Doctor Disinflation

Economist Gary Shilling is a legend. The July 7, 1997 edition of the Wall Street Journal stated that "Mr. Shilling…had the best overall forecasts" of the economy, interest rates, exchange rates and inflation "among the…57 economists polled in the latest survey." Today, he talks to us about…lead balloons.

A huge worldwide speculative balloon is now deflating. The economic outlook for the U.S. and, indeed, around the globe depends on how the hot air is expelled.

To see how we arrived at this point, go back to late 1996, when Fed Chairman Alan Greenspan made his "irrational exuberance" speech amidst a stock rally that was then 14 years old and had lasted long enough that investors were convinced it would last forever. But instead of tamping down some of the exuberance and potentially risking a bear market and a recession, the Fed sat on its hands. As a result, rampant speculation unfolded and spilled over, hyping up the overall economy in the late 1990s.

When the Fed finally got serious about tightening credit, five years ago, overblown stock speculation was already doomed. Then, as stocks collapsed in 2000, the credit authorities shifted to a massive easing cycle, starting in January 2001, in an effort to avert a major recession and to fight deflation. With record low interest rates, tax cuts, hikes in government spending and easy mortgage financing terms, housing and consumer spending sailed through, propping up the U.S. economy through the 2001 recession and the shaky recovery that followed in the years after.

The Fed had another motive for easing credit in the 2001-2003 years: a fear of deflation, which it publicly admitted in May 2003, a month before it lowered the Fed funds rate to its 1% floor.

Speculation Cycles: A New Cycle

Meanwhile, a new speculative cycle was unfolding, a cycle engineered specifically by the Fed and other central banks to stimulate growth. The generators of the hot air – propelling this new speculative balloon to stratospheric heights – were very low short-term interest rates and a steep yield curve.

As a result, hedge funds, brokers, banks, private equity pools, pension funds and insurance companies all took advantage of the wide yield-spread granted with the Fed’s seal of approval, and borrowed short-term low-interest debt in order to finance purchases of longer-term Treasurys, commodities, currencies, emerging country stocks and bonds, convertible securities and junk bonds. They gave no thought as to what might happen tomorrow.

Individuals, encouraged by low mortgage rates and easy financing terms, switched their focus of speculation from stocks to owner-occupied houses and used cash-out mortgage refinancing to pay for their consumerist habits. As a result, household real estate mushroomed from $8.7 trillion in the fourth quarter of 1997 to $15.2 in the first quarter of 2004.

These seemed to be profitable ventures at the time. As long as the curve didn’t flatten, the profits rolled in.

Now, however, with short-term interest rates beginning to rise, the yield curve is starting to flatten, and the massive extent of this reckless speculation is being revealed. Bond-yield volatility clearly shows this…

Inflation-sensitive Treasury bond yields jumped 100 basis points from mid-March to mid-June as traders anticipated a massive reversal of the carry trade. Junk bonds, emerging market stocks and bonds, commodities and foreign currencies all reversed gears and nose-dived. Copper prices dropped 15% from their March 1 peak. While U.S. stocks haven’t been hit as hard as bonds, junk and commodities, they haven’t moved much from their January 1 levels and continue to look vulnerable.

Speculation Cycles: Catching Speculators Off Guard

One troubling thought: few speculative trades have been unwound so far. This is worrisome since market-leverage is much greater than it was 10 years ago when Fed rate increases last caught speculators off guard. In 1994, the Fed managed not only to kill Kidder Peabody, but also the finances of Orange County, California as well as the Mexican economy.

For one, overnight borrowing to finance fixed-income investments, in relation to the total size of the fixed-income market, has doubled since 1994. Which major financial institutions might succumb this time around?

House prices are vulnerable to rising interest rates and less-diligent lenders. They normally move in step with the CPI, but since September 2001, median existing house prices are up 20% while the CPI gained only 5.2%. A nationwide fall in house prices would be devastating to the 69% of American households that own their own homes. And big mortgage financers like Fannie Mae and Freddie Mac, with $1.7 trillion in debts, could require government bailouts.

So the Fed finds itself in a tight spot. It raised rates at the end of June, but now it must adhere to market anticipations with further hikes or run the risk of appearing impotent. That could prove to be deadly for the leveraged speculators who have been encouraged by Fed actions – and inactions – since 1996.

And higher rates may also burst the housing bubble, and unleash numerous problems for government-sponsored mortgage lenders, as well as for young, low-income and minority families who became homeowners in recent years via low down-payments and low mortgage rates.

Delinquency rates have been rising in recent years and the concern is that, since most of these low-income families have negative net-worths outside their homes, continuing layoffs will squeeze them out of the housing market. And as that lack of demand ripples up the move-up market, housing prices from top to bottom will fall in what could be a self-feeding and serious decline leading to the first nationwide drop in housing prices in the post-World War II era.

