Japan sees long deflation in US, bets on falling Treasury yields.

“The recovery is very weak and the U.S. is running the risk of deflation…” say the Japanese investors as they are piling into US Treasuries while expecting the yields to drop sharply. They may be the only ones in current economic environment that have extensive experience investing in deflationary times and so it may be worth wile heeding their advice:

“Demand for Treasuries is very good because of the idle money in the banking system…” 

“The medium term risk toward inflation is being caused by potential policy missteps by policy makers in regards to monetary and fiscal policy and the weakening dollar…”

“Any economics textbook would tell you that the massive stimulus from the central government will eventually cause inflation, but the Japanese know it doesn’t have to turn out that way…”

“The U.S. economy has faced a double whammy: the recession and credit contraction. The U.S. will face a triple whammy with deflation. That’s good for the Treasury market.”

Bloomberg. November 09, 2009.

Japan Tops China Buying Treasuries as Lost Decade Survivors Buy.

Nov. 9 (Bloomberg) — Japanese investors who lived through a decade of deflation and recessions say U.S. Treasuries are a bargain even with yields at about the lowest levels since at least the 1960s.

Japan bought a net $105 billion of U.S. government debt through August, exceeding China as the biggest foreign buyer and boosting its holdings to $731 billion, or more than 10 percent of the total market, Treasury Department data show. The 17 percent increase is the most since a 25 percent surge in 2004.

Mizuho Asset Management Co. and Mitsubishi UFJ Asset Management Co. are among the investors buying U.S. bonds because they see similarities between America’s response to the recession and their government’s efforts during the so-called lost decade of the 1990s. An index of Japanese debt securities compiled by Bank of America Corp.’s Merrill Lynch unit returned 90 percent in the 1990s, while the Nikkei 225 Stock Average fell as much as 67 percent between January 1990 and October 1998.

“The U.S. economy has faced a double whammy: the recession and credit contraction,” said Akira Takei, head of non-yen denominated bonds at Mizuho Asset in Tokyo, a unit of Japan’s second-largest bank. “The U.S. will face a triple whammy with deflation. That’s good for the Treasury market.”

The 3.625 percent benchmark U.S. 10-year note due in August 2019 closed last week at 101 1/32 to yield 3.5 percent. The yield has averaged 3.19 percent in 2009, the lowest since the Federal Reserve began providing daily data on the securities in 1962 and down from 3.64 percent for all of 2008.

Takaei’s Forecast

Takei, who helps oversee the equivalent of $21 billion, bought Treasuries in July and predicts 10-year yields will decline to 2.75 percent by year-end. An investor who purchased $10 million of the notes would earn about $715,000 if yields dropped to Takei’s forecast, according to data compiled by Bloomberg.

Government securities have lost 2.8 percent since December, when 10-year yields fell to 2.04 percent, according to the Merrill Lynch U.S. Treasury Master Index data. Treasuries are on a pace to post their first annual losses since 1999 as the recovery in the global economy following the worst financial crisis since the Great Depression reduces the appeal of the debt as a haven.

Similar to Japan’s response to its real estate collapse in the 1990s, the U.S. is flooding the economy with cash only to see financial institutions sock the money away in bonds instead of making loans.

Inflation Protection

The Fed and the U.S. government have spent, lent or guaranteed $11.6 trillion to spur the world’s biggest economy from recession and curb a decline in asset prices. The Standard & Poor’s 500 index has gained 58 percent to 1,069.30 from its low this year of 676.52 on March 9, though it’s below the peak of 1,576.09 reached in October 2007.

“Japanese investors have been skewed to expecting deflation because of their own experience, but the more pressing concern over the intermediate term is inflation,” said Michael Pond, an interest-rate strategist in New York at Barclays Plc, one of 18 primary dealers that trade with the Fed.

Pond favors Treasury Inflation Protection Securities, or TIPS, and said Asian investors, including the Japanese, have been buying the bonds on concern the dollar will continue to decline and inflation will accelerate. Barclays expects consumer prices to rise 1.9 percent in 2010, after a decline of 0.4 percent this year, data compiled by Bloomberg show.

During the 1990s, Japan’s economy grew at an average rate of about 1 percent a year as asset prices tumbled. It hasn’t fared much better this decade, with gross domestic product expanding 0.2 percent on average and consumer prices falling 0.2 percent.

Consumer Prices

The threat of deflation, a general drop in prices that enhances the value of a bond’s fixed payments, makes Treasuries attractive to Japanese investors even with bond yields rising from last year’s lows. U.S. consumer costs fell 1.3 percent in September from a year earlier, according to the Labor Department. They dropped at a 2.1 percent annual rate in July, the most since Harry S. Truman was president in 1950.

Ten-year notes pay a real yield, or what investors get after accounting for the cost of living, of 4.91 percent, above the five-year average of 1.42 percent.

“The recovery is very weak and the U.S. is running the risk of deflation,” said Hideo Shimomura, who helps oversee the equivalent of about $55.4 billion in Tokyo as chief fund investor at Mitsubishi UFJ Asset, part of Japan’s largest bank.

Surpassing China

Mitsubishi UFJ bought Treasuries in October, said Shimomura, who expects 10-year yields will fall to 3 percent by year-end.

Japan’s purchases exceed those of China, which has boosted its holdings 9.6 percent, or $69.7 billion, to $797.1 billion, Treasury data show. Japan’s buying spree started in May 2008, after its U.S. debt dropped to a four-year low of $575.3 billion.

The Fed’s pledge last week to keep interest rates near zero for an “extended period,” the absence of a recovery in U.S. real estate and hoarding of cash by banks has Japanese investors such as Shimomura saying the parallels are too close to what happened in Japan.

The S&P/Case-Shiller home-price index for 20 U.S. cities fell 11.3 percent in August from a year earlier. Bank holdings of government securities and debt of mortgage companies Fannie Mae in Washington and McLean, Virginia-based Freddie Mac increased to $1.39 trillion in the week ended Oct. 21 from $1.26 billion a year earlier. Commercial and industrial loans fell 17 percent from an all-time high a year ago to $1.37 trillion as of Oct. 21, a record decline.

