Thursday, February 20, 2014 - Searching for Inflation

Searching for Inflation
by Sinclair Noe

DOW + 92 = 16,133
SPX + 11 = 1839
NAS + 29 = 4267
10 YR YLD + .02 = 2.75%
OIL + .02 = 102.86
GOLD + 12.10 = 1324.00
SILV + .29 = 21.92

The Conference Board’s Leading Economic Indicators rose 0.3% in January following no change in December. Over the six months through January, the LEI rose 3.1%. The LEI tracks 10 indicators designed to signal business cycle peaks and troughs. In the most recent report, 5 of the 10 indicators were positive, including a drop in jobless claims and a pickup in factory orders; on the negative side, declines in building permits and hours worked. Meanwhile, the Conference Board’s index of coincident indicators, a gauge of current economic activity, rose 0.1 percent for a second month. Overall, the leading indicators point to moderate expansion once the nation gets past inclement weather, with the caveat that consumer demand needs to pick up. No surprises in that report.

The Consumer Price Index rose 0.1% in January after a 0.2% gain in December. The CPI measures prices at the retail level. The core rate, excluding food and energy prices, also rose 0.1%. Over the past 12 months, consumer prices were up 1.5%, and the core CPI was up 1.6%. Energy costs increased 0.6% from a month earlier and were up 2.1% over the past 12 months. Food costs rose 0.1%. Gains in the cost of hotel rooms, medical care and rents were mostly offset by declining costs for new and used cars, clothing and airline fares.

Yesterday, Fed policymakers released the minutes of the January FOMC meeting and we learned they had expressed concern about inflation being too low. Some participants wanted an “explicit indication” in their annual statement on policy goals that prices persistently above or below their 2 percent inflation target would be “equally undesirable.”

Prices are about to move higher, at least for food. It’s pretty simple; the state that produces the most vegetables is going through the worst drought it has ever experienced. Just consider the statistics regarding what percentage of the produce you eat is grown in California: 99% of artichokes, 44% of asparagus, 66% of carrots, 50% of bell peppers, 89% of cauliflower, 94% of broccoli, 95% of celery, 90% of lettuce, 83% of spinach, 33% of tomatoes, 86% of lemons, 90% of avocados, 84% of peaches, 88% of strawberries, and 97% of plums.

If fruits and veggies don’t fill your plate, you’ll want to take note that the US cattle herd is now the smallest it has been in 63 years. The drought in California and also Texas means that there are fewer cows, as ranchers in the West sell off their livestock because grazing land has dried out and buying feed is prohibitively expensive. And you can’t just snap your fingers and have a cow ready for market; it takes a couple of years. The lower supply means higher prices; offsetting the supply is lower demand; nearly 40% of Americans say they eat less beef today than 3 years ago.  Ground beef prices were up 5% for the past year. Chicken prices up more than 18% in the past 3 years, and bacon up 23% in the past 3 years.

If there is any good news on the food front, the US Department of Agriculture today reported that corn, soybeans, and wheat prices should be lower over the next 12 months.

Anyway, no inflation on the horizon in today’s CPI report. And the reason is not just what is happening in the USA. Goods inflation is exposed to global trade. When China was flooding the world with low cost goods in the 1990s and 2000s, it put immense downward pressure on consumer goods prices and held down the overall U.S. inflation rate. Unlike the 1990s and early 2000s, the latest downdraft in goods inflation is likely being driven not so much by an influx of cheap goods produced by low-cost emerging market labor, but by a slowdown overseas driven by over investment in emerging markets during their boom. An acceleration of global growth is probably a necessary condition for headline inflation to accelerate.

That’s just a small part of the inflation picture. The service sector makes up a larger part of the US economy these days. Services inflation is highly exposed to domestic housing and the cost of domestic labor. In other words, rent and wages. The owners’ equivalent rent index had been rising at a steady pace through most of 2012 and 2013, with 12-month percent changes hovering around 2%, but toward the end of 2013, the pace picked up. By January OER was up 2.5% compared to year-ago levels. That’s not a hot pace for housing costs but it bears attention. Meanwhile, wages have been flat for what seems like forever, and that means there is no demand to push prices higher, at least for services. For that matter, we may be setting up a divergence between wages and rents. You can’t push rents higher unless people earn enough wages to pay the rent.

The Federal Reserve Bank of New York has issued a paper on why people are having a hard time finding a job. The old excuse was “structural unemployment.” The new excuse is a decline in “job matching efficiency.”

The White House budget to be released early next month will propose $56 billion in new spending on domestic and defense priorities and drop a proposal that was included in last year's budget as a way to attract Republican support; a plan that would have cut Social Security benefits based on a “chained CPI”. The budget would aim to reduce the emphasis on austerity that has been the preoccupation of American politics for the past four years.

A White House official said President Obama decided to release a budget that fully represents his "vision," rather than to continue to pursue a fiscal agreement, because Republicans have refused to engage in good-faith negotiations over the nation's top priorities.

The new budget is due March 4.

The protests in the Ukraine have escalated into gun battles between police and anti-government forces. The death toll has climbed to 75. Three hours of fierce fighting in Kiev's Independence Square, which was recaptured by the protesters, left the bodies of over 20 civilians strewn on the ground. Nearby, President Viktor Yanukovich was meeting with a EU delegation trying to broker a political settlement. For now, there is no agreement.

Increasingly, we’ve seen big banks involved in commodity markets, and an interesting idea was recently tossed out by Theodore Butler regarding the origins of the 2008 crash. I don’t know if it is true but it’s an interesting story.

You’ll remember that Bear Stearns imploded six years ago; JPMorgan took it over as the doors were closed. It was an unprecedented fall. As Butler said: “The cause was said to be a run on the bank as nervous investors pulled assets from the firm. Bear Stearns was said to be levered by 35 times, meaning it had equity of $11 billion and total assets of $395 billion. This is a very small cushion if something negative suddenly appears… Since Bear had a significant presence in sub-prime mortgages and that market was in distress, it is assumed the fall of the firm was mortgage related. That may be true, but there was no general stress in the stock market through mid-March 2008 reflecting a credit crisis. Was there instead some specific trigger behind the company’s sudden collapse?”

One idea is that Bear Stearns was short the silver market. The exact holdings haven’t been established but the 4 largest short traders in silver was at an extreme level of more than 300 million ounces; triple the long positions, and Bear Stearns was the largest short in COMEX gold and silver contracts.

The day of Bear Stearns demise coincides with historic high points in gold and silver. “Gold prices rose from under $800 in mid-December 2007 to $1,000 in mid-March 2008, a gain of more than $200. Silver prices rose from under $14 in mid-December to $21 when Bear Stearns failed on March 17, 2008. That was a gain of $7. This was the highest price for silver and close to the highest price of gold since 1980. Obviously, a $200 rise in the price of gold and a $7 rise in the price of silver is not good if you are the biggest gold and silver short…. Bear Stearns had to come up with $2.7 billion because gold and silver prices rose sharply in the first quarter of 2008 and the company bet the wrong way. That it couldn’t come up with all the margin money for the losses in gold and silver, is the most visible reason it went under.”

We can’t say with certainty that this is what happened to Bear Stearns, but it is probably more than mere coincidence that JPMorgan ended up acquiring Bear, and really, it makes  sense, and at the very least it’s a great story.