No Inflation and Plenty of Money
Sentinel Investments
By Christian W. Thwaites
February 27, 2012
Do we have a deal? Up to a point. The headline on Greece is that the PSI will accept i) new bonds with a face amount of around €31(the current 10-year trades around €22) ii) EFSF notes with an even stiffer haircut and iii) some GDP-linked securities which allow for additional coupon payments if Greece meets specific growth targets. In return, Greece undertakes labor and pension reform, some privatizations, etc. All standard. Read any way it's an austerity deal for Greece that may result in the debt-ratio falling from around 160% to 130% by 2020. It's all going to lead to more unemployment and a painful internal devaluation. And it is not at all certain that Greek authorities can deliver. But all this is known and much of what we hear about Greece is noise. The worst may be over.
LTRO: Full marks for Draghi executing some deft monetary policy. The ECB, having sat on the sidelines and repeated the inflation mantra for most of the last two years, offered the three-year LTRO in December that took much of the funding pressure off banks. The LOIS-EUR spread fell from a December high of 104bps to 65bp and risk assets took off. The ones that matter are European bonds. Since December, Bunds, OATs, Spanish, Italian and Portuguese bonds appreciated by 3% to 15%. Some of that is banks buying their own sovereigns to ease liquidity. But this is no simple carry trade. Some will find its way into companies and households. The second of the LTROs hits on Wednesday. Estimates are all over the place but somewhere between €500bn and €1 trillion looks likely.
Inflation: Regular readers know we have a tough time seeing inflation anywhere in the economy. We get the printing press, monetary argument. And gasoline. It's just that for the first, money still has to flow into the real economy to hit CPI (asset price inflation is another subject) and the M2 multipliers are nowhere near where they need to be to kick start inflation. And for the second, it's daft to base monetary policy on a refinery shortage. There are some good signals ahead:
- Increased Grain Production: Farmers will grow 94m acres of corn this year, up 2.3% from 2011 and the most since 1944. Coupled with a slowdown in ethanol use (finally), average corn prices look set to fall 19% this year.
- Medical: We have seen alarmist estimates for increased healthcare costs. Medicaid and Medicare represent 42% of government social benefits so this produces some worrying projections about costs and deficits. But here's what is happening:
Source: Federal Reserve Bank of St. Louis, Economic Research
Increases in medical care services, about 5% of the CPI basket, are slowly coming down and have shown remarkably steady growth for the last two years. They are not growing any faster than the general inflation rate. If this continues, the myth of escalating healthcare costs may need a re-think.
Put these two together and join it with no real increase in disposable income or earnings and the inflation outlook looks benign. This was probably the thinking behind the FOMC projections of low inflation...and they have a good record on inflation forecasting.
US Economic Stats: The U. of Michigan consumer confidence index rose to its highest level in a year. It's heavily influenced by employment numbers at this stage so it ties in with the recent improvement in unemployment and initial jobless claims. Two more Fed surveys, from Chicago and Kansas City, showed improvement in manufacturing and production. We saw a big build up in inventories in 4Q. This is beginning to work its way through the distribution chain. But as the inventory to sales ratio shows, we should not see a big halt in production...businesses are still running lean.
Source: Federal Reserve Bank of St. Louis, Economic Research
We are still fighting: worldwide fiscal drag (aka the dogma of expansionary austerity) with accommodative money polices. The PBOC joined in with someRRR cuts, although these do not mean much in the Chinese loan-quota system. And the BOJ took steps to weaken the yen. CBs are in control. Government fiscal policies remain ineffectual.
Bottom Line: US government bonds remain in a tight band of 190-210. The New Issue Market is strong with low end investment grade names trading at less than 314 over GT10s. We continue to like US equities.
Sources: Hellenic Republic, Ministry of Finance; European Central Bank; JP Morgan; Bloomberg; Peter Tillman, VOX EU; Bureau of Labor Statistics; Federal Reserve Bank of St. Louis; Federal Reserve Bank of Kansas City; Federal Reserve Bank of Chicago; Sentinel Asset Management, Inc.
(c) Sentinel Investments