‘Yields to Fall’

Banks in Japan such as Mitsubishi UFJ Financial Group Inc. and Mizuho Financial Group Inc., the two largest by assets, own 116.9 trillion yen of government securities, the most since Bank of Japan figures started in 1993.

“Demand for Treasuries is very good because of the idle money in the banking system,” said Satoshi Okumoto, a general manager at Fukoku Mutual Life Insurance Co. in Tokyo, which has the equivalent of $60 billion in assets. “In 2010, there will be a second dip in the economy. There will still be room for yields to fall.”

Fukoku plans to add to its holdings if 10-year yields rise to 4 percent, he said.

Paul McCulley, a partner at Pacific Investment Management Co., which runs the world’s biggest bond fund, said Oct. 29 that investors should sell riskier assets such as stocks and high- yield corporate debt because the U.S. recession “might not even be over.” Those types of assets carry “lofty valuations,” McCulley said a report posted on Pimco’s Web site.

New Normal

Officials at Newport Beach, California-based Pimco say there is a “new normal” in the global economy that includes heightened government regulation, lower consumption, slower growth and a shrinking global role for the U.S.

Pimco began adding longer-maturity Treasuries to the $192 billion Total Return Fund during the third quarter, according to the firm’s monthly reports.

Prospects for economic growth combined with the record amount of debt the U.S. is selling are enough to prevent Daiwa Asset Management Co., part of Japan’s second-largest brokerage, from buying. After contracting 2.5 percent in 2009, the U.S. economy will expand 2.4 percent next year and 2.85 percent in 2011, separate surveys of economists by Bloomberg News show.

Budget Deficit

“The economy will be picking up throughout the next year,” said Tsutomu Komiya, a Daiwa investment manager in Tokyo who helps oversee the equivalent of $77 billion. “The huge issuance will make Treasury yields go higher.”

The U.S. budget deficit widened to a record $1.42 trillion in the 12 months to Sept. 30 as the administration increased spending to revive the economy. The Treasury is scheduled to sell $40 billion of three-year notes today, $25 billion of 10- year debt tomorrow and $16 billion of 30-year bonds on Nov. 12. The amounts are all-time highs for each maturity.

“The medium term risk toward inflation is being caused by potential policy missteps by policy makers in regards to monetary and fiscal policy and the weakening dollar,” Pond said.

Barclays forecast that 10-year yields will rise to 4.60 percent by the end of next year. Intercontinental Exchange Inc.’s U.S. Dollar Index, which tracks the currency’s performance against the euro, yen, pound, Canadian dollar, Swiss franc and Swedish krona, fell 15 percent to 75.819 last week from its high this year of 89.624 on March 4.

Borrowing Estimate

Record U.S. debt sales may be peaking. The Treasury Department cut its estimate for borrowing in the current quarter by 43 percent on Nov. 2, largely because of reductions in a program for helping the Fed manage its balance sheet. Borrowing will total a net $276 billion from October through December, compared with a previous estimate of $486 billion.

While the difference between rates on 10-year notes and TIPS, which reflects the outlook among traders for consumer prices, widened to 2.18 percentage points from almost zero at the end of 2008, it’s equal to the five-year average.

In Japan, the so-called breakeven rate is negative 1.1 percent, when measured using nine-year bonds, the lowest among all government inflation-index debt.

“Any economics textbook would tell you that the massive stimulus from the central government will eventually cause inflation, but the Japanese know it doesn’t have to turn out that way,” said Michael Cheah, who manages $2 billion in bonds at SunAmerica Asset Management in Jersey City, New Jersey and a former official at the Monetary Authority of Singapore, that nation’s central bank.

U.S. Unemployment

Rising unemployment in the U.S. means Treasuries are still worth buying, said Shuhei Mochizuki, assistant manager in Tokyo at the foreign-bond section at Sumitomo Life Insurance Co., which oversees the equivalent of $221 billion. Ten-year yields will be 3.25 percent by year-end, he said.

The unemployment rate reached a 26-year high of 10.2 percent in October as payrolls fell by 190,000, the Labor Department said Nov. 6.

“Employment conditions are worsening,” Mochizuki, assistant manager in Tokyo at the foreign-bond section at Japan’s fourth-largest life insurer. “Yields will fall.”

Bank excess reserves with Federal Reserve signal coming loan losses.

This latest chart from November 5, 2009 release of the privately owned Federal Reserve’s report on the excess reserves is showing a sharp increas even over a few months of suppossedly “recovery” and economic “growh”. This sharp increase in excess reserve levels in a seemingly improving economic environment signals that banks know of something else. That something else is causing them to hoard cash and keep it in safest place possible, i.e. accounts at Federal Reserve banks themselves. This menacing something is likely to be huge loan losses that are result of defaults and bankruptcies by debtors. This is, of course, very deflationary.

Factors Affecting Reserve Balances.

Mother of all carry trades will lead to inevitable deflationary bust.

For now the privately owned US Federal Reserve’s efforts to reflate the financial markets are sending a flood of liquidity into speculative asset bubble blowing by the speculators. Nearly every asset class is seeing its price being bid up with cheaply borrowed US dollars. At some point an asset bubble always bursts when an event or a perception driven change of heart causes investors to unwind their speculative positions. As the article below explains, when this happens we’ll witness a huge deflationary bust which may wipe out many speculators. Will it wipe out the Central Banks is another good question that only time will be able to answer.

Financial Times. November 01, 2009.

Mother of all carry trades faces an inevitable bust.

Since March there has been a massive rally in all sorts of risky assets – equities, oil, energy and commodity prices – a narrowing of high-yield and high-grade credit spreads, and an even bigger rally in emerging market asset classes (their stocks, bonds and currencies). At the same time, the dollar has weakened sharply , while government bond yields have gently increased but stayed low and stable.

