Morning Report: Inflation versus Deflation

Vital Statistics:

S&P futures4,61417.2
Oil (WTI)84.010.41
10 year government bond yield 1.59%
30 year fixed rate mortgage 3.30%

Stocks are higher this morning ahead of a big week for data and earnings. Bonds and MBS are down.

In terms of economic data, we will get the ISM numbers this week, along with productivity and the jobs report on Friday. The Street is looking for 400k jobs, unemployment to fall to 4.7%, and a 4.8% increase in average hourly earnings.

The Federal Open Market Committee meets on Tuesday and Wednesday. No changes are expected to the Fed Funds rate, however the consensus seems to be that the Fed will announce its first reduction in the pace of Treasury and MBS purchases.

MBS spreads are still pretty tight compared to history, and especially compared to the 2013 taper tantrum. I think the difference today is certainty; in 2013 the menu of options for the Fed was much wider. In other words, the markets in 2013 thought the Fed could actually sell their portfolio of Treasuries and MBS into the market. We now know that they probably won’t even let it run off naturally. The Fed will probably reduce its purchases by $10 billion a month and will go into maintenance mode – in other words re-investing maturing principal payments back into the market – by summer.

Speaking of MBS spreads, mortgage REITs Annaly and AGNC Investment reported increases in book value for the third quarter. This is a far cry from 2013, where book values were cut in half and the mortgage REITs cut their dividends big time.

Troubled Chinese property developer Evergrande made another interest payment on Friday, which prevented a default. Another troubled Chinese developer (Yango Group) has asked international bond holders to swap its dollar bonds into a new bond. Yango bonds are trading around 20 cents on the dollar, and the cascade of Chinese real estate companies heading into troubled waters signals we might be witnessing the start of an epic real estate bust.

IMO, this will send another deflationary wave around the globe. It is worthwhile to distinguish between deflation and inflation. Inflation is “too much money chasing too few goods.” It is a monetary and supply issue. It describes the current setup in the US right now.

Deflation is a credit issue, and it happens when asset prices are falling. This makes anyone who borrowed a lot of money insolvent. This is what China is experiencing. Entire cities were built “on spec” and it looks like they will never get filled. Whoever lent money for those projects will probably get nothing on that investment. This means banks will have to start writing down assets and liquidating what they can. The Chinese government will try and manage the crisis, but this one will be epic.

The playbook for countries in this sort of spiral is to devalue the currency. The first thing FDR did (after confiscating everyone’s gold) was to change the gold / dollar exchange rate. We saw the same thing in the Asian Tiger crisis in the late 90s. China manages the exchange rate, and since it has capital controls, it can pretty much set it wherever it wants.

That means Chinese investors are going to pile into Treasuries since they will immediately reap a huge gain on that investment when the yuan devalues. It will also cut the prices of Chinese goods entering the US which could help the inflation issue.


Author: Brent Nyitray

In the physical sciences, knowledge is cumulative. In the financial markets, it is cyclical

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