Cyclical price inflation set to fall

“Inflation is always and everywhere a monetary phenomenon” – Milton Friedman

“CPI inflation rises 4.7%!” It’s a great headline, but should we worry? Maybe, but there a few more misunderstood concepts than inflation. Whether the Consumer Price index is rising or falling is not really a true measure of inflation. Systemic inflation is caused by an expansion in the money supply. Price changes may or may not be symptoms of endemic inflation. Clearly whereas excessive money supply leads inevitably to rising prices, rising price levels may reflect temporary supply/demand shocks and end up being just as temporary.

The US has recently experienced a very strong bout of M3 money supply growth – 10% annualised since mid-May and around 7.5% over the last year. While this money supply growth has made a mockery of the Fed’s monetary tightening so far, this is about to change, and possibly dramatically.

Rampant money supply growth has been caused directly from the housing market. Refinancing and equity extraction have been simply explosive in recent years, but it looks almost certain that this growth has come to an end:

1. Growth in home equity loans has plunged over the last few months,

2. The index of mortgage applications recently hit a 9 month low,

3. Higher interest rates are discouraging refinancing.

Although M3 has been strong in recent months and over the last year or so, the bigger picture (as shown on the following chart of the year-over-year M2 growth rate) is that a downward trend has been in force since the beginning of 2002.

 

 

 

Now it looks as though M3 growth is slowing suddenly, as it looks like the housing market is in trouble. The inventory of unsold housing has just hit a multi-year high and there is still a great deal of new property still being built. This is happening just as housing affordability has fallen to multi decade lows (as shown below) and house prices are at record levels relative to incomes.  The supply demand equation looks to have changed. Supply now substantially exceeds demand at record price levels. The housing market will not be in equilibrium until supply and demand are much more in balance and presumably this will now only occur at a lower price level relative to inflation and incomes,  when the existing inventory and current overbuilding has been absorbed. This will likely take years after the boom we have had.

This is more than likely a good time to wait before investing in residential property, but it also means that one of the main drivers of money supply growth has gone away. Without the massive credit creation stemming from the housing market, the overall money supply growth picture is not so bad. Indeed it may temporarily weaken.

What’s this got to do with international bonds?

This has everything to do with international bonds. With the US growth engine coming from the housing market now stalling it may not be long before US interest rates are likely to be peaking. The US economy in particular looks fragile. Q4 2005 is on track for sub 3% growth, and with a negative savings rate, higher fuel costs and massive consumer debt levels there are very few reserves left to sustain spending.

As we discussed at the beginning of the year we anticipated some US dollar strength in 2005, but this was largely because interest rate differentials widened as US interest rates rose relative to international interest rates. But now this game is nearly over, and meanwhile there is no sign that the current account deficit is narrowing at all. If anything it looks to be widening further. As soon as interest rates peak in the US the dollar will lose its shine.

This will make some international bonds begin to look very attractive. A weaker dollar and lower world interest rates combined mean that you could get a double bonus to your return. Particularly if you buy high yielding government bonds or sovereign debt in high credit worthy countries. Here are some good examples.

What should I buy?

Would you like to buy a portfolio of high yielding international mainly sovereign bonds at a discount of near 8% to their current market value with a single stock purchase? Sound too good to be true? Well you can do this right now by buying the right closed end funds. Check out www.etfconnect.com .

Aberdeen Global Income Fund (ticker FCO) is comprised mainly of government bonds from New Zealand, Australia, UK, Canada, and the US. It currently yields 5.7% and is at a near 8% discount to the fund’s assets.

Aberdeen Asia Pacific Income Fund (ticker FAX) is comprised mainly of government bonds from Australia, South Korea, US and the Philippines. It currently yields 7.3% and is also at a near 8% discount to the fund’s assets.

          For the more adventurous I would also recommend Iceland bonds which provide yields above 8% and Inflation-linked government bonds with real yields over 4%. This is a AA credit. Things are surprisingly good in Iceland now. You might be surprised to learn Icelanders enjoy the world’s longest life expectancy, and one of the world’s highest incomes per person. Crime is non-existent. It’s probably because everyone has a job… unbelievably less than 3,000 people in the entire country were unemployed in the third quarter of 2005. For more information take a look at www.bonds.is .

At yields and discounts like this, these are very attractive ways to diversify away from the dollar. Just be careful with your execution. Liquidity is sometimes restricted so make sure you only buy these stocks with “limit” orders at a price you are prepared to buy.

Summary

We hear so much these days about the risks of inflation. Sure the CPI has risen to 4.7% and this is the highest level for several years and this makes good headlines. However, systemic inflation results from money supply growth. No doubt there are several reasons why we should be concerned in the long term about this but for now the risks appear overstated.

With the sudden change in the housing market it looks much more likely that cyclical inflation will turn down. Almost certainly house prices have peaked. With wealth, credit and spending so closely tied to house prices the impact on the economy could be significant. With both the savings rate and real wages recently negative, without credit creation from higher house prices there is very little to sustain spending, either from reserves of savings or from incomes.

Not only does this mean that interest rates are close to peaking, but also that the US dollar’s one year rally is now very mature. The US dollar has benefited from widening interest rate differentials in its favour this year but the current account deficit has continued to widen. Stable to lower interest rates and a weaker dollar make foreign bonds doubly attractive. Particularly high yielding foreign government bonds with very high credit ratings.

 

 

 

 

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