在岩石和硬地之间
2009-06-08







Between a rock and a hard place

Andy Xie/ June 6, 2009



The combination of growth optimism and inflation fear is catapulting asset markets in the past few weeks. The two should drive markets in different directions. The inflation fear should limit room for stimulus and cause stock markets to retreat. But, the people behind the two concerns are separate. They go their own ways and pump up what they believe in. Stocks and commodities are already behaving like during the giddy days in 2007.



Regardless of what investors or speculators say to justify their punting, the real driving force is the return of animal spirit. After living in fear for over a year, they just couldn’t sit around anymore and decided to inch back. The resulting market appreciation emboldened more people. All sorts of theories began to surface to justify the market trend. As the rising trend has been around for three months globally and seven months in China, the most timid couldn’t take it anymore and are jumping in now in droves. When the least informed and most credulous are in the market, it usually marks market peaking. If the economy rises and grows income, it would produce more funds to fuel the market. But the global economy is stuck in years of slow growth. Strong economic growth won’t follow the current bout of stock market surge. This is a bear market rally. The people that are jumping in now will lose big.



In the past three weeks, the dollar has dived, oil and treasury yield have surged. These price movements exhibit typical symptoms of inflation fear. The inflation fear is complicating policymaking around the world. The US, in particular, could be bottled in. Fiscal stimulus by the Federal Government and liquidity pumping by the Federal Reserve are the twin instruments for propping up the bursting US economy. The fiscal deficit could top $2 trillion (15% of GDP) in 2009. It would add one third to the total stock of the federal government debt outstanding. Such massive supply of federal debt papers needs a buoyant treasury to absorb. If the treasury market is a bear market, the absorption becomes a huge problem.



The US Treasury Secretary, Timothy Geithner, is visiting China. One of his purposes for the trip is to persuade China to buy more treasuries. According to an estimate in a Brookings paper China owns $1.7 trillion of US treasuries and GSE papers (about 15% of the total stock). If China stops buying, it could plunge the US treasury market into deep bear territory. While China not buying will certainly make the treasury market worse, China buying can’t prop up the market.



In the past few years the purchases by foreign central banks have dominated the demand for US treasuries. Central banks have been buying because their currencies are linked to the dollar. Hence, such demand is not price sensitive. The amount of demand is proportional to the US current account deficit that determines the amount of dollars that foreign central banks have. The bigger the US current account deficit, the greater the demand for the US treasuries. This is why the treasury yield was trending down during the bulging US current account deficit period between 2001-08.



This dynamic in the US treasury market is changed by the bursting of the US credit-cum-property bubble. It is decreasing US consumption and the US current account deficit. The US current account deficit in 2009 is probably under $400 billion, halved from the peak. That means that foreign central banks have much less money to buy, while the supply is surging. It means that foreign central banks no longer determine the treasury pricing. American institutions and families are now the marginal buyers. This switch of who determine prices is shifting the treasury yield up greatly,



The 10 year treasury yield historically averages about 6% with inflation of about 3.5% and real yield of 2.5%. They reflect the preferences of marginal buyers in the US. Foreign central banks have pushed down the yield requirement massively over the past seven years. If the marginal buyers become American again, as I believe, treasury yields will surge much more from the current level. Inflation in future will average more than 3.5%, I believe. Some policy thinkers in the US believe that the Fed should target inflation rate between 5-6%. The treasury yield could rise to 7.5-8.5% from the current level of 3.5%.



The massive supply of the US treasuries would only worsen the market. The Federal Reserve has been trying to prop up the treasury market by buying over $300 billion. Its purchase has backfired. Treasury investors are terrified of the inflation implication of the Fed action. It is equivalent to monetizing national debt. As the Federal deficit will remain sky high for years to come, the monetization could become much larger, which might lead to hyperinflation. This is why the treasury yield has surged so much in the past three weeks.



One possible response is to finance the US budget deficit with short-term financing. As the Fed controls the short-term interest rate, such a strategy can avoid the pain of paying high interest rate by the Federal government. But, this strategy could crash the dollar.



The dollar index-DXY has dropped 10% from the peak in March, even though the US trade deficit has declined substantially. It reflects the market’s expectation that the Fed’s monetary policy will lead to inflation and dollar crash. The cause of dollar weakness is the outflow of US money, in my view. It is the primarily cause of the surge in emerging markets and commodities. Most US analysts think that the dollar weakness is due to foreigners buying less of it. This is probably incorrect.



The dollar weakness can limit the Fed’s policy. It heightens the risk of inflation; weak dollar imports inflation and, more importantly, increases inflation expectation, which can be self-fulfilling in today’s environment. The Fed has released and committed $12 trillion (83% of GDP) in bailing out the financial system. This massive overhang of money supply would cause hyperinflation if it is not withdrawn in time. So far the market still gives the Fed benefit of the doubt that it would withdraw the money. The dollar weakness reflects that the market is wavering in its confidence in the Fed. If the wavering continues, it could lead to dollar collapse and make inflation self-fulfilling. The Fed may have to make changes in its stance, even token gestures, to assure the market that it won’t let so much money out there. For example, signaling rate hikes would soothe the market. But, the economy is still in terrible shape: the unemployment rate is already at 9% and may surpass 10% this year. Any suggestion of hiking interest rate would dampen growth expectation. The Fed is caught in a rock and a hard place.



Oil price has doubled from the March low, even though the global demand continues to decline. The driving force again is the inflation and weak dollar expectation. As the US-based funds flee, some of it has flowed into oil ETFs. Its impact was initially on futures price, causing huge gap between cash and futures prices. The gap increased inventory demand as investors tried to profit from the gap. Rising inventory demand has caused the spot price to reach parity with futures price. Rising oil price causes inflation and depresses growth. It is a stagflation factor. If the Fed doesn’t rein in the weak dollar expectation, stagflation will arrive sooner than I expected.