This recovery in risky assets is in part driven by better economic fundamentals. We avoided a near depression and financial sector meltdown with a massive monetary, fiscal stimulus and bank bail-outs. Whether the recovery is V-shaped, as consensus believes, or U-shaped and anaemic as I have argued, asset prices should be moving gradually higher.

But while the US and global economy have begun a modest recovery, asset prices have gone through the roof since March in a major and synchronised rally. While asset prices were falling sharply in 2008, when the dollar was rallying, they have recovered sharply since March while the dollar is tanking. Risky asset prices have risen too much, too soon and too fast compared with macroeconomic fundamentals.

So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions.

Let us sum up: traders are borrowing at negative 20 per cent rates to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade. Every investor who plays this risky game looks like a genius – even if they are just riding a huge bubble financed by a large negative cost of borrowing – as the total returns have been in the 50-70 per cent range since March.

People’s sense of the value at risk (VAR) of their aggregate portfolios ought, instead, to have been increasing due to a rising correlation of the risks between different asset classes, all of which are driven by this common monetary policy and the carry trade. In effect, it has become one big common trade – you short the dollar to buy any global risky assets.

Yet, at the same time, the perceived riskiness of individual asset classes is declining as volatility is diminished due to the Fed’s policy of buying everything in sight – witness its proposed $1,800bn (£1,000bn, €1,200bn) purchase of Treasuries, mortgage-backed securities (bonds guaranteed by a government-sponsored enterprise such as Fannie Mae) and agency debt. By effectively reducing the volatility of individual asset classes, making them behave the same way, there is now little diversification across markets – the VAR again looks low.

So the combined effect of the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments is seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles.

While this policy feeds the global asset bubble it is also feeding a new US asset bubble. Easy money, quantitative easing, credit easing and massive inflows of capital into the US via an accumulation of forex reserves by foreign central banks makes US fiscal deficits easier to fund and feeds the US equity and credit bubble. Finally, a weak dollar is good for US equities as it may lead to higher growth and makes the foreign currency profits of US corporations abroad greater in dollar terms.

The reckless US policy that is feeding these carry trades is forcing other countries to follow its easy monetary policy. Near-zero policy rates and quantitative easing were already in place in the UK, eurozone, Japan, Sweden and other advanced economies, but the dollar weakness is making this global monetary easing worse. Central banks in Asia and Latin America are worried about dollar weakness and are aggressively intervening to stop excessive currency appreciation. This is keeping short-term rates lower than is desirable. Central banks may also be forced to lower interest rates through domestic open market operations. Some central banks, concerned about the hot money driving up their currencies, as in Brazil, are imposing controls on capital inflows. Either way, the carry trade bubble will get worse: if there is no forex intervention and foreign currencies appreciate, the negative borrowing cost of the carry trade becomes more negative. If intervention or open market operations control currency appreciation, the ensuing domestic monetary easing feeds an asset bubble in these economies. So the perfectly correlated bubble across all global asset classes gets bigger by the day.

But one day this bubble will burst, leading to the biggest co-ordinated asset bust ever: if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.

Why will these carry trades unravel? First, the dollar cannot fall to zero and at some point it will stabilise; when that happens the cost of borrowing in dollars will suddenly become zero, rather than highly negative, and the riskiness of a reversal of dollar movements would induce many to cover their shorts. Second, the Fed cannot suppress volatility forever – its $1,800bn purchase plan will be over by next spring. Third, if US growth surprises on the upside in the third and fourth quarters, markets may start to expect a Fed tightening to come sooner, not later. Fourth, there could be a flight from risk prompted by fear of a double dip recession or geopolitical risks, such as a military confrontation between the US/Israel and Iran. As in 2008, when such a rise in risk aversion was associated with a sharp appreciation of the dollar, as investors sought the safety of US Treasuries, this renewed risk aversion would trigger a dollar rally at a time when huge short dollar positions will have to be closed.

This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.

Citigroup is deflating.

In a sign of deflation Citigroup is closing without warning random consumer credit card lines. It has suffered consumer credit losses to the tune of $ 8 Billion in the third quarter of 2009 alone, that is deflation by any definition. And acting responsibly, trying to stay afloat, Citibank is cutting its losses or potential losses. This is what deflation looks like. Creditors are unwilling to lend while customers are unwilling to borrow and no infusions of liquidity by the privately owned Federal Reserve Corporation will change this.

Associated Press. October 19, 2009.

Citi closes gas-linked MasterCards without warning.

NEW YORK — Shannon Burdette tried to pay with her Shell Mastercard after filling up her gas tank this weekend but found the card rejected.

Confused, she called the customer service line on the back of the card, issued by Citibank, and was told the account was closed because of something that appeared on her credit report. But when the Sykesville, Md., resident got a copy of her credit report online, the only negative thing she saw was “closed at credit grantor’s request” on the Shell MasterCard account.

“They said there was a routine review,” said Burdette, who maintained that she and her husband, Brian, used the card regularly and always paid the bill on time.

Burdette isn’t alone. People across the country have been reporting similar experiences in postings on various consumer Web sites.

Citi confirmed the basics. The bank said in a statement it “decided to close a limited number of oil partner co-branded MasterCard accounts.” That includes not only Shell, but Citgo, ExxonMobil and Phillips 66-Conoco cards.

The close date was Wednesday, and letters were sent out Monday to customers informing them of the change, a Citi spokesman said. The bank would not say how many cards were shut down or how much available credit they represented.

But unlike the bank’s move to shut down its Home Depot cards, Citi did not discontinue the sale of these cards altogether. It is still accepting applications, promising rewards like 3 percent cash back on fuel purchases and 1 percent cash back on other spending.

No law, including the Credit CARD Act that has started to take effect, prevents banks from closing down credit accounts without warning. Credit card issuers all maintain the right, typically listed in the fine print on credit card agreements.

Citi would not say why the cards in question were shut down, issuing a statement that said only it continuously evaluates its products.

“It is kind of an extraordinary action, but these are extraordinary times,” said Ben Woolsey, director of marketing and consumer research for CreditCards.com.

