the inflation vigilantes when we need them?
Bond traders used to push rates higher at even a whiff of inflation, but with signs of rising prices now everywhere, they're overwhelmed by our desire to borrow our way to prosperity.
By Bill Fleckenstein
Faulty logic is a potent tool. Under its sway, folks bypass their better judgment to arrive at the wrong conclusions. One example: firing up those refinance engines to live beyond one's means, since seductive low rates seem to guarantee the risk-free delivery of prosperity right to your front door.
Another example: that the bond market is telling us, Don't worry, be happy. Not surprisingly, that isn't my conclusion.
Jeremy Siegels nonsensical inflation argument
On its op-ed page last Tuesday, the "New Economy Journal", aka, The Wall Street Journal, saw fit to allot a couple of column widths to Jeremy Siegel. He is another high priest from the bubble, a buy-stocks-all-the-time-and-for-the-long-run bull who folks still seem to think is thoughtful. His latest effort is a completely nonsensical argument about why inflation pressures and problems don't matter, because the bond market hasn't revolted yet.
In essence, his "logic" boils down to this: If we are pursuing an insane policy but the bond market hasn't freaked out, we should keep it.
That's a little bit like saying drunk drivers shouldn't amend their ways so long as the police don't catch them.
The Wharton School professor began with a firm grasp of the problem: To the market's surprise, the most recent Federal Open Market Committee statement didn't even hint at the threats implicit in the rise in commodity prices, especially oil, or the dollar's fall. These events have lowered the threat of deflation to virtually zero, but the Fed insists that deflation is still a slightly higher risk than inflation. He then asked:Is the Fed keeping its head in the sand? Is Alan Greenspan bowing to George Bush and the upcoming election? The answer to both those questions is yes, and he notes why such criticism is warranted:Commodity prices are rapidly increasing; the Commodity Research Bureau index of actively traded commodities is now at a level not seen since the inflation bubble of 1980. Oil stays stubbornly high, near $40 per barrel, and the Journal of Commerce Index of lightly processed commodities, once a favorite Greenspan indicator, has soared to an all-time high. And although the dollar has stabilized, it is down 25% against a basket of currencies since early 2002. Finally, the real Fed funds rate has been negative for two years and, relative to real economic growth, the most negative since the inflationary '70s. You would think that a fellow who understood all this would understand that inflation is a problem and the Fed is out of control. But the professor still manages to conclude that the Fed is doing the right thing because the bond market vigilantes have not taken matters into their own hands.
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Where are the bond market vigilantes?
Now I am going to turn the microphone over to a very knowledgeable friend in the fixed-income business, who would like to remain nameless. In a recent e-mail to me, here is what he had to say regarding the good professor's opinion of the bond market and its vigilantes:
Why is Jeremy Siegel given ANY space to give his views on bond market vigilantism or inflation or the appropriateness of Fed action/inaction? Here he is, one of the fathers of the stock market bubble, the ideological touchstone for arguing that stocks ALWAYS make sense (in the long run, of course), opining that the Fed is doing the right thing. He may be right, he may be wrong, but I wasn't aware that he had the ability to read the bond market's mind. The e-mail continued:His whole thesis -- that the bond market must be saying the Fed is right, or else rates would be higher -- misses so many points: the weight of foreign central banks and institutions buying Treasurys to help facilitate their currency devaluation (more potential news about that below), the increasing presence of mortgage hedgers as rates decline, the practitioners of the carry trade feasting on a too-low funding rate. Maybe the bond market vigilantes have just been overrun. Well said. The bond market vigilantes have been overrun. Most of America seems to be quite happy with the inflation we are experiencing (even as folks pretend there is none). They're giddy with delight that the housing market is out of control in many regions (and that stocks are at feel-good levels). However, I would just note that we may not be in total control of our own destiny.
Tokyo says 'No mas'
Japan's new fiscal year, which began last week, could be the start of a significant change and the end (recently rumored) to its currency-intervention policies. I say could be, because it's too early to tell. But, if the Japanese are no longer going to print yen to suppress its appreciation -- and therefore no longer be obliged to accumulate dollars as the other part of that trade -- then they will no longer be buying Treasurys in the same quantities as they have in the past. That will leave the Chinese as the buyer of last resort, which raises the question: How many will they or can they absorb?
The net of all that, if it comes to pass (and I emphasize if), would obviously be a weaker dollar and a rise in interest rates here. Should that occur, it likely would be the start of a problem with housing.
A lot of folks seem to forget that, in the old days, before this present band of lunatics started running the Fed so irresponsibly, rates could rise simply because of inflationary expectations. That could be where we are headed, i.e., very little growth, but still plenty of inflation.
Thus, contrary to Siegel's direct pipeline to what the bond market is "thinking," it could experience rising rates because of supply and inflation concerns -- even with the Fed (and especially because of the Fed) pegging the funds' rate at 1%. It will be very important, I think, to keep an eye on the Japanese yen and our bond market to see if this is a true inflection point. If so, as I've described, it will have very major ramifications.
A leaning tower of leverage
Meanwhile, it is this irresponsible monetary policy on the part of the Fed that set the stage for my decision to sell Annaly Mortgage (NLY, news, msgs) as I noted a couple of weeks ago. To repeat, I am uncomfortable with real-estate-oriented collateral, and I am very concerned about the low quality of consumer debt generically. I think that the level of debt is too high and that the assets consumers are borrowing against are vastly inflated. The combination of those two will cause huge problems, in my opinion.
Essentially, we have been attempting to borrow our way to prosperity. When the effectiveness of that strategy has reached its limit, we're going to see a lot of trouble, and sooner, I believe, rather than later. Are we there yet? I wish I knew, but I am paying very close attention.
Bill Fleckenstein is president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column on his Fleckensteincapital.com site. His investment positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. At the time of publication, he did not own or control any of the equities mentioned in this column. The views and opinions expressed in Bill Fleckenstein's columns are his own and not necessarily those of MSN Money.
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