The Growing Income-Expense Gap

[EJ]

The Growing Income-Expense Gap
October 20, 2006 Laura Rowley - Yahoo! Finance)

In the second quarter of this year, consumers spent a record $14.40 of every $100 they took home after taxes to cover required principal and interest payments on mortgage and consumer debt, according to the Federal Reserve. The figure rises to $18.06 of every $100 of take-home pay if you include automobile lease payments, homeowners insurance, property tax payments, and rental payments on tenant-occupied property.

And there is more troubling evidence of our credit-driven lifestyle: Some 2.33 percent of mortgages were delinquent at the end of the third quarter, the highest level since 2003, according to Equifax and Moody's Economy.com.

The worrisome part of that figure? Most of the delinquencies were not related to job loss -- the usual suspect when people fall behind on their payments. The vast majority were related to what Economy.com calls "mortgage equity withdrawal," which gauges how much cash homeowners have extracted from their dwellings through refinancing, home-equity loans, or selling and keeping some of the profits.

AntiSpin: None required when Laura writes. She is among my favorite columnists for Yahoo! Finance. Since iTulip ran its Greenspan Credit Bubble Poll in 2000 (questions and answers), the statistics on US household debt to income, debt to savings, home equity, and other measures of household financial health have, as we can see from Laura's column, deteriorated significantly.

Continuing on the theme of the theme of the dead cat bounce of the 1990s stock market bubble we're seeing in the Dow today, I'm reminded by Laura's column of the invention of installment credit in the 1920s and the consequences of excesses in consumer credit during that period in the years that followed. As stated by Joseph A. Schumpeter in his book "Business Cycles" (1939):

"Consumers' borrowing is one of the most conspicuous danger points in the secondary phenomena of prosperity, and consumers' debts are among the most conspicuous weak spots in recession and depression.

"In other words, we shall readily understand why the load of debt thus light heartedly incurred by people who foresaw nothing but booms should become a serious matter whenever incomes fell, and that construction would then contribute, directly and through the effects on the credit structure of impaired values of real estate, as much to a depression as it had contributed to the preceding booms. Nothing is so likely to produce cumulative depressive processes as such commitments of a vast number of households to an overhead financed to a great extent by commercial banks."

Given this history, I can understand why so many commentators, such as Prechter, expect deflation to follow this period of excess as it did the last.

In the 1930s, the Fed's means for creating inflation were hampered by the gold standard. Only after gold was confiscated and re-priced was the Fed able to increase the money supply, in 1933. The Fed operates with no such restrictions today. Yes, Japan suffered deflation from the 1990s until recently without the limitations on money creation of a gold standard, but when their stock and housing bubbles collapsed–the stock market bubble in 1990 and the housing bubble in 1993–they: 1) were a net creditor, running a trade surplus with the West, 2) made the fatal error of allowing real (inflation-adjusted) interest rates to fall below the zero bound, 3) followed the "advice" of the US–they had little choice, given Japan's reliance on the US for military protection–to allow the yen to appreciate; the yen has a built-in appreciation bias, due to the country's high savings rate and trade surplus, 4) credit creation was heavily dependent on their banking system, which was heavily capitalized by equities and thus became insolvent when the stock bubble collapsed, and 5) the nation is culturally inflation-phobic, as the last economic and financial catastrophe in Japan, akin to the US Great Depression, was a hyperinflation in the 1940s, leading to a policy bias against using monetary expansion to solve economic problems.

The US is a debtor. It's currency, the bonar, has a depreciation bias, its value no longer as much a function of economic performance relative to other countries as on continued demand for the currency for international transactions and trade. All the US needs to experience a massive inflation is for bonars already in circulation outside the US to come home. No additional domestic increase in the money supply is required. That is the essence of Ka-Poom Theory™. The last economic and financial catastrophe in the US, the Great Depression, was a deflationary collapse in the 1930s, leading to a policy bias toward using monetary expansion to solve economic problems. This bias toward using monetary expansion, the weapon of the last war, the war in deflation, will prove to be US policy makers' #1 future fatal error.

