First Deflation, Then Inflation. But the Timing...?
By John Mauldin
June 2, 2012 US

One of the more frequent questions I am asked in meetings or after a speech is whether I think we will have inflation or deflation. My ready answer is, "Yes." Then I stop, which I must admit is rather fun, as the person who asked tries to digest the answer. And while my answer is flippant, it's also the truth, as I do expect both outcomes. So the follow-up question (after the obligatory chuckle from the rest of the group) is for a few more specifics. And the answer is that I expect we will first see deflation and then inflation, but the key is the timing. Today we will examine that question in more detail, as we look at how interest rates could actually be negative (!!!) this week in German and Swiss bonds and why the US ten-year has dipped below 1.5%. The very poor May employment number needs some analysis, too, and we'll check the prospects of a synchronized global slowdown. Rarely have I come to a Friday with so much data that simply begs for a more thorough look, but we will try to hit at least the most important topics.

US Unemployment Turns Back South

The US unemployment numbers for May were released this morning, and they were rather dismal. Mainstream economists were expecting something on the order of 150,000 new jobs, but they came in sharply lower at 69,000. March and April estimates were revised down 50,000. As long-time readers know, I pay as much or more attention to the direction of the revisions than to the actual monthly numbers, as the direction of the revision is a reasonable leading indicator. And what it indicates is what I was writing four months ago: we are in for another summer of poor jobs growth.

With the revisions, we have had the first back to back sub-100,000 new jobs months since last summer, with the average gain for the last three months a poor 96,000.

The unemployment rate rose to 8.2%, as the labor force rose a very strong 642,000. This is why I wrote, at the beginning of this recession some four years ago, that employment would take longer to come back this cycle. That is because of the way they count employment. If you have not looked for a job in the last four weeks, you are not counted as unemployed. The rise in the labor force is largely due to the growing number of people now looking for jobs, as those on extended unemployment benefits are beginning to come to the end of their two-year benefits period in fairly large numbers each month.

As more people look for a job, the statistical reality is that it takes more new jobs to move the unemployment number down. And with numbers like this month's, that means the unemployment rate will start to march back up. That is not something anyone wants, least of all politicians, who are fond of taking credit when the number of jobs rise but try to change the subject when unemployment climbs.

The more realistic unemployment number would be one that counted people who are unemployed but would take a job if they could get one. While economists can argue how to actually come up with that number, nobody (without a serious political bias) would argue that it is less than 10%, and some would argue it's north of 12%. And the duration of unemployment is now back to a median time of over 9 months, with that number sadly rising as well. It is just taking longer to find a job if you don't have one.

CNN Money did a story last month with the note that "... there are far more jobless people in the United States than you might think. Last year, 86 million Americans were not counted in the labor force because they didn't keep up a regular job search. While it's true that the unemployment rate is falling, that doesn't include the millions of nonworking adults who aren't even looking for a job anymore. And hiring isn't strong enough to keep up with population growth. As a result, the labor force is now at its smallest size since the 1980s when compared to the broader working age population."

The household survey (which is different from the establishment [or business] survey) showed the creation of 422,000 jobs. We get the unemployment percentage (of 8.2%) from the household survey. You can't really look at the monthly numbers on the household survey, because they fluctuate wildly. "Change in the adjusted household survey over the last five months: +491,000, +879,000, -418,000, -495,000, +400,000. That nets out to +857,000, little different from the establishment survey's 823,000. Further evidence that one should look at the adjusted household numbers as a longer-term check on the establishment survey and basically ignore the monthly changes." (The Liscio Report)

The interesting thing to me in the household report was that the number of part-time jobs was up 757,000, which is far larger than the rise in the number of employed. Full-time employment actually dropped by 266,000. The broader measure of people who are unemployed or underemployed (part-time but wanting full-time work) is now back up to 14.8%. The Gallup Poll people, using a different survey basis, show an 18% underemployed rate.

