Replies to post #207897 on Zeev's Turnips Patch-No Politics (ZEEV)

[M3]

ml,

Would you mind elaborating on your positioning for the year, ST, IT, LT?

Are you still basically holding your gold longs, gg, wht, etc?

If you recall awhile back I posted to you that there is no ppt, I think you missed the humor there as I was being incontrovertibly facetious.

I see a st rally 2/26-3/5, a correction into 4/26, a spring summer rally where the majority of the long gains will be made for the year, late summer we pullback or head sideways into the election, blurry post election, maybe some santa rally, then the wheels come off and we crash 05.

Highly respect your views, and glad to see you coming out of hibernation, hope your health is bullish.

All the best,

M3

[basserdan]

*** Stephen Roach (3-5-04) ***


Global: A Time for Courage

Stephen Roach (from London)
March 5, 2004

In its most practical sense, macro is best at identifying risks. And in my view, the balance of risks in the US economy has shifted. It was just about a year-and-a-half ago when I first sounded the alarm on deflation (see my 14 August 2002 dispatch, “A Deflationary Mosaic”). Today, I am more worried about inflation. But it’s inflation with an important twist — not the CPI-based inflation of product markets but the asset inflation of financial markets. I fear that America’s post-bubble recovery is in serious danger of spawning a new round of asset bubbles that could well pose the most deflationary risks of all.

The Federal Reserve’s post-bubble policy gambit is at the heart of my concerns. By holding the nominal federal funds rate at just 1% in the context of a 1% core inflation rate, a “zero” real federal funds rate sticks out like a sore thumb in the aftermath of 6% real GDP growth in the second half of 2003. That’s even more apparent when judged against the Fed’s own forecast of 4.5% to 5.0% real GDP growth over the four quarters of 2004. No one doubts that America’s central bank is injecting extraordinary stimulus into the financial system. The debate is over the impacts of these efforts. That’s where it gets tricky. Monetary policy is a very blunt instrument. The authorities can set the overnight bank lending rate, but they have little say on the channels of the policy transmission mechanism. In particular, there are no guarantees that policy stimulus goes directly into the real economy or into the financial markets.

This ambiguity is especially worrisome in the current climate. Inflation in the traditional sense is not a problem. Sure, commodity prices are now surging, but unit labor cost pressures are going the other way — down 1.7% on a year-over-year basis through 4Q03. With labor accounting for five to six times the share of commodities in the overall business cost structure, the forces of disinflation continue to have the upper hand. That shows up loud and clear in the ongoing deceleration of underlying inflation — a core CPI inflation rate that has slowed from 1.9% y-o-y in January 2003 to 1.1% in January 2004. But with the US economy having rebounded sharply in the second half of last year and expected to record a solid increase in 2004, the gap between aggregate supply and demand is finally beginning to close. For that reason, alone, it appears now safe to conclude that the risks of an immediate deflation are receding — at least for the time being. At the same time, with most businesses lacking in pricing leverage and labor costs still contracting, the odds of a spontaneous acceleration in inflation are exceedingly low, in my view.

Alas, that doesn’t mean the Fed’s aggressive reflationary efforts have disappeared into thin air. With inflation in goods and services low and still falling, the impacts of monetary stimulus appear to have spilled over into financial assets. The property market is a case in point. Nationwide home prices surged at a 14.7% annual rate in 4Q03, according to figures recently released by the Office of Federal Housing Enterprise Oversight (OFHEO). That brought the year-over-year appreciation in housing prices to 8.0% in year-end 2003; that nearly matches the 8.2% peak rate of nationwide housing inflation hit in mid-2001 — the strongest gain since the inception of this series in 1990. Housing experts and central bankers are always quick to stress the regional cross-currents in US property markets — all but denying the possibility of extremes in nationwide property appreciation. Let the record show that all but two states experienced house price appreciation in the final period of 2003, according to detailed OFHEO statistics.

Nor is property the only asset class displaying bubble-like tendencies, in my view. The same can be said for most fixed-income instruments, starting with long-dated Treasuries. That shows up most clearly in the real interest rate component of nominal Treasury yields, which currently stands at a near record low of 1.6% for a 10-year maturity as measured in the so-called TIPS market. For a rapidly growing US economy plagued with the twin deficits of outsize fiscal imbalances and a massive current account deficit, there is a compelling case for considerably higher real interest rates. The same can be said for most “spread products” — especially corporates, high-yield debt, and emerging market securities — where yield gaps relative to Treasuries remain at cycle lows. Our credit strategist, Greg Peters, argues that the problem may lie less in the spread and more in the absolute level of yields on these riskier assets. Inasmuch as I believe that the Treasury benchmark, itself, is sharply overvalued, I don’t draw much comfort from that observation.

I continue to believe that the mounting froth in both property and fixed-income markets is largely traceable to the Fed’s extraordinary policy stimulus. Low interest rates continue to fuel the excess demand and price behavior in the housing sector. Moreover, with the US central bank anchoring the short end of the yield curve at 1%, commercial banks, institutional investors, and speculators are all rushing to take advantage of what could well be the “mother of all carry trades.” There’s no secret that this is the biggest and probably the most levered bet in financial markets today. The risk of multiple asset bubbles can only intensify as the Fed clings to its stance of extraordinary accommodation in the face of a rapidly growing and still inflationless US economy. With excess liquidity creation not being absorbed by the real economy, it is now slopping over into an increasingly broad array of asset markets. That’s what bubbles are all about.

These are the concerns that prompted me to make the seemingly outrageous suggestion that the Fed normalize its policy stance by immediately hiking the federal funds rate to 3% (see my 27 February dispatch, “Open Letter to Alan Greenspan” also published in the 1 March edition of Newsweek International). I have taken a lot of flak for making this suggestion. The main objections are that such a policy shock could quickly unwind the carry trades and do great damage to an overly-indebted US economy — especially the ever-oblivious American consumer. It’s hard to argue with those concerns. But that’s not a good reason, in my view, for holding interest rates artificially low and creating the even greater danger of multiple asset bubbles. There are those, of course, that insist central banks have no right to overrule the verdict of the millions who freely vote in financial markets every day. But then there are others — most recently the ECB’s Otmar Issing — who argue that central banks must now take heed of “the risks associated with asset-price inflation and subsequent deflation” (see “Money and Credit” in the 18 February edition of The Wall Street Journal). I suspect that history will long take note of the outcome of this debate.

As we all should have learned four years ago, the asset bubble is the gravest risk of all. And that could well be the ultimate irony of the great inflation-deflation debate. From the start, my case for US deflation was critically dependent on the perils of a post-bubble shakeout. History tells us that most serious deflations arise from just such circumstances. Just ask Japan, or take a look at America in the 1930s. For the time being, a rapidly growing US economy may well have sidestepped the immediate perils of a CPI-based deflation. But it may not be so lucky in the aftermath of the bursting of another asset bubble. Unlike the situation four years ago, when the Fed had 600 basis points of ammunition to fight the post-bubble damage-containment battle, the central bank only has 100 bp left in its arsenal today.

With risks of new asset bubbles rising, there is a growing urgency for a normalization of US interest rates. Unwinding an ever-dangerous carry trade is a small price to pay to avoid the most treacherous endgame of all. America, in my view, is probably only one bubble away from outright deflation. Paul Volcker had the courage to stand up to inflation in 1979. Now it’s up to Alan Greenspan to wage an equally heroic battle

http://www.morganstanley.com/GEFdata/digests/20040305-fri.html