He noted that Citi is not the healthiest bank. In fact, Citi posted $8 billion in consumer credit losses for its third quarter last week, including both mortgages and credit cards. Like many banks with big consumer lending portfolios, Citi is expecting defaults on credit cards to rise in coming months. Credit card delinquencies typically track the unemployment rate, which is at 9.8 percent and is expected to top 10 percent soon.

Analysts noted following the earnings report that Citi has sharply reduced its outstanding credit to consumers.

A card being closed may, but does not always, damage a person’s credit score.

Such scores, which lenders use to determine if you’re a good credit risk, take into account a series of factors, including how long you’ve had credit accounts, your payment history and the balance versus available credit.

It could be that last factor that hurts consumers most, said John Ulzheimer, president of educational services for Credit.com. If a consumer had a high credit limit on the closed account, and that credit is no longer available, it could alter the “utilization ratio” for the person’s remaining credit. If another type of credit carries a high balance, the loss of the credit line could push down their score.

Ulzheimer said banks have been routinely making such moves in the past year and a half, mostly on a case-by-case basis. “Every once in a while you’ll get a huge pop in one particular card product,” he said.

Card holders who think their cards were unfairly shut down can try to contact the bank and ask for reinstatement, but Ulzheimer didn’t hold out much hope for success. “In this environment,” he said, “it’s not as successful as it was in the heyday of credit cards, where you could in fact call and plead your case.”

Deflation is firmly taking root in USA. FED is still in denial.

Even though the signs of deflation are everywhere as expressed in contracting credit, money supply, and prices, the privately owned Federal Reserve’s executives continue to beat about the deflationary bush by referring to it as “disinflation” and talking about it in future tense. It has been happenning already for the past year and a half and it will continue as evidenced by record low long term Treasury yields this week. The below article provides a detailed discussion and solid evidence of deflation and how it works.

Bloomberg.  October 02, 2009.

Stiglitz Deflation Threat Pushes Fed to Stay at Zero.

Oct. 2 (Bloomberg) — The U.S. faces the possibility of deflation for the first time since the Eisenhower administration, a threat that may prompt the Federal Reserve to keep interest rates near zero through next year.

Executives at Kroger Co., the largest U.S. supermarket chain, blamed deflation for a 7 percent drop in earnings in the second quarter, while falling prices for food, gasoline, and electronics left August sales unchanged at Costco Wholesale Corp. A sustained price drop might set off a chain reaction in which lower profits force employers to pare wages and payrolls. That would erode consumer demand, exacerbating wage cuts and firings.

Such a spiral led to Japan’s “lost decade” of slow economic growth in the 1990s. A more vicious version in the U.S. helped create the Great Depression six decades earlier. Bond investors are forecasting retreating consumer prices, as shown by the yield they demand to hold a one-year bond versus a similar inflation-protected bond.

“Deflation is definitely a threat right now,” Nobel laureate Joseph Stiglitz, 66, a professor at Columbia University in New York, said in a Sept. 22 interview. “The combination of the deflation threat and the sluggish recovery should keep the Fed on hold for quite a while.”

Consumer prices are experiencing deflation, with the consumer price index sliding for six straight months from year- earlier levels, the longest stretch of declines since a 12-month drop from September 1954 to August 1955, according to the Labor Department.

So far, the core consumer-price index, which excludes food and energy, is facing disinflation, a slowing in the pace of increase. The core index rose 1.4 percent in August from a year earlier, down from 2.5 percent in September 2008.

Fed Trio

Regional Federal Reserve Bank Presidents Janet Yellen, of San Francisco, James Bullard, of St. Louis, Richard Fisher, of Dallas, and Charles Evans, of Chicago, have expressed concern in past weeks about the possibility of declining prices.

“Disinflationary winds are blowing with gale-force effect,” Evans, 51, said in a Sept. 9 speech in New York.

While the economy contracted 2.7 percent during the 1953 recession, it shrank 3.8 percent in the current recession, the most since the 1930s. Economists at New York-based JPMorgan Chase & Co. and Goldman Sachs Group Inc., the second- and fifth- biggest U.S. banks by assets, say there’s so much deflationary excess labor and plant capacity in the economy that the Fed won’t raise interest rates until at least 2011.

Gross Pessimism

“The potential for a deflationary downdraft continues for several years” if economic growth doesn’t accelerate, Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co. in Newport Beach, California, said in a Sept. 29 interview with Bloomberg Radio.

At their most recent meeting on Sept. 23, Fed policy makers agreed to leave the benchmark interest rate in a range of zero to 0.25 percent, where it’s been since December 2008.

Only 69.6 percent of the country’s factories, utilities and mines were in use during August, close to the record low of 68.3 percent reached in June.

Former Fed Chairman Alan Greenspan said the economic rebound won’t prevent a further slowing of the pace of price increases. “We are still, by any measure, in a disinflationary environment,” Greenspan, 83, said in a Sept. 30 Bloomberg Television interview in Washington.

At the same time, recent reports on manufacturing, housing, and consumer spending suggest that any investor concerns about the danger of deflation are overblown, said Dean Maki, chief U.S. economist at Barclays Capital Inc. in New York.

Growth Outlook

The median projection of economists surveyed by Bloomberg News is for first quarter growth of just 2.4 percent, compared with a decline of 6.4 percent in the first quarter of 2009. Maki sees a 5 percent expansion in the first quarter of 2010.

That would translate into higher prices.

“Inflation is driven more by the level of demand and pace of growth than by the size of the output gap,” said Stephen Stanley, chief economist at RBS Securities Inc. in Stamford, Connecticut. “As the economy returns to solid growth in 2010, we are quite confident that, in sharp contrast to the consensus Fed view, core inflation will be creeping higher.”

Fed officials are already planning for that, and publicly discussing an exit strategy once the economy does pick up. At that point, the Fed may have to move with “greater force” than some anticipate to keep inflation from accelerating too rapidly, Fed Governor Kevin Warsh, 39, said in a Sept. 25 speech in Chicago.