This hot-air balloon is a lead balloon; watch out below…


Gary Shilling
for The Daily Reckoning
July 15, 2004

Editor’s Note: Dr. Gary Shilling is president of A. Gary Shilling & Co. Inc., an investment advisory and economic consulting firm and publisher of the monthly INSIGHT newsletter.

Prescience has empowered Dr. Shilling to beat the stock market by a wide margin over many years while providing consistently accurate forecasts to his subscribers. Twice ranked as Wall Street’s top economist by polls in Institutional Investor, Dr. Shilling was also named the country’s number one Commodity Trader Advisor by Futures magazine. And last year, MoneySense ranked him as the 3rd best stock market forecaster, right behind Warren Buffett.

A regular columnist for Forbes magazine, Gary Shilling appears frequently on radio and television business shows and has written six books, including ‘Is Inflation Ending? Are You Ready?’ in 1983 and, more recently, two books detailing his forecast for the new world order and its consequences for your wallet.

Where are we now?

Oh yes…Baltimore…2004 AD…the 4th year of the great bear market…the 17th year in the reign of Alan Greenspan…

What is going on?

In the stock market – nothing. But in the real estate market – oh la là!

More below…

First, the news from Eric Fry in New York City:


Eric Fry, checking in from the Big Apple…

– "Oops! We did it again!" Britney Spears might have said, yesterday, if she were a pinstriped oil analyst rather than a bare-midriffed pop diva.

– Once again, Americans burned through more oil than they stockpiled. The Energy Department reported a 2.1 million-barrel draw down in crude supplies for the week ended July 9, to a total of 302.9 million barrels. The American Petroleum Institute estimated an even larger draw down of 5.1 million barrels. Either way, we consumed a lot more oil than we stored.

– The large inventory decline occurred in the face of massive crude oil imports. For the eighth straight week, U.S. imports topped 10 million barrels – "the longest such streak ever," according to the Government’s report. The shockingly large drop in inventories sparked an explosive rally in crude oil. Over in the energy trading pits of the New York Mercantile Exchange, the price of crude jumped $1.53 to $40.97 a barrel – a new six-week high.

– Despite record-high oil and gasoline prices, Americans continue to guzzle the stuff…but the nation’s ever-rising energy bill is starting to take a big bite out of discretionary spending. Retail sales plummeted 1.1% in June – the biggest decline in 16 months – thanks largely to a 4.3% fall in auto sales. Apparently, we Americans are not buying quite as many things we don’t need with the money we don’t have. We’ve even curtailed our once-robust consumption of common stocks.

– The major equity averages fell again yesterday, as the Dow lost 39 points to 10,209 and the Nasdaq slipped nearly 1% to 1,915. As stocks slipped, the dollar also weakened, falling half a percent to $1.238 per euro. The gold market made the most of the dollar’s weakness by jumping $3.80 to $405.45 an ounce.

– The stock market bulls say stocks should be higher. We say they SHOULD be lower, especially if $40-a-barrel crude oil keeps hanging around like an annoying party guest. The balance between supply and demand in the energy markets is delicate at best. As the world’s developed countries continue to find new and ingenious ways to exhaust the earth’s finite energy supplies, Chinese and Indian demand for fossil fuels is booming.

– "Indian villagers, who account for more than 70 percent of the nation’s 1 billion population, are spending on televisions, refrigerators and other goods at more than twice the pace of their urban counterparts," Bloomberg News report. "Demand for consumer products in India’s 627,000 villages is expanding by 25% a year compared with growth of 10 percent in cities and towns, according to a survey by the Federation of Indian Chambers of Commerce and Industry."

– All these new gadgets mean lots more demand for energy…and all the while that demand booms, the global oil supply struggles against the forces of inevitable depletion. What’s more, the global balance between supply could become quickly imbalanced if terrorist attacks disrupt supplies.

– Time Magazine reports that the FBI sent a classified intelligence bulletin to local law enforcement agencies last week warning of a potential terrorist threat to the U.S. energy infrastructure. Meanwhile, half a world away, Islamic militants continuously plot to disrupt the oil infrastructure within Saudi Arabia.

– "An increasing number of Saudis who crossed the border into Iraq are returning home to plot attacks against the Saudi government and Western targets in the desert kingdom," the Washington Post Foreign Service reports. "Other Saudis are returning after spending time in newly established training camps across the Red Sea in remote parts of Sudan where central government influence is weak…some Western officials express fear that the homecoming will grow if Iraq stabilizes."

– After the Iraq insurgency is over, ‘there will be people who are freshly trained in the art of guerrilla warfare,’ said a Western diplomat who spoke to the Post on condition of anonymity. ‘It’s a real concern.’

– We could certainly imagine the oil price falling from current levels. But it’s so much easier to imagine it rising. Hmmm…what would Britney say?


