by: Abigail Doolittle
July 7, 2011
Well, there’s the most recent “bottom” in housing.
By “there," I mean the tiny trough to the right. Of course, this “bottom” is below the original “bottom” in housing made back in early 2009 and perhaps this lower low – aka the double dip in housing – suggests that the real bottom shall be found somewhere closer to levels last seen in the 1990s and the awkward base to this particular chart found a bit below 100k.
Should housing find that charted base, we’re looking at another 15-25% decline in home prices and something that will keep any economic “recovery” tethered to a deflationary string.
After all, so long as the asset class at the eye of the still-ongoing financial crisis is deflating, sustained inflation is unlikely if not outright impossible. This is particularly true with (1) Core CPI still below the Fed’s unofficial target of 2%, (2) the June Beige Book noting that “selling prices increased only modestly” even in the context of rising food and energy costs while (3) the more than 3% rise in CPI over the last 12 months is likely to be moderated by the recent 15% decline in the CRB Index.
All of this is another way of saying that the risk of deflation is more of a near-term concern than inflation and despite the recent hype over the latter. Similar to 2009, the only inflation out there is asset inflation – speculation – fueled by QE2.
The Fed has taken a lot of flak for this type of inflation too, but, ironically, it may be to the Fed’s credit considering that deflation was a significant impetus to the informal announcement of QE2 last August as told by Fed Chairman Ben Bernanke at the post-FOMC meeting press conference on June 22. Essentially such inflation has moved the economy back from the edge of the deflationary cliff that the Fed was concerned about at that time.
However, the very nature of such asset inflation is temporary, or transitory, and particularly in the context of a deflating housing market and a velocity of money that is near a 30 year low. Such factors strongly point to a stagnant, swamp-like economy that is a breeding ground for prices – and even wages – to drop as the months tick on.
In turn, so long as deflation is of any concern at all, QE3, or even QE-Perpetual, is on the table.
Put otherwise, artificial asset inflation is the preventative medicine to the possibly incurable cancer of deflation even though I don’t think we will ever hear Mr. Bernanke talk about it in quite this way.
But as deflationary as a slumping housing market in a cesspool of slow-moving money might seem, the real gravity of the potential for deflation – the Fed’s real deflationary worry – may be summed up in its Flow of Funds Accounts. In fact, the picture of total net borrowing and lending as told by the Fed itself may be the biggest reason to think that QE3 of some sort shall be announced, formally or informally, and announced soon.
Specifically, annualized total net borrowing as of June 9 stood at $912 billion and an amount equal to global borrowing back in the early 1990s. On first blush, this may seem healthy or even desirable in relation to the overheated and unsustainable borrowing of nearly $4.5 trillion back in 2007 with almost all of it coming from the private sector.
However, when we back out the federal government’s $736 billion borrowing contribution to non-financial domestic borrowing of $828 billion, annualized active borrowing in 2011 would be closer to $93 billion – the thick green line below – and a figure that was last seen – including borrowing by the federal government and the financial sector – in 1967 when U.S. GDP was about $3.9 trillion relative to GDP today of approximately $15 trillion.
For an economy that runs on money and credit, it seems unlikely that GDP of $15 trillion can grow from current levels on credit activities that are akin to something seen back in the late 1960s when GDP was less than $4 trillion.
I admit that I do not have the precise mathematics worked out behind this argument, but I have a hard time seeing $100 billion worth of domestic credit activities (closer to $0 if financial sector borrowing is included) supporting $15 trillion worth of GDP and particularly in light of the approximately 30-year average of about $1.5 trillion of borrowing activities that supported a tremendous economic expansion over that time period. It is no accident that the Great Recession occurred as the private sector violently deleveraged in 2008 and 2009 nor is it an accident that such deleveraging was offset – to some degree – by the Fed’s wild leveraging of 2008, 2009 and 2010.
By extension, then, were it not for the Fed’s Q1 borrowing activities, we would have been looking at annualized total net borrowing of about $0 to $300 billion depending on whether you include the financial and non-domestic sectors and something that may not have supported meager 1H 2011 GDP growth. In fact, total net borrowing of just $0 to $300 billion could have even allowed for a contraction.
And thus it seems that the Fed’s real deflationary worry may be larger than an unstable CPI, an unimpressive velocity of money and a slumping housing market. It is tied up in continued private sector deleveraging as shown by anemic private sector credit activities.
Forget about a lender of last resort, the Fed needs to be the borrower of last resort even though the two are essentially the same.
Should this needed borrowing miraculously come from the private sector, the Fed can step away from that role of borrower/lender of last resort. However, continued private sector deleveraging bodes poorly for this possibility and this is likely to mean, sooner rather than later, additional accommodation by the Fed or QE3 if we are to believe that deflation – even disinflation – remains Mr. Bernanke’s signal to inject more liquidity into the system.
Such potential accommodation is really a continuation of what began in 2009 and something that is likely to continue for years – a QE Perpetual drip of liquidity – on some level until the private sector is able to participate in the world’s credit activities a bit more broadly again such that active global borrowing and lending activities stabilize due to the support of the private sector. The other possibility, of course, is the truly feared double dip of the recessionary sort.
And perhaps it is such debt deflation – and the driving force behind the slumping housing market, anemic bank lending and weak velocity of money – that some market participants have used as a signal to take copper more than 12% higher over the last nearly two months as the dollar has traded sideways looking for a real cue as the 10-year yield dipped below 3% again.
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In fact, it may be the chart of copper that is the clearest signal of all that the asset inflation train has nearly left the station ahead of what seems to be the inevitable announcement of some form of monetary stimulus – QE3 or otherwise – from the Federal Reserve and this may mean it makes sense to go long equities and commodities for at least a limited period of time.
“Limited” because some other long-term charts may suggest that the risk rally has only another 5-10% left in it and this could mean that some form of QE is necessary just to prevent a steep decline in the risk assets.
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