The Catch-22 of Inflation Fears and Bond Yields

John Maynard Keynes famously said that speculating on the stock market is like participating in a newspaper beauty contest. In a newspaper beauty contest, readers choose the five prettiest people out of a hundred or so contestants. The winner is he who chooses the five most popular people. Therefore, in order to be successful you can’t just pick who you think is prettiest, but who you think everyone else thinks is prettiest. I find this is a useful perspective to keep in mind when following trends in financial markets.

One such current trend is the increased concern investors have about inflation. Many expect that the massive fiscal stimulus, quantitative easing, and low interest rates will lead to considerable inflation in the future. In this case, the “newspaper contest” perspective would have lead to good short-term investment decisions as many market participants share these fears. Prices of inflation-resistant assets like commodities, precious metals, and TIPS have done well in the last few months as these fears have become more widespread. As I have written before, Gold is likely to stay around $950 or higher as long as there are fears of inflation and the possibility of China increasing its gold reserves.

However, while buying inflation-protected assets is a good short-term investment strategy, I am not sure the fears of inflation are economically valid. First, as Paul Krugman pointed out in a recent Op-Ed, since banks aren’t lending out extra reserves, quantitative easing is not having an inflationary effect. Second, large deficits are not necessarily inflationary. Governments rarely inflate themselves out of debt. The US debt was 120% of GDP after World War II, yet inflation remained low throughout the 1950s.

Government bonds are different from corporate bonds in that quantity does not necessarily imply higher yields. As government debt rose in Japan in the late 1990s, government bond yields fell as more debt was issued.

The opposite has occurred in the US and UK. As more treasuries and gilts have been auctioned off, yields keep increasing. A large reason for this trend is the movement from inflation vulnerable assets like bonds to inflation resistant assets like gold and oil, reinforcing the “back to normalcy” trend I discussed in my previous posts.

Is inflation a threat to the US economy? Yes. Is it as great as a threat as many investors assume? No. The severity of inflation will larely be decided by economic growth. If our economy achieves constant growth, we can grow out of the deficit like we did after WWII, because we’ll have the tax revenues to do it. As for balancing the budget, I am certain Obama will make steps to address this by the end of his first term. Deficit spending is currently the GOP's most potent criticism of the Obama administration.

Paul Krugman wrote in his article, “When it comes to inflation, the only thing we have to fear is the fear of inflation itself.” He meant that the fear of inflation could put political pressure on Obama and lead him to abandon his policies. I doubt this is a legitimate possibility. The real reason to fear the fear of inflation is the effect on treasuries. Though quantitative easing is putting downward pressure on yields, inflation fears are doing the opposite, resulting in what Niall Ferguson calls “a painful tug-of-war between our monetary policy and our fiscal policy.” As long as inflation fears push investors into non-income producing assets like commodities and precious metals, treasury yields will continue to increase, resulting in higher mortgage rates. Mortgage rates recently hit 4.91%, up 75 basis points in only a few days--not a good sign for beseiged homeowners. It is a catch-22: inflation fears are raising borrowing costs, thereby derailing the economic growth needed to prevent inflation.

Sterling's Attempt to Return to Normalcy

It’ll be interesting to see how Sterling fares against the dollar in the next couple weeks. After a sharp drop against the dollar in the fall, Sterling has rallied in May (see chart below). Sterling is currently at a critical point. There are two technical indicators traders will be watching closely. First, there is a support/resistance level at around 1.62 GBP/USD. Second, the 200 day moving average is set to cross the 50 day moving average soon. (It is a sign of upward momentum when a short term average crosses above a long term average.) Therefore, if Sterling continues its rally over the next week it is a good sign the strength of Sterling is sustainable.

Fundamental factors also make this an interesting time. First, the rally comes after UK Chancellor of the Exchequer Alistair Darling revealed a controversial budget that forecast high debt until 2018. The FT described it as a “gamble on a rapid economic recovery and severe spending cuts.” Second, S&P downgraded the UK’s outlook from stable to negative this Thursday. The market responded to this news with a strong sell-off; however, by the next day Sterling was higher than before the news. Fundamentally, Sterling should have fallen more than it did. The reason it didn’t give up its gains is Sterling is in the middle of a broader realignment against the dollar.