Fed Purchases

That day is far off for bond investors. Inflation fears, raised by the more than $1 trillion the Fed has pumped into the economy by lowering rates and buying Treasuries and mortgage- backed securities, are fading.

“There’s been a significant flattening on the long end of the curve,” reflecting concern about deflation, said Pacific Investment’s Gross, 65, who is buying longer-maturity Treasuries in response. The yield on the 10-year note, which was 3.95 percent on June 10, was 3.18 percent at the close of New York trading yesterday. The difference in yield between nominal and inflation-protected Treasury securities maturing in one year is negative 0.4 percent, suggesting investors expect deflation during the next 12 months. Over five years, that inflation premium is now 1.21 percent, down from 1.86 percent on June 10.

The Fed needs to “keep inflation expectations from slipping to undesirably low levels in order to prevent unwanted disinflation,” Vice Chairman Donald Kohn, 66, said Sept. 10 in Washington during a speech at the Brookings Institution.

Oil Role

Falling consumer prices are partly a reflection of a 52 percent decline in oil prices to about $70 a barrel yesterday from $145.45 a barrel on July 3, 2008.

The slowing in core prices is more of a concern, said Michael Feroli, an economist at JPMorgan. The core rate fell following three prior recessions in which unemployment rose above 7 percent. That “suggests that core inflation could well be below zero within two years,” Feroli said in an interview.

Core CPI fell 5.3 percent following the recession of 1973- 1975, 10.7 percent following the recession of 1981-1982 and 3 percent following the recession of 1990-1991.

Unemployment rose to 9.8 percent in September, a Labor Department report showed today, and it will likely climb to 10 percent in the fourth quarter, according to the Bloomberg survey of economists. The jobless rate was estimated to average 8.8 percent in 2011.

With unemployment elevated, companies may not need to raise pay to attract workers, even when the economy picks up.

‘Enormous Slack’

“My personal belief is that the more significant threat to price stability over the next several years stems from the disinflationary forces unleashed by the enormous slack in the economy,” Yellen, 63, said Sept. 14 in San Francisco.

Wages for U.S. workers fell for eight months in a row, dropping 5.6 percent from October 2008 to June 2009, according to Commerce Department figures. In contrast, wages continued to grow in the 1954-1955 deflation period.

Stagnating wages and fading job prospects are sapping demand. Consumer spending may increase in the fourth quarter by just 1 percent and in 2010 by an average of only 1.6 percent, according to the median estimate in the Bloomberg survey of economists.

Consumption rose by an average 5.7 percent a quarter in the five years before the recession began in December 2007.

“A weak labor market in a competitive environment puts downward pressure on wages,” said Stiglitz, who won the Nobel prize for economics in 2001. “So, the possibility of another actual decline in wages cannot be ruled out.”

Declining Incomes

The deflation danger is compounded by household debt, said Paul Ashworth, senior U.S. economist at the consulting firm Capital Economics in Toronto. U.S. homeowners owed $13.9 trillion in the third quarter of 2008, compared with an average of $8.5 trillion in the 57 years the Fed has kept records.

“As incomes start to fall, that debt gets bigger in real terms: You have a smaller income to pay off that debt,” Ashworth said. “Deflation combined with high indebtedness can be very problematic.”

Inflation happens when too much money chases too few goods. Gary Shilling, president of the investment research firm A. Gary Shilling & Co. of Springfield, New Jersey, said that even as the Fed continues to pump money into the economy, the money supply, as measured by the central bank’s M2 index, has dropped 1 percent since mid-June.

“Look what is happening to money supply, it is actually contracting now when supposedly the economy is picking up,” Shilling said in an interview on Bloomberg Television Sept. 21. The economy is facing deflation “because you’ve got basically an excess-supply world,” he said.

Profits Dwindling

Profits have evaporated as companies lose pricing power. The 419 non-financial firms in the S&P 500 reported earnings down 28 percent in the quarter ending June 30. Analysts surveyed by Bloomberg anticipate a 30 percent decline for the third quarter, which ended this week.

“Businesses trying to sell products and services feel they are pushing on a string and are adjusting their behavior accordingly,” Fisher, 60, the Dallas Fed president, said in a Sept. 3 speech at the University of California in Santa Barbara. “They are cutting prices.”

Rodney McMullen, president of Cincinnati-based Kroger, blamed price reductions for second-quarter earnings that fell 10.5 percent short of analysts’ estimates.

“We certainly sold more units. But lower retail prices and profit per unit pressured” results, McMullen told analysts in a Sept. 15 conference call. “We began to see deflation.”

The average amount spent per transaction in August at Issaquah, Washington-based Costco was about 7 percent below last year, Bob Nelson, vice president for financial planning, said on a Sept. 3 conference call with investors.

At Wal-Mart Stores Inc., the world’s largest retailer, “headwinds” from deflation were in part responsible for a 1.4 percent drop in second-quarter revenue to $100.9 billion, chief financial officer Thomas Schoewe told analysts Aug. 13.

Is PIMCO betting on long term deflation?

When one of the world’s largest fixed income investment funds goes long US Treasuries this only means one thing – they are betting on sustained deflation. After spiking in the early spring the Treasury yields are slowly grinding down again. The 30-year Treasury is now yielding a little above 4% which is a long term low.

Bloomberg. September 29, 2009.

Pimco’s Gross Buys Treasuries Amid Deflation Concern.

Sept. 29 (Bloomberg) — Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., said he’s been buying longer maturity Treasuries in recent weeks as protection against deflation.

“There has been significant flattening on the long end of the curve,” Gross said in an interview from Newport Beach, California, with Bloomberg Radio. “This reflects the re- emergence of deflationary fears. The U.S. is at the center of de-levering as opposed to accelerating growth.”

Gross had said during the midst of the credit crunch that Treasuries offered little value as investors seeking a refuge from turmoil in global financial markets drove yields to record lows in December. He boosted the $177.5 billion Total Return Fund’s investment in government-related bonds to 44 percent of assets, the most since August 2004, from 25 percent in July, according data released earlier this month on Pimco’s Web site. The fund cut mortgage debt to 38 percent from 47 percent.

