Wednesday, July 21, 2010

Has Deflation Arrived?

Stocks fell and treasuries soared today after Ben Bernanke called the economic outlook "unusually uncertain".

Here are a few of his comments:

"WASHINGTON (Reuters) - The Federal Reserve stands ready to ease monetary policy further if the budding U.S. economic recovery stumbles, Fed Chairman Ben Bernanke said on Wednesday, as he called the outlook "unusually uncertain."
Policy makers, however, still expect growth to be sustained despite a recent softening in the economy evident in data, Bernanke said in congressional testimony.

The Federal Reserve is continuing "prudent planning for the ultimate withdrawal of monetary policy accommodation" even as it recognizes the uncertain outlook, Bernanke told the Senate Banking Committee.

"We remain prepared to take further policy actions as needed to foster a return to full utilization of our nation's productive potential in a context of price stability,"

The U.S. central bank has kept interest rates near zero percent since December 2008 and has bought more than $1.5 trillion in mortgage and Treasury bonds to fight the deep recession and virulent financial crisis.

The economy resumed growth about a year ago, but stubbornly high unemployment, a fresh drop in housing activity and a slowdown in manufacturing have raised fears of a "double-dip" recession.

Stocks fell sharply as Bernanke testified. Some investors were surprised by the amount of time Bernanke spent in his prepared remarks discussing the Fed's exit strategy rather than possible measures to lower borrowing costs further. Others were taken aback by his economic assessment."

My Take:

Ben hardly sounded confident during his testimony.  

The bond market wasn't a big fan of his speech either which was reflected in the 10 year today.  In fact, the move down today on the TNX broke a key technical level as far as I am concerned:

Aside from the QE announcement, the TNX hit a new low.  The last time we saw the 10 year down here was when Greenspan slashed rates in response to the tech crash.

The low rates seen during this period was the fuel that Wall St then used to create the famed housing bubble.

The fact that we broke threw these lows over the past few days is significant, and I wouldn't be surprised to see the trend continue.  

The bond market is basically telling us that we are about to see a Japanese style deflationary collapse. 

The Japenese 10 year has collapsed during this period and still have not recovered 20 years later:


Bernanke has always been extremely concerned about deflation and it's destructive positive feedback loop where prices eventually collapse as demand evaporates. 

Basically what happens is buyers head to the sidelines as prices fall thinking that they will get a better deal if they wait.

This induces more price drops which then pushes more people to the sidelines and this continuous cycle continues until is basically destroys pricing power.  This then ultimately destroys the banks as their balance sheets become filled with now over priced assets.

This loop also takes the market down with it.  Take a look at the Nikkei during Japan's bout with deflation:

The Nikkei now sits at 9300 today after peaking at almost 39,000 back in 1989.  It's easy to see why Ben is so afraid.  Japan hasn't ever fully recovered from their credit bubble collapse.

The Bottom Line 

The inflation/deflation debate for now has been answered.  The risks have clearly leaned toward deflation.  The bond market is clearly signaling this as they pile into treasuries.

The question now becomes do we have enough control over the deficit to keep the bond boys there?  If Ben attempts another QE2 then they may decide to head for the hills.  Let's hope this doesn't happen because the USA will look a heck of a lot like Greece if it does.

After today's speech I don't think Ben is ready to head down the QE2 road yet.  I have to give him some kudos for not panicking and showing some restraint here.  He even talked about reducing the deficit.

Let's see if he can stick to his guns as the economic crisis intensifies.  I hope that Ben is starting to realize that you cannot force someone to borrow via lower rates when they don't have the desire or ability to do so.

The dangerous combination of high unemployment and falling prices that we are now witnessing is sending our market straight towards deflation and there is nothing the Fed can do to stop it.

What scary is our situation in some ways is worse than Japan's.  When deflation hit Tokyo they had an export economy to fall back on to soften the blow. 

Our consumption economy is not setup for deflation.  If the consumer heads to the sidelines(as it appears they already have in May/June) our economy will be hit by something this country hasn't seen since The Great Depression.

Greenspan said we hit a temporary wall in June.  The problem is that wall is filled with 3 feet of concrete.  What really happened is this country hit a wall in terms of the consumer's ability and/or willingness to borrow.

There is no economic recipe to turn this around other than lots of time, jobs,  and lower prices. 

Disclosure:  No new positions at the time of publication.


Forrest Drake said...

Monetary easing is a great strategy and can work forever, just ask in Zimbabwe how great they are doing.

Jeff said...


I hear ya.

There has been no straight printing over here yet.

The Fed would prefer deflation over hyperinflation because the banks all hold dollars.

We will see how desperate the Fed becomes as this situation worsens.

So far the bond market is betting against printing and these guys are rarely wrong.

We'll see.