But why should we worry? "The jobless rate in the U.S. could drop to as low as 6 percent by the first half of 2013, a bigger decrease than most economists currently project, according to research from the Federal Reserve Bank of New York. The relationship between the number of Americans newly unemployed and those recently finding work indicates joblessness will continue to decline, according to economist Aysegul Sahin." (BusinessWeek) Such scholarly work should help Mr. Sahin to land a job with the White House on the President's Council of Economic Advisors. Although, to be fair to the Fed, their more consensus view is that unemployment will still be 7.4% to 8.1% in the 4th quarter of 2013.)

Perhaps the key driver of the US economy is consumer spending. And consumer spending requires consumers to have income. But this month's survey and the revisions to recent reports shows that hours worked are down slightly and wages are not keeping up with inflation. Total payrolls were down 0.3% for May, which is just a killer for consumer spending. GDP for the first quarter was revised down to 1.9%, and it looks like this quarter may not be any better or may even be worse, despite the higher expectations of mainstream economists.

But I suggest that you not take much comfort from consensus forecasts. There are certain analysts who I can almost always count on to be wrong. And they get there with the aid of a large number of graphs and charts and words to prove their points. But being consistently wrong can be useful, and I appreciate the effort it involves. However, there is wrong and there is just really bad. The Blue Chip economics consensus has never forecast a recession. And they largely miss recoveries. Essentially, they always forecast a continuation of the current trend. As a group, they are largely useless. They are not even a good contrarian indicator.

My friend James Montier (now of GMO) has long had fun with the poor track record of consensus economic forecasts. This graph pretty much says it all.

A Synchronized Global Slowdown

While synchronized swimming may be an event (if an odd one) at this summer's London Olympics, a synchronized global slowdown is not an event in which you want to get a medal. We looked at a spate of bad data last week, and we got even more this week. Lost in the bad employment data this morning was the news out of Asia. Australian manufacturing is clearly in a recession. India is posting its slowest growth in nine years. China is on the edge of a downturn in manufacturing. Unemployment is rising all over Europe and is much worse than in the US. German (!!!) credit default swaps are rising and are now higher than in 2008! Bank deposits in Europe are contracting at a faster rate than at any time in the last 14 years (the farthest back I can find data).

And while I don't want to steal too much thunder from next week's Outside the Box, I will pass along just this one graph from Greg Weldon ( www.weldononline.com), showing that the PMI numbers for Europe came in almost universally bad. Note that the two-year average is getting ready to go negative.

The jobs number suggests the US is at stall speed. I wrote at the beginning of the year that if someone could guarantee 2% growth for the year I would take it. That still seems like a good bet, as I don't think we are going to get near 2%. An economic shock from Europe, which is quite possible, could push the US and most of the rest of the world into recession. The weakness in China and the rest of Asia gives even more cause for concern.

Recessions are almost always by definition deflationary. And with that thought in mind, let's turn our eyes to this week's rather puzzling moves in European interest rates.

Why Would You Buy a Bond with Negative Interest?

It is entirely understandable why Spanish and Italian interest rates are rising, as the news, especially from Spain, is quite negative. But so far, there is little evidence that there is significant shorting of Spanish debt, as almost everyone believes that the European Central Bank will ride to the rescue of Spain, as it has in the recent past. That is a tough environment for short sellers. One morning you wake up and there is massive movement against your short position and you can't get out without large losses. But the longer interest rates rise without ECB intervention, the more likely they are to rise even faster at some point, forcing either an ECB intervention or a failed Spanish bond auction and an eventual default. Given that the latter events are so disastrous, it is not unreasonable to think that the ECB will act, at some point.

Yields on Spanish ten-year bonds are now at 6.62%, up 50 basis points in the last 45 days. That is a record 548 basis points higher than similar German debt. Greece, Portugal, and Ireland had to seek aid when rates rose over 7%. "Economy Minister Luis de Guindos said late yesterday that the future of the euro is at stake, as data showed a net 66 billion euros ($81 billion) of capital left Spain in March. 'I don't know if we're on the edge of the precipice, but we're in a very, very, very difficult situation,' he said at a conference in Sitges, Spain.