[Jim Nickerson]

Re: The Growing Income-Expense Gap

The US is a debtor. It's currency, the bonar, has a depreciation bias, its value no longer a function of relative economic performance relative to other countries but rather dependent on continued demand for the currency for international transactions and trade. All the US needs to experience a massive inflation is for bonars already in circulation outside the US to come home. No additional domestic increase in the money supply is required. That is the essence of Ka-Poom Theory™. The last economic and financial catastrophe in the US, the Great Depression, was a deflationary collapse in the 1930s, leading to a policy bias toward using monetary expansion to solve economic problems. This bias toward using monetary expansion, the weapon of the last war, the war in deflation, will prove to be US policy makers' #1 future fatal error.

So what are the factors, events, circumstances that will make the above occur?

[Christoph von Gamm]

Re: The Growing Income-Expense Gap

So what are the factors, events, circumstances that will make the above occur?

In my view a little and subtle loss of confidence already does suffice.

Repratriation of US dollars, causing first a downwards exchange rate against Euro and Yen, maybe together with an increase in the commodity price might just be a start.

Next, maybe because of misspeculation another hedge fund blows up, therefore exposing 4-5 billion of extra debt, somewhere... therefore some US denominated hedgefonds will be sold, money will be extracted and repatriated into Switzerland or other safe haven... causing the Dollar to further spiral downwards, increasing import prices for the US etc etc...

Then maybe the FED might underreact or overreact ... underreact by keeping interest rates low, making dollars even less attractive for foreign buyers and heating up inflation, therefore ... or overreact, by raising rates and therefore breaking up the economy and letting corporate profits dwindle therefore making stocks less attractive for foreign investors... so either ways the sitation is not funny at all...

[jk]

Re: The Growing Income-Expense Gap

So what are the factors, events, circumstances that will make the above occur?

how about a u.s. slowdown/recession? commodity prices go down, interest rates drop on the short end of the curve as the fed tries to stimulate. the dollar declines.

meanwhile, oil begins to be priced in euros, or rubles, or gold, or anything-but-dollars, reducing the necessity for other countries to hold dollars in order to buy oil. so the dollar declines.

central banks around the world pursue the increasingly stated goal of "diversifying" their reserve holdings, i.e. reducing the percentage held in dollars. the dollar declines.

countries with big dollar reserves, like japan and china, note that reduced u.s. consumption [in the context of a u.s. recession] produces less in the way of dollar revenues. there is a diminished need for the big exporters to hold up the dollar to maintain the u.s. market for their exports, since there is only a shrunken u.s. market for their exports. so the dollar declines.

[foreign central banks must reduce their purchases of u.s. debt. remember, their dollar revenues have shrunk, so they can't buy that many bonds with revenues. in order to buy more bonds, they would have to purchase dollars from other dollar holders, and then use those dollars to buy bonds. this seems unlikely to say the least. thus we have a scenario in which the u.s. federal budget deficit is shooting even higher, which it does during a slowdown, and a shrunken pool of overseas dollars to buy bonds. so the bonds have to be sold domestically or, more likely, be monetized by the fed.]

what does a dollar holder have to do, in the face of a declining dollar, to maintain the overall value of their holdings? use the dollars to buy something. oil for a strategic reserve, like the one china is filling, is one good use. other commodities are worth buying. but then what do the oil sellers and commodity sellers do with their dollars if they want to keep their reserves "diversified." buy something.

so the dollar is the old maid, or hot potato. individuals and countries keep spending their dollars. ultimately there is only one place for dollars to be spent which doesn't feed into the international hot potato frenzy: the u.s. there is one place which will always accept dollars, when sellers of various goods and services around the world don't want any more dollars: the u.s.

so, buy u.s. real estate, u.s. corporations, u.s. goods, u.s. possessions. the dollars come home.

