Saturday, November 22, 2008

Merrill's Rosenberg: Deflation is Here!

Good Afternoon Folks

A few comments before I go watch some college football! Here is Merrill Lynch's David Rosenberg's most recent update. Sorry, no link here folks. David's major concern is deflation next year. I am a big fan of this guy as you all well know.

Take a look:

"The CPI and deflation

Prices dropped in October. More to come.

Headline CPI dropped by 1% for October, the largest monthly decline in the 60-year history of the series, and core CPI declined by 0.1%, the first decline since 1982. We expect the November data to be even softer. The numbers suggest that businesses are trying to counter a massive drop-off in demand by cutting prices, and the price cuts they have taken so far are not doing the trick. With unemployment increasing, price competition will only intensify. That suggests that there is a genuine risk that the US economy could fall into a corrosive deflationary phase, one in which inflation turns negative while aggregate demand is weak.

CPI likely to deflate year-over-year in 2009

This is a trend in the making, in our judgment. Our models indicate that, by the second quarter of next year, there will be sequential declines in the CPI, and the index will be deflating on a year-on-year basis for the first time in five decades. The last time that occurred, the funds rate was 1% and the 10-year Treasury mote yield was hovering around 2-1/2%.

Interaction of aggregate supply & demand drives inflation

From a top-down perspective, what drives inflation are the shapes and the interaction of two different curves – the economy’s aggregate supply curve and the aggregate demand curve. The movements of these curves indicate where the “output gap” is at a particular time – the difference between the level at which the economy is actually operating and the level at which it would be operating if it were running flat-out at full employment.

In other words, the gap measures the degree of slack in the labor and product markets. According to our models, the output gap, currently at 2%, is right where it was the last time the Federal Reserve had cut the funds rate to 1% and when the yield on the 10-year note was hovering near 3.5%. That was during the summer of 2003. The difference, of course, is that back then the housing bull market was in full swing, the credit expansion was about to turn parabolic, and we were on the verge of a five-year upswing in profits, commodities, equity valuations,and the economy. In the year after the mid-2003 cut in the funds rate to 1%, real GDP expanded 5% and that output gap was sliced in half.

Output gap to widen to a never-before-seen level

Barring a further large dose of monetary easing and major fiscal stimulus, our models predict that the output gap is going to widen to 8% by the end of 2009. That’s a magnitude that we have not entered before. The extent to which the inevitable deflation will be sustained beyond 2010 is likely to hinge critically on the government’s ability to bolster aggregate demand growth. We sincerely wish the Fed and our fiscal policymakers good luck in dealing with this state of affairs. Deflation is a pernicious development insofar as it raises the real cost of debt and debt-service and, as a result, frustrates the private sector’s moves toward balance sheet improvement"

Bottom Line:

Mr. Rosenberg is basically telling you that he expects to see deflation at an unprecedented scale. Notice in the chart above, the last time we saw prices on assets drop anywhere near this far was in the early 80's when interest rates well over double digits as we fought the wicked inflation that haunted us in the 1970's.

The fact that this oncoming deflationary period is expected to surpass the early 80's deflation due to high interest rates is a frightening proposition. This basically tells me we are pretty screwed unless Obama pulls a rabbit out of his hat.

This does not bode well for housing prices or any other assets prices over the oncoming year. There is still no rush to go and buy a house right now folks! As you can see, Rosenberg expects a total freefall on assets in 2009 from a pricing perspective. Go read about Japan's deflation if you want to see how devastating hte effects of deflation can be. You can take a look at an old post of mine to see what it did to Japan's stock market.

A few reads:

A great commentary here from Bloomberg's Jonathan Weil. Why even get involved in this rigged game on Wall St?

3 more bank failures announced Friday

Until next time!



Anonymous said...

Jeff, you are talking about rigged games? You must be kidding me. Guess what happened on Friday afternoon? Our president-elect Obama and his team short squeezed the hell out of the bears. This was done on purpose. Candidate of change? Oh yeah! I would say same ol', same ol'.

Jeff said...


Oh yeah.

I totally agree. What made it even worse is it was options Opex which killed many bears holding short options.

That was a pretty shady move. Just what we need! More games and less transparency!

Thats why I am putting my focus elsewhere. I am starting to get into gold as you can see. I am also starting to look at natural resouce stocks.

Once the VIX drops I am justg to buy a bunch of long term PUTS so I can avoid this volatility.

This is becoming a joke over here.

Anonymous said...

What do you mean by "over here"?

Jeff said...


The US markets.

I will still dable in them but for the most part my money will stay on the sidelines.

The manipulation and desperation in the US markets is at unprecedented levels.

The economic nimbers are going to continue to look terrible and get much worse.

The Fed and Treasury will take riskier and riskier chances as they attempt to save the economy.

This will result in crazy, unpredictable moves in the stock market and also increase the chances of some type of economic disaster like a bond market dislocation.

Note what Roubini said yesterday:

"This is why now a desperate Treasury is starting to think about using the remaining TARP funds to directly unclog the unsecured consumer debt (credit cards, student loans, auto loans) market and the securitization of such debt. Desperate times required desperate and extreme actions.

Even “Crazier” Policy Actions Are Required to Reduce Long Term Market Interest Rates

But even more desperate or “crazier” monetary actions are needed to address the increase in real long term market rates. These actions are needed to prevent deflation from setting in, to reduce the credit spread (the difference between long term market rates and long term government bond yields) and to reduce the yield curve spread (the difference between long term government bond yields and the policy rate).

Thus, dealing with this deadly combination of deflation, liquidity traps, debt deflation and defaults that I termed as global stag-deflation may be the biggest challenge that U.S. and global policy makers may have to face in 2009. It will not be easy to prevent this toxic vicious circle unless the process of recapitalizing financial institutions via temporary partial nationalization of them is accelerated and performed in a consistent and credible way; unless such actions are combined with massive fiscal stimulus to prop up aggregate demand while private demand is in free fall; unless the debt burden of insolvent households is sharply reduced via outright large debt reduction (not cosmetic and ineffective “loan modifications”); and unless even more unorthodox and radical monetary policy actions are undertaken to prevent pervasive deflation from setting in.

Thus, while the Fed may pursue radical, “crazy” and “crazier” monetary policy actions the true policy responses to the risk of deflation may lie elsewhere: when monetary policy is in a liquidity trap a properly-targeted fiscal stimulus is more appropriate and effective; cleaning up the financial system and properly recapitalize it is necessary"

Jeff said...

Bill FLeckenstein has a great commentary on this same subject of market manipulation. Unintended consequences anyone?:

"Capitalism, free enterprise and free markets have all been given a bad name. Not because they are inherently bad but because of the people who have meddled with them.

When government knuckleheads interfere with capitalism, you can bet the law of unintended consequences will be quick to rear its head.

Interfering with the markets was a function of the Federal Reserve during Alan Greenspan's reign. That meddling was a major contributor to the tremendous edifice of debt and speculation that had built up over the past 20 years."