"Investors have lost more on Spanish debt this year than any government securities apart from those of Greece. Spain, the fourth-biggest euro economy, owes bondholders 731 billion euros, more than the three countries that have already been bailed out combined. (Prime Minister) Rajoy's suggestion that his country risks being forced out of capital markets reinforces concern that it may not be able to manage its debts..." (Bloomberg)

But in recent speeches, ECB president Mario Draghi has said that European leaders must clarify their own vision of what Europe is to be. He correctly points out that it should not be up to the ECB to fill a policy vacuum created by European inaction.

"'Can the ECB fill the vacuum of lack of action by national governments on fiscal growth? The answer is no,' Draghi told the European Parliament. 'Can the ECB fill the vacuum of the lack of action by national governments on the structural problem? The answer is no.'

"In his sharpest criticism yet of euro zone leaders' handling of the crisis, Draghi urged they spell out detailed plans for the euro and fiscal cooperation, something he believes will require governments to surrender some of their sovereignty to succeed.

"'How is the euro going to look like a certain number of years from now? What is the union vision that you have a certain number of years from now? The sooner this is specified, the better it is,' Draghi said." (Reuters)

That does not sound like a man who wants to buy Spanish bonds. And that is why, the longer he hold off, the more the market may sense he is waiting on European leaders to act. And that may take some time, as so far all they seem to want to do is kick the much-dented can down the road.

But even given the pessimism in Europe, why should Germany be able to sell €5 billion of two-year bonds at zero percent interest last week and see them trade this week at a slightly negative interest? Why would anyone buy a bond that is guaranteed to not even give you your money back? Is that a sign of severe potential deflation?

The answer is, not really. Buying German bonds, even at a slightly negative rate, is actually a cheap call option on the eurozone breaking up. A German bond that became a new Deutschemark-denominated bond would rise in value at least 40-50% almost overnight. If you are a pension fund, for instance, with a lot of sovereign debt from a variety of European peripheral countries and you think a break-up of the eurozone is possible, it is a way to hedge your investment portfolio.

Switzerland actually sold outright this week bonds that have a negative coupon. Again, not a sign of deflation but another call option, betting that the Swiss Central Bank will have to give up on its peg to the euro. That peg has got to be one of the biggest losing trades in central banking history, and the Swiss seem determined to lose even more money. If the euro goes to $1.15 or lower, that trade becomes an even more massive loser. At what point in the next year will the Swiss Central Bank decide it has endured all the pleasure it can stand in fighting the fall of the euro? If they abandoned the peg, the move in the Swissie (as traders call the Swiss franc) would be large and almost instantaneous. And the reward for investors outside of Switzerland buying Swiss bonds with a negative yield will be large.

First Deflation, Then Inflation

As noted above, recessions are by definition deflationary. Deleveraging events are also deflationary. A recession accompanied by deleveraging is especially deflationary. That is why central banks all over the world have been able to print money in amounts that in prior periods would have sent inflation spiraling upward. This drives gold bugs nuts as they see the money being printed, but they are not factoring in the velocity of money. If the velocity of money were flat, inflation would be quite significant by now. But velocity has been falling and is going to fall even further. The US Fed and the ECB are going to be able to print more money than we can imagine without stoking inflation ... at least for a while longer.

But interest rates are down in a lot of countries. Look at this table of ten-year bond yields (courtesy of Barry Ritholtz at The Big Picture):

Today's employment numbers not only sent stocks tumbling and gold soaring, they had a significant effect on bond yields, which fell across the board. Look at today's numbers from Bloomberg.com. Note the 30-year US Treasury is at 2.52%!


One of the champions, for a rather long time, of the deflationary outlook has been my friend David Rosenberg (formerly chief economist at Merrill and now with Gluskin Sheff in Toronto). He has been talking for years about a target of 1.5% for the ten-year US bond. Today we got down to 1.5% and did not even pause, ending the day at 1.47%. I noted that in a phone conversation to Rich Yamarone, the chief economist at Bloomberg, and he said he believes we will scare 50 basis points before we are through. To which Rosie replied in a later text, "He's nuts." We will all be at a special evening for the University of Texas McCombs School of Business next Thursday. I will offer to hold their coats while they have a lively discussion.