[Jim Nickerson]

Re: The Growing Income-Expense Gap

I do not know if the following scenario would produce anything like EJ's surmise, but to me it represents one potential factor that could set the markets into turmoil.

From Barrons, dated 10/23/06 in Current Yield by Randall Forsyth.

"Japan's domestic economy has been showing signs of softening, writes Jonathan Alum of KBC Financial Products in The Blah!, his daily newsletter out of Tokyo. "The BOJ, in particular, seems in denial on this, arguing that the apparent signs of slowing/weakness are either a function of inadequate data or the weather," he writes. Absent support from domestic demand, Japan's economic recovery is heavily dependent on capital spending and exports, adds Stephen Roach, chief economist of Morgan Stanley. In that case, the Bank of Japan would appear to be in no hurry to raise rates, which would boost the yen and hamper exports.

With the yen and Japanese interest rates capped, levereraged speculators have been piling back into the yen-carry trade. "What better way to add a little oomph to your year-end performance than lever-up -- borrowing at [0.25%] in a currency that is all but guaranteed to remain weak?" writes Stephanie Pomboy of MacroMavens in her weekly missive.

The resurgence of the yen-carry trade has contributed to the feeling of ample global liquidity, observes F. Mark Turner, head of Pentagram Partners, a Milton, Mass., global hedge fund. But, Pomboy warns, that tide of liquidity could recede quickly if the dollar falls, and by extension, the yen rises. The reversal of the yen-carry trade then could cause all sorts of havoc.

[Jim Nickerson]

Re: The Growing Income-Expense Gap

Reluctant Rally Still Has Life
Interview With James Paulsen, Chief Investment Strategist,
Wells Capital Management
By SANDRA WARD

from Barron's 10/23/06:

Paulsen: A couple of months ago, there was the impression consumers were suffering under the weight of a stock market that was down 10% and being told everyday that their house values were going to hell. Mortgage yields had risen to their highest level of the cycle, job creation seemed like it was grinding to a halt and everybody was paying $3 at the gas pump. It was a disaster. Now, mortgage yields are back to where they were at the end of last year, the Dow Jones Industrial Average is at an all-time high, [former Federal Reserve Chairman] Alan Greenspan says the housing market has bottomed, and we found another 810,000 jobs we didn't know we had. Last night, when I paid $2.09 at the pump, it seemed cheap.

The nature of this whole recovery has been to switch sentiment every 120 days or so from concerns about an overheating economy to one headed for recession. But the undertow of the rally has been good throughout. In the short term we've come off the market lows of June and gone to new highs. Longer term, this recovery cycle started in March 2003. Before the cycle ends or truly peaks, there's got to be some increase in long-term borrowing costs. Right now, the 10-year-yield is at 4.80%, not much different from where it's been for four or five years. Yields were up to 5.25% in June but were promptly taken down again. One of the reasons the economy keeps going is we haven't sat on it with any kind of force, and some of the things that were biting at it have changed of late, mainly energy.

What about the outlook for housing?

Greenspan has said the worst might be over for housing, and I have to agree. Refinancing applications have exploded to the upside and are at the highest levels since last year. Lumber futures are showing signs of bottoming. Mortgage yields are back down. Housing stocks have been rising since July even though the reports have been bad. Construction jobs have been up about 30,000 in the last two months, despite the so-called housing collapse.

Short-term there are a number of factors suggesting that things get better. Housing has rolled over and the economy is OK. Real residential housing is off about 1.2% in the last year, and yet overall GDP is up 3.6%. Year-to-date real housing spending is down over 5% at an annualized rate in real terms and the economy is growing 4.2% year to date. There are really two separate housing stories at work, one gets all the play and one doesn't. As residential housing has rolled over, non-residential construction is exploding to the upside. This tells you the slowdown in housing isn't primarily because of interest rates because higher rates would have also killed off commercial construction, and it didn't.

