While the world’s attention was focused on the dollar, inflation, and the possibility of resurgent inflation, signs of deflation crept back into asset markets. Some vintages of subprime AAA’s, a barometer of sorts of household health, are trading at all time lows of less than a quarter on the dollar (click on chart to enlarge).
This is not surprising given that foreclosure rates rose 18 percent in May, according to figures released Tuesday by RealtyTrac. There were more than 300,000 foreclosures in May. The collapse of household finances and the effect of sustained high unemployment continue to eat away at asset quality. Some subprime pools are likely to show loss rates of 80%, which makes the 25-cents-on-the-dollar price for some pools sadly justified.
I continue to see paralysis rather than a directional move, and stocks chopping sideways rather than collapsing or rallying. When rates backed up sharply in the (false) expectation that the Fed would have to raise rates later in the year and the (questionable) expectation that resurgent BRIC demand would push up global inflation rates, it occurred to investors that a 4% Treasury and a 5.5% mortgage rate would take the wind out of the sails of the housing recovery. There never was a housing recovery to begin with, but in the past week the 10-year Treasury yield has dropped from 4% at the peak to 3.67% at this afternoon’s close.
Chinese banks have doubled their rate of lending this year and Chinese production shows some signs of revival, but it does not seem likely that China or the other emerging economies will have sufficient weight to counter the continuing collapse of demand in the industrial world.
It is easy to miss the fact that the collapse of demand in the US is structural rather than cyclical. The aging boomers didn’t save because the value of their assets had grown sufficiently to create the illusion that capital gains would substitute for savings. The rise in the personal savings rate in the US to date has been substantial — from 0% to 5% — but it has a long way to go (click to enlarge).
US Personal Savings Rate
The personal savings rate needs to rise above 10% for households to replace the assets lost to the collapse of home and equity market prices. The boomers do not have the money with which to retire, and they need to catch up.
The deadly downdraft of falling demand will continue for years. The government cannot effectively substitute for private expenditures, especially not when government funds are spent to placate high-cost organized labor constituencies.
High savings rates are deflationary. Savings postpones consumption. Savers forgo consumption of present goods for future goods by purchasing securities rather than current production. That drives down the price of current goods and increase the price of future goods (bonds). Japan’s great deflation of the past 20 years is in part the result of persistently high savings rates due to the country’s already extremely high savings rates. Japan’s population is so old that it will begin spending down its savings, and its deflation should moderate. But the deflationary impact of higher saving in America is a powerful counterweight to the inflationary impulses coming from the government and central bank.
This makes the inflation vs. deflation calculation extremely hard to reckon. There’s nothing to do but to own reliable long-term cash flows (high quality bonds) with some inflation hedges.