The Pound/Dollar example is important to watch because it is a demonstration of the strength of the currency market’s attempt to return to normalcy. Precipitated by the fall of Lehman Brothers, most currencies fell heavily against the dollar during fall 2008. The common consensus was that the dollar was a safe haven during perilous times, though some, like billionaire Jim Rogers (who is very bearish on the US economy, government, and dollar), argued the rise in the dollar came from currency speculators covering their shorts. Either way, as the idea of green shoots has become more widespread, the dollar has fallen in value. One metric to measure this is the CBOE volatility index (the Vix), which has risen and fallen with the dollar. It is not coincidence that Sterling rebounded from the S&P downgrade in the same week the Vix broke 30.

The current return to normalcy was attempted earlier this year in January, though gains in the euro, pound, and yen were quickly eliminated after further negative economic news. This return to normalcy has been a trend in many other asset classes as well. It will continue as further (relatively) positive economic data gives way to gains of hemorrhaged assets like the pound, the euro, corporate debt, and oil.

More on Oil Prices

I want to elaborate a little on why I am bullish on oil. I am not bullish because of industry fundamentals—i.e. I do not think there is more demand than supply. The reason oil is a good buy right now is a question of macroeconomics. As long as our economy is in a downturn and our financial system besieged, the Fed will keep interest rates at 0. This is reflected in the implied fed funds rate (from Cleveland Fed):

Also, the Fed will continue quantitative easing and keep treasury yields low. Third, investor’s risk appetite will return, as we’ve already seen in equity markets. Therefore, investors will start leaving safe US dollar assets like treasuries at greater rates. Because of low interest rates, the US dollar has little support. As the dollar falls, the price of oil will become greater because more dollars will be needed as payment. It’s that simple. (It also doesn’t hurt that the memory of $145/barrel oil is still fresh on speculators' minds.)

CAFE Standards and Oil Prices

What Greenspan called the “solid edifice” of free markets may have been discredited, but its power has not. The power of markets is the seamless aggregation of incentives; therefore, to unleash the full power of the free market, incentives must be properly aligned. Obama’s push for tighter emissions standards is an example of a misaligned incentive that will further disrupt the natural pricing of oil.

As many have pointed out, Obama’s toughening of the Corporate Average Fuel Economy (CAFE) standards is inefficient compared to a fuel tax. CAFE’s problem is it creates artificial incentives for certain vehicle types. Because of CAFE, light trucks and SUVs have gone from 10% of car sales to 50% in thirty years. By making these cars cheaper and smaller cars more expensive, CAFE is indirectly encouraging fuel consumption. Also, it makes new, more efficient cars more expensive in relation to old, inefficient cars.

A fuel tax is a much cleaner incentive because it acts directly on the factor the Government is trying to manipulate—fuel consumption. For example, the CBO estimates a $.46/gallon increase in fuel taxes will lead to a 10% decrease in consumption. This incentive is effective because it acts directly on the price elasticity of demand. The higher CAFE standards on the other hand can expect to reach this goal at six times the cost. This inefficiency comes from the distance between the incentive and the target.

Determining the fair value of oil has always been difficult because of the role speculation plays in the process. It is even more difficult when one takes into account the diverse tax and subsidy policies. (For example, India subsidizes and taxes fuel.) Take a look at this graphic for more information on the extent of fuel subsidies. Fuel subsidizing countries have experienced massive growth the last few years, and, since their domestic demand isn't priced according to the global market, oil demand has grown in correlation with GDP. Morgan Stanley estimated in 2008 25% of oil is subsidized when it reaches the ultimate consumer.

Analysts said the recent oil price increase from $50 to $60 a barrel was not based on “fundamentals,” referring to large inventories. It is hard to see when oil prices have ever been based on fundamentals over the last year. First there was “peak oil exuberance.” Then, after September 2008, oil prices have been closely aligned with the stock market. The reason for this correlation is that many expect oil prices to recover when the economy recovers. People seem to forget oil didn’t comfortably reach $60 until 2006, in the midst of a “forward Minsky journey” asset price inflation.

Nevertheless, the truth is simply there will continually be upward pressure on oil prices. If there are more signs of green shoots, prices will rise or linger above $60. Now that states are in fiscally different positions it will be interesting to see how government policies change—naturally we should expect less subsidies and more taxes. But this will not occur until prices start to cause the same damage they caused last summer. The CAFE standards mean that once prices get high again, it will take longer for the US to adapt, because the economic incentives are indirectly tied to their target. It will take countries with high subsidies, like Indonesia, even longer. CAFE standards and subsidies both decrease the price elasticity of demand. As long as governments enact policies such as these, oil is a safe bet.