Stagflation in the 1970s spawned the development of rational expectation theory in economics. Monetary stimulus works by fooling people into believing the value of money while the central bank is cheapening it. This perception gap stimulates the economy by fooling people into demanding more money than they should. Rational expectation theory clarified the underpinning for the Keynesian liquidity theory. However, as they say, people can’t be fooled three times. As central banks tried to use stimulus to solve structural problems in the 70s, their stimulus didn’t work. As they tried again and again, people saw through it and began to behave accordingly, which translated monetary stimulus straight into inflation without stimulating economic growth.



Rational expectation theory discredited Keynesian theory and laid the foundation for Paul Volker’s tough love policy that jagged up interest rate massively to trigger a recession. The recession convinced people that the central bank was serious about cooling inflation and adjusted their behavior accordingly. Inflation expectation dropped sharply afterwards. The credibility that Paul Volker brought to the Fed was exploited by Greenspan who kept pumping money to solve economic problems. As I have argued before, special factors made Greenspan’s approach effective at the same. Its byproduct was asset bubbles. As environment has changed, rational expectation theory will again exert force on monetary policy impact.



The movements in the treasury yield, oil and dollar show the return of rational expectation. Policymakers have to take actions to dent the speed of its returning. Otherwise, the stimulus will lose traction everywhere and the global economy will slump. I expect at least the US policymakers to make gestures to assuage the market’s concerns about the rampant fiscal and monetary expansion. The noise would be to emphasize the ‘temporary’ nature of the stimulus. The market will probably be fooled again. It will wake up fully only in 2010. The US has no way out other than printing money. As a rational country it will do what it has to do regardless of its rhetoric. This is why I expect a second dip for the global economy in 2010.



While inflation expectation is causing part of the investor community to act, the rest are betting on strong economic recovery to come. Massive amounts of money have flowed into emerging markets, making it look like a runway train. Many bystanders can’t take it anymore and are jumping in. Markets, after trending up for three months, are gapping up. Unfortunately for the last-minute bulls the current market movements suggest peaking. If you buy now, you have 90% chance of losing money when you try to get out.



Contrary to all the noises in the market, there are no signs of a significant economic recovery. The so-called green shoots in the global economy are mostly due to inventory cycle. Stimulus might juice up growth a bit in the second half of 2009. Nothing, however, suggests a lasting recovery. Markets are trading on imagination.



The return of funds flow into property is even more ridiculous. A property burst usually lasts for more than three years. The current burst is bigger than usual. The property market is likely to remain in bear territory for much longer. The bulls are talking about inflation as the bullish factor for property. Unfortunately, property price has risen already and needs to come down even as CPI rises for the two to reach parity.



While rational expectation is returning to part of the investment community, most are still trapped in institutional weaknesses that make them behave irrationally. The Greenspan era has nurtured a vast financial sector. All the people in the business need something to do. Since they invest with other people’s money, they are biased towards bullish sentiment. Otherwise, if they say it’s all bad, their investors will take back the money, and they will lose their jobs. Governments know that and create noises to give them excuses to be bullish.



This institutional weakness has been a catastrophe for people who trust investment professionals. In the past two decades, equity investors have done worse than owning bonds in the US market, lost big in Japan and emerging markets in general. It is astonishing to see how a value-destroying industry has lasted for so long. The bigger irony is that the people in this industry have been 2-3 times as well paid as in other industries. The key to its survival is volatility. As markets collapse and surge, it creates the possibilities for getting rich quickly. Unfortunately, most people don’t get out when markets are high like now. They only go through the ride.



Indeed, most people who invest in stock market get poorer. Look at Japan, Korea, and Taiwan. Even though their per capita incomes have risen enormously in the past three decades, the investors in their stock markets have lost money. Economic growth is a necessary but not sufficient condition for investors to make money in stock market. Most countries, unfortunately, don’t possess the conditions for stock markets to reflect economic growth. The key is good corporate governance. It requires the rule of law and good morality. Neither is apparent in most markets.



It is a widely accepted notion that long term investors in stock market make money. Actually, it’s not true. Most companies don’t last for more than twenty years. How could long term investment make money for you? The bankruptcy of General Motors should remind people how ridiculous this notion is. General Motors was a symbol of the US economy. It is a century old company but has succumbed to bankruptcy. In the long run all companies go bankrupt.



Property on surface is better than stock market. It is something physical that investors can touch. However, it doesn’t hold much value in the long run either. Look at Japan. Its property price is lower than three decades ago. The US property price will likely bottom lower than twenty years ago adjusting for inflation.



China’s property market holds even less value in the long run. Chinese properties are sitting on land leased for seventy years for residential properties and fifty years for commercial properties. Their residual values are zero at the end. The hope for perpetual appreciation is a joke. If you accept zero value at the end of seventy years, the property value should only be the usage value during these seventy years. The usage value is fully reflected in rental yield. The current rental yield is half of mortgage interest rate. How could properties not be overvalued? The bulls want buyers to ignore rental yield and focus on appreciation. But, appreciation in the long run isn’t possible. Depreciation is, as the end value is zero.



The world is setting up for a big crash again. After the last bubble burst, governments around the world have not been focusing on reforms and are trying to pump a new bubble to solve the existing problems. Before inflation appears this strategy is working. As inflation expectation rises, its effectiveness is threatened. When inflation happens in 2010, another crash will become inevitable.



If you are a speculator and have confidence that you would get out before it crashes, then this is your market. If you think this market is for real, you are making a mistake and should get out as soon as possible. If you have lost money last three times you entered the market, you should stay away from this one as far as you can.