“We’ve exchanged our mortgages for the government’s check” as the Federal Reserve winds down purchases of agency debt, Gross said today. “Mortgages are expensive compared to Treasuries and other vehicles.”

Fed policy makers last week committed to complete their $1.45 trillion in purchases of mortgage securities and extended the end of the program to March from December.

Policy Reversal

Pimco’s Total Return Fund handed investors a 17.85 percent gain in the past year, beating 94 percent of its peers, according to data compiled by Bloomberg. The one-month return is 1.94 percent, outpacing 57 percent of its competitors. Pimco is a unit of Munich-based insurer Allianz SE.

Pimco in July reversed a policy to steer clear of U.S. debt when it said it would buy five- to 10-year Treasury securities.

“With Treasury yields near the top of our expected range, Pimco plans to overweight duration and take exposure to the five- to 10-year portion of the yield curve,” the firm said July 20 in a report on its Web site.

On that day, the yield on the 10-year note touched an intra-day high of 3.72 percent and a low of 3.57 percent. The note yielded 3.29 percent at 10:36 a.m. today in New York.

Gross said intermediate- to long-term bonds will perform well as long as policy rates and inflation remain low, after minutes of the Federal Open Market Committee’s Aug. 11-12 meeting was released on Sept. 2.

‘New Normal’

Officials at Pimco have forecast a “new normal” in the global economy that will include heightened government regulation, lower consumption and slower growth. The economy will likely expand at a 2 percent to 3 percent rate going forward, Gross said.

The world’s largest economy shrank at a 1.2 percent annual rate from April to June, more than the originally reported 1 percent contraction, according to a Bloomberg News survey before the Commerce Department’s Sept. 30 report. The jobless rate climbed to 9.8 percent this month, from 9.7 percent in August, according to a separate Bloomberg survey before the Labor Department reports figures on Oct. 2.

The Lowdown on Deflation.

The basics of deflation and inflation are summed up very well in this short piece on Minyanville.

Minyanville.com. September 25, 2009.

The Lowdown on Deflation.

Deflation is the contraction (reduction) of money and credit. It occurs when the economic system is carrying too much debt to be supported by the level of income generated by economic activity. It occurs because too much debt has been incurred to create unproductive assets that don’t generate income. Deflation is a corrective process, it’s simply the market (you and I) not being able to service debt, so we must forfeit.

Since central banks and accepted economic theory are all about creating debt to grow (artificially) economies, periods of inflation (creating money-debt and credit) last a long time: Debt is accumulated incrementally until there is too much of it. So people don’t really understand the tells of deflation.

For example, the things that drive currency movements are quite different. If we’re in an inflationary period (expanding credit) and we get a good economic number, people expect the value of the dollar to rise: A growing economy will attract investment so foreigners buy dollars to invest in US stocks. If you get a bad economic number on the margin, you’d expect the dollar to fall.

We just now saw a disappointing durable goods number. If we were in an inflationary period, you would see the dollar fall. The number actually made the DXY rise by 30 basis points. Why?

In deflation, there’s too much debt. If the economy is slowing down, it makes it more difficult to pay back that debt and you would expect more to default. The more debt that forfeits, the more dollars are destroyed. The more dollars destroyed, the more they’re worth.

Central banks of countries with massive external debt (the US) are desperate to create inflation (keep credit from contracting), but the mechanism to do that is broken (because there’s too much debt).

Always ask the question why something is happening rather than just observe patterns because patterns change depending on the environment. This is the difference between deductive (rational) logic and inductive (empirical) logic.

Is China betting on deflation in US?

China is reportedly loading up on US treasuries in the face of weakening dollar. This means they are quite happy to collect low interest payments on their massive holdings of US Treasuries for years to come and are not concerned about the dollar weakening at the same time. This sound deflationary to me.

Bloomberg. September 21, 2009.

China Can’t Buy Enough Treasuries as Dollar Drop No Deterrent.

Sept. 21 (Bloomberg) — International investors are increasing purchases of Treasuries on a bet U.S. inflation will remain subdued, even as the dollar falls to the lowest levels of the year and the budget deficit tops $1 trillion.

Investors outside the U.S. bought 43.1 percent of the $1.41 trillion of notes and bonds sold by the Treasury Department this year, compared with 27.1 percent of the $527 billion issued at this point in 2008, government figures show. The Merrill Lynch & Co. Treasury Master Index of U.S. securities returned 1.18 percent in the third quarter after the worst first half on record as demand from the investor group that includes central banks climbed to record levels at Treasury auctions.

The trade-weighted U.S. Dollar Index’s 15 percent decline from its high this year on March 4 has proved no obstacle in Treasury auctions, aiding President Barack Obama’s efforts to sell an unprecedented amount of debt. Fund managers say their money is safe in the U.S. with expectations for inflation as measured by indexed bonds below the five-year average.

Treasuries are “starting to look like even a better value with a weaker dollar,” said Dave Chappell, who manages $90 billion in London at Threadneedle Asset Management Ltd., and has been buying longer maturity U.S. government debt.

The benchmark 10-year note yield rose 12 basis points last week, or 0.12 percentage point, to 3.46 percent, according to BGCantor Market Data. That’s the most since gaining 37 basis points in the five days ended Aug. 7. The 3.625 percent security due August 2019 fell 1, or $10 per $1,000 face amount, to 101 11/32.

Record Issuance

This week the U.S. will sell $112 billion of 2-, 5- and 7- year notes. The amount will be a record for that combination of maturities, exceeding the $109 billion sold the week of Aug. 24. Treasuries rallied that week, with the yield on the 10-year note falling 12 basis points to 3.45 percent.

Federal Reserve holdings of Treasuries on behalf of foreign accounts rose 16 percent to $2.07 trillion since the March high in the Dollar Index.