China's Subprime

In the fourth quarter of 2007, when US banks first started their subprime writedowns, Chinese banks reported 60% year on year earnings growth. In March 2009, the FT included a large spread in its “the Future of Capitalism” series on how Chinese banks that weren’t even in the top 50 by market cap in 1999 are now the top three—Industrial & Commercial Bank of China, China Construction Bank, and the Bank of China. Recently, these banks reported a year on year 20% increase in issued loans. Considering loans account for 4/5ths of these Banks’ earnings, one would expect a year on year increase in earnings. However, CCB’s profits fell 18.2%, BOC profits fell 14.1%, and ICBC’s profits rose only 6.2%.

The reason for the decrease in earnings is tighter margins and rising credit costs. This quarter alone, credit costs doubled to $2.5bn. This likely indicates trouble for the Chinese financial system in the next 5-10 years. Chinese lending is a top-down process. The government sets lending levels targeted to keep people employed and to prevent instability. The increase in lending in China is not going to dynamic private companies but state owned enterprises and small, inefficient production facilities. STRATFOR reports Chinese lending is creating oversupply as it boosts export industries in an effort to maintain employment, creating a structural mess because of a lack of demand.

Chinese banks are no strangers to bad debt. Starting in 1999, Chinese banks transferred Rmb 2,400bn to four asset management companies (AMCs) in exchange for bonds backed by the People’s Bank of China. These bonds were worth the full face value of the bad debt, even though the loans were only worth 1/3 the amount. This trade left Chinese banks exceptionally well capitalized. The Chinese bad bank scheme reflects the same alchemy of finance that characterized the subprime boom. It is essentially hiding (and mispricing) risk. The AMCs only have to pay back interest on these 10-year bonds. Because their assets are worth 1/3 the face value, the AMCs will never be able to repay the principle when these bonds mature over the next few years. At this point, the government will have to fill the void, but considering current economic conditions, it is more likely for them to rollover the loans and deal with them in the future.

If you combine the old bad debt that was never addressed properly with the billions of new loans that are likely doomed to a similar fate, you get a serious financial problem. Not now, but in a few years, the government will have to make substantial bail-outs. I wrote in my last post on China that being able to control the velocity of money is one of the benefits of an authoritarian regime. It may be a benefit in the short run, but it is its bane in the long run. The Chinese financial system is structurally inefficient. It is simply too young of a system to have fully revealed these inefficiencies.

Shorting the Swine Flu

The FT has an article today comparing the flu outbreak with the economic crisis. The market response to the flu has been similar to that during an economic crisis—irrational and erratic. The powerful effect the swine flu (now apparently renamed H1N1) has had is based on the unpredictability of the system. It could be a pandemic that kills millions of people. But this is highly unlikely. You are more likely to get into a deadly car accident than for this to occur. And the BBC reported today the swine flu is a mild strain that would have to mutate to be deadly.

In Fooled by Randomness, Taleb describes how people focus on risks that are vivid and ignore the abstract, because risk detection and aversion is an emotional process rather than a logical, thinking one. Taleb’s argument is based on Daniel Kahneman and Amos Tversky’s work on how people manage risk and uncertainty, which they called “prospect theory” (it also shows up in Peter Bernstein’s Wall Street classic Against the Gods). An experiment from Kahneman and Tversky showed people will pay more for insurance against a terrorist attack while traveling than for insurance if they died on the trip. Similarly, people in California view floods from earthquakes in California as a bigger threat than any floods in North America. People focus on risks they have vividly imagined.

Last summer, Hurricane Dolly displayed a similar effect. After the strong effect past hurricanes have had on refineries and the price of oil, upon hearing about the hurricane the market responded drastically as if destruction was assured. I was lucky enough to notice this and managed to get in a few nice shorts. I think a similar thing is happening now. The specter of a flu pandemic has lead to much speculation on which firms will profit. For that reason, many small cap biotech firms have ballooned in value. They have already fallen somewhat today, but I think they still have some downside.

I've had some luck with Novavax (NVAX):
And BioCryst (BCRX), though I would wait a day at least: