Pondering the Great Dichotomy While the Fed Meets

The Fed meets today to discuss its next move in the exciting game of "Re-inflate the Bubble." Sure the Fed thinks it's playing whack-a-mole against lousy economic data. Every time a bit of bad news peeps its head out into the supposedly robust economic recovery, the Fed whacks it down with some other ingenious bit of monetary easing. Our monetary authorities are just looking for more and more ways to flood our financial markets with free money, at the behest of Wall Street, so financial assets will rise in value so all of those underwater residential, commercial and other loans can be refinanced or repackaged and sold without another financial catastrophe. You see, it's working really well. Deflation is our worst enemy. Today anyway. That's what Bill Gross says so it must be true. So if we need another $2 trillion in quantitative easing, so be it. Right?

In the economic bad news/deflation corner:

• Fannie and Freddie continue to bleed cash, albeit at slower rates than before. After posting their most recent losses, the mortgage lenders increased their borrowing from the Treasury to a total of $148 billion. Mind you, Fannie and Freddie are 90% of the mortgage market, so regardless of the economic health of the rest of the banking sector, the true state of the mortgage market is reflected by Fannie and Freddie's performance.

• Productivity slowed by a unexpectedly jarring 0.9%. So much for the theory about robust profit growth leading to increased productivity leading to increased hiring.

• Unemployment remains stubbornly high at 9.5% and will likely not decrease unless productivity continues to increase.

In the good news/inflation corner:

• Money is flooding the system and investors have nowhere to go with it, so they are just piling into anything reasonably safe with a yield and forcing rates lower. The WSJ has two articles this morning, one on MLP shares ripping on zero fundamental improvement this year and another on the relentless march lower in corporate bond yields. The FT has commentary on how the bottom line at strong companies is getting stronger while weak companies are floundering. Case in point: IBM can issue debt at 1%. Can you?

I call this the Great Dichotomy. Part of the economy is flashing deflationary signs, the other inflationary signs. What's a good Fed to do?

Zero Interest Rates, But Where's the Inflation

Currently deflation is winning the first couple of rounds in the inflation/deflation debate raging among economists, analysts, and investors. CPI/PPI remains subdued. GDP growth is sluggish as evidenced by this morning's GDP report, which showed a slow down in second quarter growth to a 2.4% annualized rate. Wage price inflation? Forget about it. You have to have a job first before you demand higher wages. Commodities surging? Yeah, cocoa prices hit all time highs, mostly due to some jokers at a commodities hedge fund who are clearly trying to build the world's largest chocolate bar, because why else would you take delivery of the biggest amount of physical cocoa in 14 years? But the price of gold hasn't really kept up with the gold bug crowd's expectations. Even hedge fund manager John Paulson has suffered losses in his funds, and he had managed to expertly time every hairpin turn in the market for some time.

So the Fed is keeping interest rates at zero, and anyone who's had any economics classes knows that exceedingly friendly monetary stimulus coupled with exceedingly friendly fiscal stimulus should cause runaway inflation. Except that hasn't happened yet. Instead prices for everything have either taken a breather from heading lower (i.e. housing,) or are still actively going lower (i.e. your favorite retailers are having a sale.)

The only thing staging a monster rally is financial assets. The stock market ripped, and is currently taking a reflective pause to decide if it can defy all the recent rotten economic news to rip ever higher. Heck even the Fed's portfolio of Maiden Lane securities is staging a big comeback. Paper profits on "formerly" toxic securities! But the real out-performer is the bond market. Interest rates on treasuries are at record lows. This was the busiest July on record for sales by junk issuers. Financial firms are jumping on the bandwagon, feverishly issuing debt at record low rates before the window of opportunity closes. According to the FT:

Wall Street executives say recent debt issues were triggered by “reverse inquiries” – informal approaches by fundmanagers seeking to raise their exposure to a sector they had largely avoided since the crisis.

Fund managers have so much cash with nowhere good to go with it, so they're begging financial firms to issue debt. Why financial firms? Because they are too big to fail. So you get slightly higher rates than treasuries, with the US government's stamp of approval on it. What is too much money chasing too few goods? I think that's called inflation.

Seems like the "reverse inquiry" situation was exactly what was going on in the mid-00's, when Wall Street needed subprime product to continue to feed the CDO machine. All the demand for subprime mortgages perpetuated the frenzy in housing. Again CPI/PPI was subdued and interest rates were low because there was no "inflation," just a massive financial bubble in the making. Will the story end the same way this time?

Inflation VS. Deflation Inside the Fed

The WSJ has a somewhat troubling front page piece on the current debate raging inside the Fed over what poses the biggest threat to the US economy. It seems as if our fearful economists who control the US money supply can't agree over what to fear most: inflation or deflation. Here I thought the fed was busy genially discussing the nuances of a zero percent vs. .25% fed funds target. It turns out, they can't even diagnose the underlying economic issues that need to be targeted. It's as if our leading economists have turned into an episode of "House" where Dr. Foreman is arguing over some treatment that will kill the liver to save the heart, while Thirteen thinks it's a brain tumor. Yet every episode of "House" neatly resolves itself when the brilliant Dr. House has some sort of epiphany that leads him to discover that the patient was just pregnant. And then Dr. Cuddy adopts the unwanted child.

If only economics were so cut and dried. Markets seem to have concluded that the Fed has figured out how to extricate itself from the massive experimental quantitative easing and zero percent fed funds policies of the past couple of years without doing any harm. Interest rates are still relatively low, volatility is sagging at pre-crisis levels, bond spreads have tightened and equities have rebounded sharply. Commentators have resurrected the "goldilocks economy" phrase from the mid-oughts that served us so well right before the economy crumbled and went to Hell.

Whether the inflationists or deflationists are right won't likely be determined for some time, particularly since Fed policy has so much to do with the outcome. Yet Janet Yellen, widely rumored to be the next Fed Chairman is siding with the deflationists. That, my friends, is why I'm siding with the inflationists. No disrespect to Ms. Yellen, but there is one thing I know for certain: the Fed will not perform its duties perfectly. It always has and always will overshoot in one direction or another. If the person leading the charge is leaning towards a more accommodative monetary policy then we're headed towards much higher inflation down the road.

Cash Piles Grow in Bank Deposits and Money-Market Funds

Admittedly, the headline should read "Finance Bloggers Desperate for Material on Slow News Day," but this Bloomberg story on growing cash piles is the best I could come up with for interesting reading today.  According to Federal Reserve data complied by Leuthold Group and Bloomberg, $8.85 trillion dollars are currently held in cash, bank deposits and money-market funds, equal to 74% of the market value of US companies.  This represents the highest ratio of cash to market value since 1990.  Apparently, the eight previous times that cash peaked compared with the market capitalization the S&P 500 rose an average 24% in six months.  Note, however, that the rise in the S&P is dependent on knowing the actual peak, which makes this bold observation less meaningful.  The statement is similar to saying "100% of the time after the S&P reached its peak, it declined."  So while 74% seems high, who says this is the peak and that the ratio won't go to 120%?  

In theory, investors at some point will grow weary of earning 0% returns on their money, and start to dip their toes back into higher risk fare.  However, if we become trapped in a deflationary spiral, investors will have little incentive to part with their cash and return to the stock market.  So the big question remains:  Are we in for a period of deflation, as treasury yields suggest or will another bubble be stoked by the Fed's zero interest rate policy?  I am leaning towards the latter, albeit after a brief period of deflation due to asset prices over-shooting to the downside.  While I believe that some assets have already suffered significant corrections, many have not, as I will discuss in more detail in my forthcoming posts on predictions for the new year.  Certainly, the inflation versus deflation argument stands to be one of the most important of 2009, as the answer will determine if and when investors decide that stocks are worth the risk again.