Bill Bonner, back in Baltimore…

*** "They are jealous!"

"I couldn’t believe it. But I keep hearing it. Americans think that the rest of the world is jealous of them. They tell each other what a great country they have…they fly the flag all over the place…and they think that when another country causes problems or doesn’t agree with them, it is because they are jealous."

The person speaking was a young Belgian woman who lives in Baltimore. We had gotten together a small group of French speakers to celebrate Bastille Day. Not that we have any sentimental attachment to the French Revolution. We do not approve of revolution – even the American one. But we never forgo an opportunity to drink too much.

"Even after September 11, I heard on the news," she continued, "that the reason bin Laden had attacked the U.S. was because he was jealous. They seem to think that the reason people in other countries are the way they are is because they have failed in their efforts to be like Americans."

It is a fatal conceit. It leads Americans to believe the most absurd things – that if they offer American-style institutions to foreigners, even at the point of a gun, they will take them up readily and then say ‘thank you.’ And that they will live indefinitely on foreigners’ savings; the Huns and Frogs and Japs are so eager to put their money into the world’s most dynamic country, they’ll never ask questions.

But the conversation veered from money to war…and back again.

"Belgium is a strange, unnatural country. It is meant to be a buffer state between France and Germany. We are always getting invaded. Half the country – well, really, a third – feels they are French. Another third feels it is German. So that when the Germans invaded in WWII, the people in the East of the country welcomed them, and collaborated. The French speakers resisted. At least, that’s what the Walloons (the French speakers) like to believe. My grandfather got sent to a slave labor camp during the war. My grandmother lived in a cave for two years. It was horrible.

"And even now, two or three generations later, and I was talking to a woman from Holland. She asked me what I thought of the Germans. I said, frankly, I didn’t trust them. Of course, I don’t know them at all. It’s just a reflex.

"The Germans are not likely to go to war anymore. They’ve had enough of it…but here in the U.S.A., I’m a little shocked by how eager Americans are to go to war…"

*** From Alexis de Tocqueville’s ‘Democracy in America’:

"The Americans have no neighbors and consequently they have no great wars, or financial crises, or inroads, or conquests to dread; they require neither great taxes, nor large armies, nor great generals; and they have nothing to fear from a scourge which is more formidable to republics than all these evils combined: namely, military glory. It is impossible to deny the inconceivable influence that military glory exercises upon the spirit of a nation.

"General Jackson, whom the Americans have twice elected to be the head of their government, is a man of violent temper and very moderate talents; nothing in his whole career ever proved him qualified to govern a free people; and, indeed, the majority of the enlightened classes of the Union has always opposed him. But he was raised to the Presidency, and has been maintained there, solely by the recollection of a victory which he gained, twenty years ago, under the walls of New Orleans; a victory which was, however, a very ordinary achievement and which could only be remembered in a country where battles are rare. Now the people who are thus carried away by the illusions of glory are unquestionably the most cold and calculating, the most unmilitary, if I may so speak, and the most prosaic of all the nations of the earth…"

For most of their history, Americans were mostly inept at war. They were no good at it because they had better things to think about and better things to do. And, except for Lincoln’s intramural war against the southern states, there was no need. While France faced danger from either side – Britain and Germany…and Germany faced danger from France and Russia…America stood only against Canada and Mexico, neither of which could inflict any real harm.

This is not to say that the average grunt lacked courage or discipline; on the contrary, he almost had too much. Farm boys went to war thinking they were the greatest soldiers on earth. The illusion of invincibility went to their heads; they forgot to duck.

We say that after reading more of Thomas Fleming’s history of Woodrow Wilson and WWI. The poor doughboys got killed in appalling numbers. It was as if their officers had learned nothing from the slaughter of the French and British over the preceding two years. They sent their men across open ground to attack machine guns. At the end of the battle, American bodies were spread out like a carpet. The German machine guns were still in place.

"Private First Class James Rose of the First Division later told of advancing across an open field to within fifty yards of the German Line," writes Fleming. "Suddenly, the air around the men ‘became a solid sheet of machine-gun and artillery fire. No words could possibly describe the horror of it. Body stacked upon body in waves and piles…our boys never faltered, they came, wave upon wave, climbing over the bodies of their fallen comrades with one obsession in mind, to reach and destroy every machine gun that was mowing down our advance.’ These brave men were obeying the orders of the division commander, Major General Charles Summerall, who summed up his tactical thinking on how to deal with machine guns in two brutal words: ‘Charge ’em!’"

‘Charge ’em’ brings to mind an entirely different kind of recklessness today: the credit bubble has reached practically every Middlesex village and farm.

"I was flabbergasted by what is going on in the real estate market – even here in Baltimore," said another member of our Bastille Day party.

"I remember when I left here 4 years ago, there was a townhouse for sale across the street in Fell’s Point. It was advertised at $87,000 and probably sold for less. Well, it’s back on the market – this time for $380,000."

"Vive la revolution!"