China, the biggest foreign owner of Treasuries, added $24.1 billion in July after net sales of $25.1 billion in June, raising its stake in U.S. government debt 3.1 percent to $800.5 billion, Treasury data showed on Sept. 16. The country’s holdings have risen 10 percent this year, after a 52 percent gain in 2008 amid the surge in demand for the safety of U.S. government debt as global credit markets froze.

Foreign governments have little choice than to buy Treasuries because they hold so may dollars. The U.S. dollar accounts for 65 percent for world currency reserves, up from 62.8 percent in mid-2008, according to the International Monetary Fund in Washington.

Chinese Demand

The Obama administration needs the foreign help to fund the debt sales needed for his $787 billion stimulus spending package. Chinese Premier Wen Jiabao said in March that the Asian nation was “worried” about the safety of its investment as a weakening dollar erodes the value of its record $2.1 trillion of foreign-exchange reserves.

“The interest rate on long-term Treasury bonds is at a very low level by historical standards,” said David Dollar, the U.S. Treasury Department’s economic and financial emissary to China on Sept. 11 at the World Economic Forum meeting in Dalian, China. “That says that the market has confidence the U.S. will get the fiscal problem under control.”

Inflation Protected Debt

Yields on U.S. inflation-protected debt show there’s little concern about consumer prices eroding the value of bonds’ fixed payments. The difference in rates on 10-year notes and Treasury Inflation Protected Securities, or TIPS, which reflects the outlook among traders for consumer prices, is 1.82 percentage points. While up from 0.04 points in November, the level is below the average of 2.19 points over the past five years.

The U.S. has the lowest so-called breakeven rates of any major sovereign debt market except Japan. The difference between three-year maturities is 0.71 point, below the average of 2.21 points this decade.

Prices of goods imported into the U.S. tumbled 15 percent in August from a year earlier, after a record 19.2 percent drop in July, the Labor Department said Sept. 11.

“There is no inflation on the horizon,” said Michael Cheah, who manages $2 billion in bonds at SunAmerica Asset Management in Jersey City, New Jersey. “The market is comfortable that the Fed will keep rates low and there isn’t much of an alternative.”

Current Account Deficit

The Fed’s announcement June 24 that it anticipates the target rate for overnight loans between banks will stay at zero to 0.25 percent for an extended period is keeping two-year notes anchored near current levels. Policy makers meet Sept. 22-23 in Washington. Traders are pricing in less than a 50 percent chance of a rate increase before March, federal funds futures show.

A weaker dollar has increased concerns among some investors as the budget and current-account deficits come back into focus in the currency market. The U.S. government and the Fed have spent, lent or committed more than $12 trillion in a bid to revive the economy and credit markets.

Economists forecast the current-account deficit will rise to 3.2 percent of gross domestic product in 2010 and 3.5 percent in 2011 from 2.9 percent this year as consumer and business spending boost imports and oil prices increase, according to the median estimates in Bloomberg News surveys.

“Even though U.S. asset markets are doing well, they’re not doing well enough,” Steven Englander, the chief currency strategist for the Americas at Barclays Capital Inc., said in an interview with Bloomberg Radio on Sept. 17. “The question is, what is there in the U.S. to attract capital? And that answer is hard to find.”

Yield Forecast

Investors buying a 10-year note today will lose 0.2 percent if yields rise to 3.57 percent by year-end as projected in a Bloomberg News survey of forecasts. On an unhedged basis, European investors would have lost 13 percent on 10-year notes since the start of the year, according to Merrill Lynch index data.

Even with last week’s drop in bond prices Treasuries have returned 2.8 percent in the past three months, including reinvested interest, beating the 2.3 percent return for mortgage-backed bonds, according to indexes compiled by Merrill. The rally reflects skepticism about the sustainability of the economic recovery once government stimulus ends.

The Obama administration forecasts that unemployment in the world’s largest economy will rise above 10 percent in the first quarter. The jobless rate increased to 9.7 percent in August, a quarter-century high. Fed Chairman Ben S. Bernanke said in Washington Sept. 15 that the worst U.S. recession since the 1930s probably ended, while adding that growth may not be strong enough to quickly reduce unemployment.

Good ‘Entry Point’

“If you subscribe to the double dip school of thought this may not be a bad entry point for Treasuries,” said Steve Rodosky, the head of Treasury and derivatives trading at Newport Beach, California-based Pacific Investment Management Co., manager of the word’s biggest bond fund. “The longer term risk is that the weaker dollar is the cause or affect of people diversifying their holdings or using other currencies as a global currency, but we are a long way from that.”

Yields on 10-year notes may fall toward 3 percent, the least in five months and down from 3.47 percent last week, as the inflation rate drops, Francesco Garzarelli, chief interest- rate strategist in London at Goldman Sachs Group Inc., wrote in a Sept. 15 research report.

“The international community has not lost favor with Treasuries, and the weakening currency allows an opportunity to increase their exposure,” Rodosky said.

Pimco’s Changes

Bill Gross, who runs the fund, increased holdings of government-related debt last month to the most in five years, according to the Pimco Web site. Gross boosted the $177.5 billion Total Return Fund’s investment in Treasuries, so-called agency debt and other bonds linked to the government to 44 percent of assets, the most since August 2004, from 25 percent in July.

The U.S. will sell $43 billion in two-year notes tomorrow, $40 billion of five-year debt on Sept. 23 and $29 billion in seven-year securities on Sept. 24.

Indirect bidders, the class of investors that includes foreign central banks, bought 49.4 percent of the notes at the two-year auction, up from 33 percent in July’s sale. They purchased 56.4 percent of the five-year notes, compared with 36.7 percent in July, and 61.2 percent of the seven-year notes, above the average of 43.7 percent at the prior six sales of that maturity.

“China and a few other central banks have grumbled about the dollar but they don’t have many other alternatives so they keep buying,” said Michael Atkin, head of sovereign research at Putnam Investments in Boston, who helps oversee $12 billion in fixed-income assets.

Q2 2009 private sector credit collapsed at – $2.2408 Trillion annual rate.