[jk]

Re: The Growing Income-Expense Gap

I do not know if the following scenario would produce anything like EJ's surmise, but to me it represents one potential factor that could set the markets into turmoil.

From Barrons, dated 10/23/06 in Current Yield by Randall Forsyth.

"Japan's domestic economy has been showing signs of softening, writes Jonathan Alum of KBC Financial Products in The Blah!, his daily newsletter out of Tokyo. "The BOJ, in particular, seems in denial on this, arguing that the apparent signs of slowing/weakness are either a function of inadequate data or the weather," he writes. Absent support from domestic demand, Japan's economic recovery is heavily dependent on capital spending and exports, adds Stephen Roach, chief economist of Morgan Stanley. In that case, the Bank of Japan would appear to be in no hurry to raise rates, which would boost the yen and hamper exports.

With the yen and Japanese interest rates capped, levereraged speculators have been piling back into the yen-carry trade. "What better way to add a little oomph to your year-end performance than lever-up -- borrowing at [0.25%] in a currency that is all but guaranteed to remain weak?" writes Stephanie Pomboy of MacroMavens in her weekly missive.

The resurgence of the yen-carry trade has contributed to the feeling of ample global liquidity, observes F. Mark Turner, head of Pentagram Partners, a Milton, Mass., global hedge fund. But, Pomboy warns, that tide of liquidity could recede quickly if the dollar falls, and by extension, the yen rises. The reversal of the yen-carry trade then could cause all sorts of havoc.

heaven help us if the yen-carry trade ever gets unwound in something approaching a hurry. japanese derived liquidity is holding up every asset class. long dated out-of-the-money yen calls might be good insurance. i guess gold, too.

[hayfield]

Re: The Growing Income-Expense Gap

All the US needs to experience a massive inflation is for bonars already in circulation outside the US to come home. No additional domestic increase in the money supply is required. That is the essence of Ka-Poom Theory™. [/B]

Trying to connect the dots between bonar repatriation and inflation, I read inflation to mean (Keynsian) price inflation, resulting from previously baked-in-the-cake (Austrian) monetary inflation. True?

So this begs the question, what prices would be bid up, assets, consumer goods, ... ?

If assets are the first to benefit from bonar repatriation, does the current stock rally extend through the period of dollar repatriation even as corporatate profits fall? Does the housing boom rock on as MBS are gobbled up for the few basis point spreads over treasuries?

Or if the inflation is to show up in consumer goods, with 70% of the US economy being consumer spending, how will all of the soon-to-be-unwanted bonars held by foreigners end up in the hands of consumers who ultimately bid up prices? And should those dollars land in the hands of consumers, does the current stock market rally continue because profits rise in absolute terms?

Or is it irrelevant, as the dollar is devalued through falling demand, the price of gold/commodities/xyz rises because it's a better store of value than the dollar?

[metalman]

Re: The Growing Income-Expense Gap

Trying to connect the dots between bonar repatriation and inflation, I read inflation to mean (Keynsian) price inflation, resulting from previously baked-in-the-cake (Austrian) monetary inflation. True?

So this begs the question, what prices would be bid up, assets, consumer goods, ... ?

If assets are the first to benefit from bonar repatriation, does the current stock rally extend through the period of dollar repatriation even as corporatate profits fall? Does the housing boom rock on as MBS are gobbled up for the few basis point spreads over treasuries?

Or if the inflation is to show up in consumer goods, with 70% of the US economy being consumer spending, how will all of the soon-to-be-unwanted bonars held by foreigners end up in the hands of consumers who ultimately bid up prices? And should those dollars land in the hands of consumers, does the current stock market rally continue because profits rise in absolute terms?

Or is it irrelevant, as the dollar is devalued through falling demand, the price of gold/commodities/xyz rises because it's a better store of value than the dollar?

see "Can the US have a peso problem?"

http://www.itulip.com/faceofinflation.htm