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Thursday December 1, 2005 - 11:51:05 GMT
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Is partial inversion telling us something?


“The further we progress in our knowledge, the more clearly we can discern the vastness of our ignorance.”

Sir Karl Popper

FX Trading
US bond prices have balked a bit on “good” growth gleaned from Q3 GDP and “bad” inflation news brought to us by the Fed’s Beige Book yesterday. But, based on what we think we know about rising inflation pressures, the yield conundrum seems even more confusing now that a partial yield curve inversion sneaks up on us.

I know Bond King Bill Gross has been wrong on the Fed lately. But the jury is still out on that—at least that may be what the curve inversion is telling us.

A very astute reader of CC sent me this the other day: “If I am correct, the average Joe is going to get so beaten up this winter by enormous heating bills, higher minimum credit card payments, and, in some cases, higher adjusted mortgage payments. Even Merrill Lynch sees it: They estimated that the first two of the three I listed might add as much as $700 to the monthly budget. Nobody earning $53K per year can absorb $700 per month without suffering a dire personal recession. Multiply that times $100 million households and you've got a mess.

“My prediction: Spring seasonal housing market opens and the buyers are no shows. Game over.”

I think my reader is on to something. This from the Journal yesterday [our emphasis]:

“This year, 6.23% of the loans are delinquent, on average, in their first nine months, a rate not surpassed until the 20th month for 2004 mortgages. By September 2004, that year's mortgages had a delinquency rate of only 3.72%.

“The conclusion seems obvious: These folks were among the last to get mortgages during a great boom, and laggards tend to be worse credit risks. They flocked to short-term, floating-rate mortgages, interest-only loans and loans that require little documentation.

“What makes this so troubling is that the dollar amount of two-year ARM mortgages was much smaller in 2003 than in 2004 or this year. Mark Agah, another analyst at Portales, estimates that there were about $220 billion in two-year ARMs in 2003. That soared to about $400 billion last year and should be around $440 billion this year.”

Mr. Consumer and his major wealth generator—housing—has been the major spending prop to for this economy for a long time. Many continue to lose betting against Mr. C.

But, the amount of money now in adjustable rate mortgages (ARMs) does suggest the inversion on the short-end of the curve—the area where the Fed hikes ARE biting—could be the Achilles heel of Mr. C and the US economy.

So maybe the inversion of the yield curve could again be signaling a recession or major slowdown or financial dislocation it has so deftly done before.

But long rates HAVE to go higher we hear from the gurus. It’s inflation don’t you know! Well, we know we’ve seen rising prices in the industrial economies. We know we’ve seen rising commodities prices based on real supply-liquidity-and-demand dynamics, but is that the same as “inflation”?

One would think that if we had a global runaway inflation problem, the fastest growing part of the world would be having the problem in spades. But it ain’t!

Japan is in fact still concerned deflation’s tight grip may still be squeezing. South Korea just reported its consumer price index rose 2.4%, slowing for a second month. And of course, the Big Dog China (if we can believe their numbers and most do when it suits their needs) isn’t having much of an inflation problem despite all those raw material it sucks in at higher and higer prices. In fact, some are growing concerned the Big Dog’s massive liquidity bowl is sowing the seeds of deflation:

“The specter of falling Chinese prices runs counter to most views of the world's sexiest economy. China ended five years of deflation in 2004 by stimulating investments in real estate, automobile manufacturing, power generation and elsewhere. And it worked; inflation climbed as high as 2.3 percent in the first six months of 2005.

“’We can't go on stimulating the economy this way as this method will inevitably lead to oversupply, which in turn will take us back to deflation,’ says Justin Lin Yifu, a Beijing- based professor at Peking University and a government adviser. Lin thinks China could slip back into deflation by the end of the year or early 2006,” according to Bloomberg columnist William Pesek Jr.

Let me repeat Mr. Lin’s concern: “China could slip back into deflation by the end of the year or early 2006.”

Sure, it could be yet another doom and gloom forecast on China that goes awry. But at least it’s not the usual pabulum of Chinese growth as far as the eye can see and the mind can imagine—that mantra is way past its prime.

Anyway, the point is, there may be very good reasons why the inflation premium in the long bond ain’t what it “should” be. And Bill Gross didn’t become the Bond King by being wrong too often.

Jack Crooks
Black Swan Capital


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