Deflation is accelerating in US economy despite all the Fed’s efforts to reflate.

The just released privately owned Federal Reserve’s Flow of Funds report for September 17th, 2009  shows that the second quarter of 2009 brought the greatest credit collapse of all time (http://www.federalreserve.gov/releases/z1/current/z1r-3.pdf).

 

Open Market Paper: Instead of growing as it had in almost every prior quarter in history, it collapsed at the annual rate of -$735.2 billion. (See line 2.)

Banks lending: Credit markets [collapsed] at the astonishing pace of -$931.3 billion per year, their biggest cutback of all time (line 7).

Nonbank lending: (line 8.0) pulled out at the annual rate of -$398.7 billion, also one of the worst on record.

Mortgage lenders: (line 9) pulled out for a third straight month at an annual rate of - $239.5 billion. (Their worst on record was in the prior quarter.)

Corporations were able to buck the trend somewhat (with government backing of course) and on the tide of rising stock market and economic expectations of a “recovery” were able to pull in from investors some $230.7 billion dollars to stay afloat for now (see line 6).

Consumers: (line 10) were shoved out of the market for credit at the annual pace of -$166.8 billion, the worst on record.

The ONLY major player still borrowing money in big amounts was the United States Treasury Department (line 3), sopping up $1896.4 billion of the credit available — and leaving LESS than nothing for the private sector as a whole.

Overall total credit in the economy shrank at an unprecedented annual rate of -$241.1 billion.

Private sector credit fell at an astonishing - $2.2408 Trillion.

At the same time total household wealth is down by - $11020.9 billion or – $11.0209 Trillion  from end of October of 2007 when the recession began (see Fed Flow of Funds, Balance Sheets report  http://www.federalreserve.gov/releases/z1/current/z1r-5.pdf). It is up slightly from the March 2009 lows due to stock market rally.

Deflation it is.

FDIC wisdom from 2005 – U.S. Home Prices: Does Bust Always Follow Boom?

This analytical research piece from FDIC from February 10, 2005 makes quite interesting and amusing read now in September of 2009. The main premise of this article is that booms are not always followed by a bust. We now know it is nonsense. What goes up must come down, especially if it is not based on fundamentals. The laws of physics have already proven the quasi educated Federal clowns to be wrong, but that is not stopping them from trying to blow another bubble, or rather reflate the one that just burst in pretty much every asset class. The benign wind of deflation is luckily for us blowing against their efforts and will frustrate all attempts at going back to the irresponsible and unsustainable bubble economic model of the last 25 years, or some might argue of all the years since 1913 when the illegal and privately owned Federal Reserve dollar counterfeiting enterprise was set up by bribing a handful of corrupt Congressmen.

FDIC. February 10, 2005.

U.S. Home Prices: Does Bust Always Follow Boom?

U.S. home prices have boomed in recent years. Average U.S. home prices rose 13 percent in the year ending September 2004, and are up almost 50 percent over five years. In December 2004, the Office of Federal Housing Enterprise Oversight (OFHEO) noted, “The growth in home prices over the past year surpasses any increase in 25 years.”² Because of this rapid growth, some have become concerned about the possibility of a home price collapse, either nationwide or in a number of major cities.

But before we evaluate the implications of the recent housing boom, it is useful to put it in a historical context. How extensive has the surge in home prices been in recent years? What can history tell us about the likelihood of “booms” to go “bust”? This issue of FYI examines the historical movement of home prices at the metro level to gain insight into the outlook for U.S. home prices. There is some evidence that home price booms can be followed by busts—although we find, at least by our criteria, that this pattern may be more the exception than the rule.

An Overview of the Historical Home Price Data To measure the extent of home price booms and busts, this paper uses home price data from the House Price Index (HPI) published by OFHEO. The HPI is published on a quarterly basis and tracks average house price changes in repeat sales or refinancings of the same set of single-family properties. OFHEO’s index is based on data that was obtained from mortgages sold to Fannie Mae and Freddie Mac and includes more than 28.8 million transactions over the past 29 years. OFHEO analyzes the combined mortgage record of these two government-sponsored enterprises, which form the nation’s largest database of mortgage transactions.3 As of third quarter 2004, OFHEO published home price data for 361 metropolitan areas of varying sizes. Full data for all of these cities is available only since the mid-1990s, although 90 percent of cities in the data set have history going back to 1990. The longest data series in the OFHEO data set go back to 1975, but this lengthy history is only available for 13 major cities. Between 1980 and 1990, quarterly data are available for just 133 cities, or slightly more than one-third of the cities covered by the HPI. This limited history constrains our ability to get a complete sense of the prevalence of booms and busts prior to 1990. Nevertheless, we feel there is sufficient information in the OFHEO data set and that this data set is the most appropriate one for our purposes.

Defining a Housing “Boom”
In order to examine the historical evidence of home price booms and busts, we first need to arrive at some definition of a “boom.” Although there are many possible ways to approach this issue, we chose a fairly simple definition based on a cursory examination of cities that have exhibited some of the strongest home price cycles in recent decades. We define a “boom” simply as a 30 percent or greater increase in inflation-adjusted (or real) home prices during any three-year period. For our “1/3 in 3″ rule, we adjust the nominal home price series that is published by OFHEO using the Bureau of Labor Statistics consumer price index (CPI) less the price of shelter, which is used by OFHEO to adjust home price changes for inflation.

Table 1: Historical Evidence of U.S. Home Price Booms and Busts, 1978-2003 – PDF 18k (PDF Help)Table 1 Accessible Version

Table 1 summarizes our findings. It shows that applying our “1/3 in 3″ rule results in the identification of a number of individual metro-area price booms since 1978. In fact, 63 different U.S. metropolitan areas have experienced at least one boom during that period, and 24 cities experienced more than one boom. Geographically, home price booms have been concentrated in cities in California and the Northeast, which account for almost 70 percent of our 63 boom markets. This share may be overstated, however, due to the limited availability of data for many cities outside these areas prior to 1990.