Since I was thinking about bond yields, I called Dr. Lacy Hunt (one of the more brilliant economists in the country, and not just in my opinion). He has been forecasting interest rates for a long time and been the guiding light at Hoisington Asset Management, which has established perhaps the best track record I know of for bond returns, if a tad volatile. They have been long bonds for a very long time, which has been the correct position, if a difficult and lonely one. Most bond managers think rates are set to rise.

Not Lacy. He thinks we will get close to 2% on the 30-year bond and has said so for decades. (Interestingly, he will be in the audience on Thursday, along with Van Hoisington. I think I will refrain from saying anything about bonds that night and talk about something more predictable, like politics or Europe.)

Dr. Gary Shilling wrote his first book, called Simply Deflation, in 1998 and followed it up recently with another great work, titled The Age of Deleveraging. He first went long bonds in 1982, which has been one of the great trades of the last 30 years. He lists a whole host of reasons for a deflationary period over the next few years.

The argument for deflation is rather straightforward. The boom in the US and much of the world from 1982 until 2008 was partially the result of financial innovations and massive leveraging. That process has come to its end, and the private sector is deleveraging and will do so even further as the economy softens and we slip into the next recession. Governments are coming to the end of their ability to borrow money at reasonable rates in Europe, and soon in Japan and eventually in the US (and that time is not as far off as we would like). I described the whole process in my book Endgame. Assuming the US government deals with its coming deficit crisis in a realistic manner, the results will be deflationary. I will comment later on the Fed response.

The next big deflationary force is the slowing of the velocity of money. I have written numerous e-letters and devoted a lot of space in the book to the velocity of money and won't go into it again here. It has been falling for five years, pretty much as I wrote it would, back in 2006. (I was writing about the velocity of money at least as far back as 2001, and probably earlier. It is a very important concept to grasp.) We are now close to the historical average velocity of money, but since velocity is mean-reverting it will go well below the historical average. This process takes years; it is not something that is going to end any time soon.

A slow-growth, Muddle-Through economy is deflationary. High and persistent unemployment is deflationary.

Absent some new piece of data that I can't see now, we are in for lower bond yields in the US. Rates are going lower and are going to stay low for longer than any of us can imagine.

I think the Fed will respond to the government acting in a fiscally responsible manner, which is inherently deflationary, by fighting that deflation with the only tool it has left; and that is outright monetization of debt. They will call it something else, of course, but that will be the actual outcome.

And they will be able to monetize more than you think they can without causing a repeat of the 1970s. Eventually it will catch up to us, as there is no free lunch, but they are betting they will be able to reduce some of the threat of actual inflation by cutting back on the money supply and raising rates. But we are years off from that. So, yes, at some point inflation will be back.

Anybody who says they know the timing is a lot more confident in his/her crystal ball than I am. Mine is rather cloudy on this topic. But I think I can see out a year or so, and it looks like continued low rates and deflation. By the way, just to appease the gold bugs among my readers, given my deflationary call, I will note in passing that solid gold stocks were up hugely during the deflationary Great Depression of the '30s. Even with the dollar on the gold standard. Just saying.

It is time to hit the send button, as I have to get up too early to go to New York this morning (it is already way too late).  Trust me, it's not any harder than figuring out Europe. And certainly not as hard as it will be to get out of bed in a few hours. So enjoy your week, and over the next few months we will look at some deflation trades that might work for you.

Your learning to enjoy the ride analyst,

John Mauldin

Copyright 2012 John Mauldin. All Rights Reserved.

June 3, 2012 8:07 pm
Look beyond interest rates to get out of the gloom
By Lawrence Summers

It is more likely that a pessimistic view is again taking over as falling incomes lead to falling confidence that leads to reduced spending and yet further declines in income. Financial strains hurt the real economy, especially in Europe, and reinforce existing strains. And export-dependent emerging markets suffer as the economies of the industrialised world weaken.

