Thursday, April 7, 2011

Inflation vs the end of QE2 - Ari Paul

Over the last two years commodity prices have rallied 101% (measured by the GSCI index), while inflation in consumer goods has been an anemic 5%. The simplest explanation for that contrast is excess capacity. When there's plenty of factory capacity and high unemployment, a rise in input prices isn't fully passed on to consumers. This effect is so pronounced because commodity prices make up a surprisingly small component of many products. For example, the actual cotton is usually just 15-30% of the price of a finished cotton dress. The rest is labor, manufacturing, transportation, administration, etc.

Still, over time input prices impact consumer prices and we're starting to see a stronger impact. The CEO of Wal-Mart recently stated that he expects CPI to rise sharply by June as commodity price increases and a tightening labor market in China are finally felt by US consumers.

Competing against this inflationary pressure is the end of quantitative easing in June. As part of the QE2 program, the federal reserve was scheduled to purchase $600 billion in government bonds. Some fed hawks are suggesting the Fed may stop $100 billion short. While I think that is unlikely, the statements suggest that there is currently no QE3 planned. If you believe, as I do, that quantitative easing has been the primary driver of rising asset prices and improving corporate fundamentals, than the end of quantitative easing is potentially both bearish and deflationary.
Europe just raised interest rates to 1.25% and China raised its benchmark 1-year rate for the 4th time in 6 months to 6.31%. This increases the political pressure on the US to tighten.

So, we have the inflationary pressure as rising commodity prices are finally passed on to consumers, but the possible end of the quantitative easing program in June. If these were the only factors, I would quickly emphasize the end of QE2 and be confident in a deflationary outlook, but it's not quite that simple. There's increasing recognition that US debt is a ponzi scheme, and that's not hyperbole. Paul Volcker and Michael Bloomberg recently pointed out that if the US were valued as a company, its net worth would be negative $35 trillion due to the present value of medicaid and medicare liabilities. Bill Gross, the co-manager of the largest bond fund in the world PIMCO, noted that the Fed is currently buying 70% of all US treasury issuance, compared to 10% normally. If the Fed stops buying, who will replace them? If no one steps up to the plate with an appetite for at least $600 billion in additional treasury purchases a year, the Fed will have no choice but to continue buying.

Finally, there's growing political pressure by the republicans for fiscal spending cuts. The current spending bill is held up for a trivial difference of $30 billion, but Representative Paul Ryan is pushing a bill that would potentially cut $6.2 trillion over 10 years. Ryan's bill is unworkable and might not even save any money (most of the savings push healthcare payments to states and emergency rooms), but it reflects the political winds. Still, it's almost never a good idea to bet on politicians exercising political restraint.

In conclusion, we have to balance rising input costs, the likely end of QE2, and a more fiscally conservative political environment. The simplest change is that CPI is likely to do much better relative to commodity price increases than it has in the past. I have no great confidence in how this will play out, and I'm mostly unwinding my trade of the last two years: long commodities vs short equities. My current positions are slightly short US equities, slightly long natural gas producers, slightly short the Euro, and short the Yen.

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