The Next Bubble?
Initial Claims (444k today and upwardly-revised to 448k last week) continues to creep down, but seems very reticent to press below 440k or so. Considering the strong Employment data we digested less than one week ago, and the breathless analysis we saw of those figures, it qualifies as a disappointment the longer ‘Claims remain this high. As I pointed out last week, though, it is Payrolls that is the outlier: all other useful indicators of employment show improvement, but very slow improvement. The bond market was reasonably stable for a bond auction day, and ended near unchanged. TYM0 was +2/32nds, with the new 10y note at 3.55%.
Stocks weakened, partly because the Wall Street witch hunt is gathering steam (oddly, Bernanke weighed in on the side of keeping banks together with their swaps trading units, which this author has advocated, but the main news today concerned the widening probe into the influence Wall Street firms had on the ratings of mortgage bond deals). Another part of the equity weakness was, I think, because the euphoric bounce on the European bailout package was not followed up with any post-euphoric follow-through. Most opaquely, but perhaps most importantly, today’s wobbling of stocks may also be partly due to the slowly-dawning realization that the bailout package is less than meets the eye. The ECB has reportedly already slackened purchases of government bonds after an initial show of strength, but both the shock and the awe seem to be fading pretty rapidly…and it hardly bears noting that another weekend is approaching. Stocks ended the day down 1.2%.
Since the bursting of the property bubble, everyone has been asking “what’s the next bubble?” I don’t know what the formal definition of a bubble is, but it surely implies a trend that has carried much too far relative to fundamentals, usually accompanied by contemporaneously-generated explanations for why the difference makes sense.
In that context, I think perhaps we should consider whether the Euro itself was a bubble, which began to deflate shortly after the property bubble crested in 2006-2007 and has recently begun to recede somewhat more quickly. The chart below shows the relative strength of the Euro against the US$, adjusted for changes in the price level. (That is, since inflation has been modestly higher in the US than in Europe, arguably some of the rise in the Euro is explained by changes in purchasing power parity).
The chart begins in 2001 because that’s when the Eurostat Eurozone HICP series begins on Bloomberg, but arguably true currency union didn’t begin until January 2002 when Euro coins and bills actually entered circulation. Since then, until late 2007/early 2008, the Euro has enjoyed an almost-uninterrupted rise against the dollar. (To be sure, some of that rise came because of dollar-loathing rather than Euro-loving, but a negative bubble is still a bubble no?)
Europhiles will perhaps raise an objection that the rise in the value of the Euro reflects the gains in efficiency from combining the riot of separate currencies. That is one of those contemporaneously-generated explanations for the strength of the Euro, but it doesn’t really withstand scrutiny over this time period. If in fact the creation of the Euro unleashed these terrific efficiencies, then one of two things must have happened: either prices in Euroland fell relative to the US (which effect is already included in the chart above) or output in Euroland outstripped that in the U.S.. That hasn’t happened either. I assembled the chart below from annual IMF data, adjusted for the EUR/USD exchange rate and then further adjusted for the purchasing-power-parity effect. In fact, Europe’s economy has actually shrunk a little bit compared to the US, once you eliminate the appreciating currency from the calculation.
So, in short, the Euro appreciated some 60% from 2001 to 2008, but the currency is associated with a bloc of countries who collectively have a sketchy work ethic, even-more-intrusive government, and awesome demographic challenges (to be sure, the U.S. is catching up on all three). The currency rose mainly because it became fashionable to believe in the Euro and, partly I am sure, because it did create a plausible alternative reserve currency and that fact enticed some international diversification.
Those effects are over, the bloom is off the rose, and international suspicion of the value of European Union is rising. I see no reason that the Euro shouldn’t drop another 40% relative to the dollar over the next couple of years.
Now, some people will say “wow, that means inflation in the U.S. will remain contained.” That is partly true: clearly, all else being equal a rise in the value of the USD will tend to depress domestic inflation relative to foreign inflation. But the sneaky part is in those last four words: relative to foreign inflation.
Think of a big vat filled halfway up with water. Give the vat a shove, and it will create a wave in the vat. Now, pretend the level of the water at any given point represents the price level in a particular country. It is a zero-sum game: if the water is a little lower in one area, because you’re near the trough of the wave, then it must be a little higher in another area…near the peak of the wave. Currency fluctuations set up these waves. They are zero-sum, depressing the price level in one country (the one with the appreciating currency) and raising the price level in another (the one with the depreciating currency).
However, suppose that while we are watching these waves lap around the tank, we are also pouring more water into it so that the average water level is rising. You can see that even though the waves themselves change the relative height of the water from one point to the next, the height of the water at every point is going to rise over time. This is the global inflation process, and it happens when more money is added to the economy than needed to support real growth.
So right now, while investors might breathe a small sigh of relief because the dollar is strengthening and that will tend to diminish inflation, they shouldn’t breath too easily because there are a lot of central bankers positioning their hoses over the vat, “just in case.”
This leads me to another issue. I wrote yesterday about one fear I have about my model: it incorporates M, but ignores (as most models of this sort do) V, and right now that is important. My model also incorporates the dollar, because over the last 20 years the water level has been more or less stable so that the ripples in the pool had added importance. This creates another concern in my mind about my model, and that’s that when inflation starts to rise appreciably on a global basis, the strength of the dollar will (correctly) indicate that U.S. inflation will be tamer than it would otherwise be, but the model will incorrectly assume that means it should be tame (absolutely speaking).
I guess that sort of makes it sound like my model sucks, but I think most inflation models probably suffer from the same shortcomings right now. In my case, at least I think I understand what those shortcomings are, I hope!
Tomorrow, we finally get some important economic data, although Retail Sales (Consensus: +0.2%, +0.4% ex-autos) this month suffers from extra-wide uncertainty because of the Easter effect. What that means for us is that a wider deviation from expectations can be tolerated before we conclude that a surprise was meaningful.
Industrial Production and Capacity Utilization (Consensus: +0.7%, 73.8%) is also due, along with the preliminary Michigan Confidence number (Consensus: 73.5 vs 72.2). All of these numbers continue the trend of upbeat forecasts from the bow-tied set, and hence make disappointment relatively easier to achieve. I think stocks are at an unstable equilibrium here. Even a small further decline could turn into a rout; a modest rally to new weekly highs, though, would raise a lot of spirits heading into the weekend. In short, I doubt we will trade here very long.