The question is not whether the current policy path is acceptable. The question is what should be done? To come up with a viable solution, consider the remarkable level of interest rates in much of the industrialised economies. The US government can borrow in nominal terms at about 0.5 per cent for five years, 1.5 per cent for 10 years and 2.5 per cent for 30 years. Rates are considerably lower in Germany and still lower in Japan.

Even more remarkable are the interest rates on inflation-protected bonds. In real terms, the world is prepared to pay the US more than 100 basis points to store its money for five years and more than 50 basis points for 10 years. Maturities would have to reach more than 20 years before the interest rates on indexed bonds become positive. Again, real rates are even lower in Germany and Japan. Remarkably, the UK borrowed money last week for 50 years at a real rate of 4 basis points.

These low rates even on long maturities mean that markets are offering the opportunity to lock in low long-term borrowing costs. In the US, for example, the government could commit to borrowing five-year money in five years at a nominal cost of about 2.5 per cent and at a real cost very close to zero.

What does all this say about macroeconomic policy? Many in both the US and Europe are arguing for further quantitative easing to bring down longer-term interest rates. This may be appropriate given that there is a much greater danger from policy underreacting to current economic weakness than from it overreacting.

However, one has to wonder how much investment businesses are unwilling to undertake at extraordinarily low interest rates that they would be willing to with rates reduced by yet another 25 or 50 basis points. It is also worth querying the quality of projects that businesses judge unprofitable at a -60 basis point real interest rate but choose to undertake at a still more negative real interest rate. There is also the question of whether extremely low safe real interest rates promote bubbles of various kinds.

There is also an oddity in this renewed emphasis on quantitative easing. The essential aim of such policies is to shorten the debt held by the public or issued by the consolidated public sector comprising both the government and central bank. Any rational chief financial officer in the private sector would see this as a moment to extend debt maturities and lock in low ratesexactly the opposite of what central banks are doing. In the US Treasury, for example, discussions of debt management policy have had exactly this emphasis. But the Treasury alone does not control the maturity of debt when the central bank is active in all debt markets.

So, what is to be done? Rather than focusing on lowering already epically low rates, governments that enjoy such low borrowing costs can improve their creditworthiness by borrowing more not less. They can also invest in improving their future fiscal position, even assuming that no positive demand stimulus effects are likely to materialise. At a time of negative real rates, accelerating any necessary maintenance project and issuing debt leave the state richer not poorer; this assumes that maintenance costs rise at or above the general inflation rate.

As my fellow Harvard economist Martin Feldstein has pointed out, this principle applies to accelerating replacement cycles for military supplies. Similarly, government decisions to issue debt and then buy space that is currently being leased will improve the government’s financial position. That is, as long as the interest rate on debt is less than the ratio of rents to building values, a condition almost certain to be met in a world of government borrowing rates of less than 2 per cent.

These examples are the place to begin because they involve what is in effect an arbitrage, whereby the government uses its credit to deliver essentially the same bundle of services at a lower cost. It would be amazing if there were not many public investment projects with certain equivalent real returns well above zero.

Consider a $1 project that yielded even a permanent 4 cents a year in real terms increment to GDP by expanding the economy’s capacity or its ability to innovate. Depending on where it was undertaken, this project would yield at least 1 cent a year in government revenue. At any real interest rate below 1 per cent, the project pays for itself even before taking into account any Keynesian effects.

This logic suggests that countries regarded as havens that can borrow long-term at a very low cost should be rushing to take advantage of the opportunity. This is a view that should be shared by those most alarmed about looming debt crises because the greater your concern about the ability to borrow in the future, the stronger the case for borrowing for the long term today.

There is, of course, still the question of whether more borrowing will increase anxiety about a government’s creditworthiness. It should not, as long as the proceeds of borrowing are used either to reduce future spending or raise future incomes.

Any rational business leader would use a moment like this to term out its debt. Governments in the industrialised world should too.


The writer is Charles W. Eliot university professor at Harvard and a former US Treasury secretary

Copyright The Financial Times Limited 2012