The deflationary depression thesis this blog has been forecasting is right on track. Despite U.S., European and Japanese central bank goals of higher inflation and historically unprecedented qualitative easing (money printing), government statistics on price inflation show low, declining and even negative rates of price inflation, with slowing economic growth and even economic contraction.
In the U.S., the cost of living fell 0.3 percent in November, the largest monthly drop since 2008, with the 12 month number clocking in at a 1.3 percent increase, well below the Fed’s stated 2 percent goal. With energy prices crashing in December, lower inflation and even deflation is on the way.
Federal Reserve Bank of Chicago President Charles Evans said today the U.S. might not hit the Fed’s target inflation rate until 2018; so much for the power of the Fed!
The eurozone inflation rate turned negative for the first time since October 2009, as the annual rate is expected to be minus 0.2 percent in December 2014, down from 0.3 percent (annualized) in November, according to a flash estimate from Eurostat, the statistical office of the European Union. Only two EU countries, Austria and Finland, were above one percent inflation.
Japanese annual core (minus fresh food) consumer price inflation slowed for a fourth straight month in November. Stripping out the effect of the recent sales tax hike, the annual rate was 0.7% in November, down from 0.9% in October.
Many believe government statistics are politically motivated, so ignore the absolute numbers and focus on the trend, which is clearly down. In fact, playing Devil’s Advocate, there is a case to be made the official numbers are too high!
Consumer prices around the world are pulling back so rapidly, along with the collapse of oil prices, that official measures of inflation have yet to capture the magnitude of the decline. But the Billion Prices Project, now known as the State Street PriceStats inflation series, which scrapes the Internet daily to capture changing prices online, is recording a significant and broadening plunge in consumer prices.
The PriceStats index was actually running a little higher than the Labor Department’s Consumer Price Index (CPI) this summer – reaching about 2.5 percent in June and July – and has now declined by 1.5 percentage points, compared with the 0.4 percentage point drop in the CPI. The official CPI number (November) is at 1.7 percent compared to the one percent annual rate calculated by PriceStats, interestingly, these are the same official numbers and PriceStats numbers for all OECD countries as of December 16.
This blog certainly agrees the 5 percent stated GDP growth for the third quarter in the U.S. is about as misleading as government statistics can get. While the “machine” may have spitted out this number, it could only be due to increased spending from Obamacare mandates. The U.S. economy is certainly not growing this well with labor force participation continuing to decline, a strong dollar hurting exports, our main trading partners growing (some) at two percent or less, and consumer spending barely growing.
The European Commission predicted real GDP growth of 1.1 percent for the euro area in 2014 as recently as October, but these numbers have since been revised downward to 0.8 percent. Japanese GDP contracted 0.5 percent in the third quarter.
The collective wisdom of the “market” agrees. If the market foresaw inflation, interest rates would be much higher. For the first time in history, the average 10 year bond yield of the U.S., Japan and Germany fell to less than one percent, according to Steven Englander, global head of G-10 foreign exchange strategy of Citigroup. This is even more amazing given the truly massive amounts of government debt, especially in Japan.
As the economy slides into a deflationary depression, investors’ fears of declining incomes and the possibility of the loss of principal due to bankruptcy and default will cause investors to sell their bond holdings, especially for riskier debt. When bonds are sold, rates rise to attract new buyers. Rates on the weakest issuers rise first, but eventually even to supposedly “risk free” government debt.
The spread between the Barclay’s U.S. Corporate High Yield Index (weak issuers) over Treasury debt was 3.2 percent in June; it is now approaching 5 percent! So, even though interest rates on Treasury debt have been declining, our short position in JNK has increased in value as junk bonds have been declining in price. This spread can and will continue to increase. In the subprime crises of 2008, the spread reached more than 20 percent!!
Not only will the spread increase, but Treasury debt rates appear poised to rise as well. The 10 year Treasury yield actually bottomed way back in July of 2012. It has since been rising with classic higher highs and higher lows, yet bullish sentiment has reached an extreme.
Yesterday’s Daily Sentiment Index (DSI) reached 97% meaning 97% of traders are bullish. This is an astounding extreme, what Wall Street calls a “crowded” trade; with 97% of investors on one side of the boat, the boat is likely to tip over! As a contrarian, this fact alone would make me want to bet on the other side of the trade — Treasury debt yields are going to rise and the prices of Treasury debt will fall.
There is more though to this analysis. Treasury debt has traded and closed above the upper boundary of a two standard deviation mean of the monthly price for over four months. Again, this is an astounding statistic. Not only will prices revert to the mean, they will typically continue on the reverse extreme.
A reversal in interest rates is inevitable; interest rates will rise. This blog tends to be slightly early, so stick with the trade, it will be profitable. When rates rise, the value of existing debt goes down. A trade could be placed on almost any category of debt and do well, but some niches will likely do better than others.
Student loans now exceed one trillion dollars. Many recent grads are under- or unemployed.
Sub-prime lending is rampant in automobile loans, especially risky is the debt used to buy GM cars.
Depending on whose numbers you use, junk bonds issued to energy companies represent somewhere around 18-20% of the outstanding total and accounted for approximately 60% of all 2014 issueances; many of which will default due to rapidly falling oil prices.
The government Law of Unintended Consequences strikes again. The unprecedented Qualitative Easing has led to an unbelievable mispricing of junk (high yield) bonds. This is a bubble for the ages. This market is like an athlete on steroids; it performs well for a while, but never ends well.
There is already a double position recommendation on JNK, so a new recommendation is being made — shorting the high yield debt of emerging countries. When U.S. companies catch a cold, these companies will catch pneumonia. The problems of declining sales and profits from the deflationary depression will still need to be overcome and there is an added hurdle in that the recent strength in the dollar will cause even greater problems for foreign companies attempting to repay dollar-denominated debt as their earning will be worth less in dollars.
Short the Wisdom Tree Emerging Markets Debt Fund (ELD), current price $41.24. The stock has already dropped 15% from its summer highs, while interest rates have been declining, so when interest rates start rising again, this stock will drop even further. Make the investment double your normal position sizing.
In a deflationary depression, cash is king and debt is death!
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