Mortgage Credit News by Louis S Barnes - November 12, 2021

The top story this week is the inflation question, and below some perspective to offset media hysterics. Begin with the CPI report which drew all eyeballs, then interest rates, then the question. Several charts below.

The CPI report. In October alone the all-items CPI rose 0.9%, roughly double the forecast and double the September figure. So much for the improving trend. Even CPI core, ex-food and energy jumped 0.6%.

The headline everywhere but here: “Last Year Inflation 6.2% Worst Since 1990!” Yep. What happened in 1990? Oil in today’s dollars spiked from $40/bbl to $80/bbl. Saddam Hussein invaded Kuwait in August 1990, and in addition to regional disturbance in oil markets, set on fire 85% of Kuwait’s wells -- 650 of them. Doomers said fields were ruined, millions of barrels/day lost for good.

February 1991, Norman Schwarzkopf’s left hook finished Saddam. Enter Red Adair, Boots & Coots, Wild Well Control, Safety Boss, and a team of Hungarians with two Mig-21 turbine engines mounted on a WW II T-34 tank, hosing high-velocity seawater. Fires out, wells good, oil back to $40 in three months, inflation scare over.

Rates. Interest rates are more sensitive to inflation than any other market, and should be. The CPI report did get a quick reaction, but only a push of the 10-year T-note back into the middle of its 2021 range.

We began this year at 0.93% but by March ran up to 1.74%. Then Covid and economic optimism faded, back to 1.20% in August. New optimism combined with Fed and inflation fear, we ran up to 1.66% just three weeks ago -- but could not reach the March high, nor even hold the new run, and last week fell to 1.45%. Today 1.57%. No significant effect on mortgages.

10s are the best market indicator of inflation because their long-term duration magnifies damage to investors, but markets are not aboard with an inflation threat. If bonds feared an indolent Fed not reacting to inflation, or a new and too-easy chair, Lael Brainard replacing Powell, then long-term rates would rise, the yield curve steepening as long rates pull away for short. The opposite is happening: the 2-year T-note has risen more than 10s. (BTW: there is no policy daylight between Brainard and Powell.)

A great deal of money is still buying Treasurys. Inflation worry can be offset by other worries. Treasurys are the safe harbor during a credit meltdown, and China is melting. Not directly into a 2008 kind of thing, but enough defaults underway to make markets more careful about the location of invisible dominoes.

Treasurys are also the safe harbor for (gulp) war. Now is a reasonable moment for bad guys to try to take advantage of weakness in US leadership and our political divide, notably Czar Putin with troops massed on the Ukraine border, and his vassal next door, Belarus attempting to destabilize Poland by refugee flood, and Europe by stepping on the natural gas pipeline. The US is divided, and even Covid pushed us farther apart, but there is one sure way to pull us together: external threat.

Credit and unrest may push some extra money to bonds, but stick with Fr. Occam and simplicity: bonds are not worried about inflation.

Inflation. If the owners of $22,658,378,000,000 in US Treasurys (as of November 9, total IOUs trading in markets) are not worried, why not?

We have a lot of experience with US inflation, beginning with the rising wave in the 1960s, the crest in 1980, and the decline until 1995 when the whole world flipped to risk of deflation.

1. Two kinds of inflation: cost-pushed, and income-pulled. The former tends to be temporary, and the second is deadly dangerous. Costs fade when high prices beget new supply, but when incomes grow much faster than productivity and enter an upward, tail-chasing spiral with costs... we have no means to stop the spiral except recession throwing many millions of people out of work.

2. In our well-documented history it takes a long time, multiple error, and intractable shortage-cost to get inflation to spiral. Our only bad interval in 100 years began with LBJ’s 1965 “guns and butter,” simultaneous spending on Vietnam and the Great Society without raising taxes. Then that small candle flame was fueled by two oil shocks, 1973 and 1979 as well as a Fed accommodating politicians of both parties.

3. Inflation is easier to get going in an inflexible economy. Many people object to overseas competition, but it is the source of post-1980 flexibility. From WW II through 1970s the US had little foreign competition. The surge of global trade beginning in the 1990s put most American workers in direct competition with far more people who were (and are) happy to work for a fraction of US pay.

4. What about all the stimulus and new spending proposals? Stimulus beginning in the 2020 panic has resulted in an unprecedented surge in bank deposits -- instead of growing on trend to $15 trillion, we have $18 trillion. Could that cash be spent, fuel inflation? Sure, but even in a good economic recovery the excess is not being spent. We tacked several trillion onto the national debt, gave the money to ourselves, and have kept it. The infrastructure bill does have corresponding tax increases, and given the wreckage of the Biden administration, BBB is headed for 000.

5. My one worry is the potential to recreate the 1970s by well-intended climate urgency. The ‘70s were as ugly as they were because it took 15 years to find new energy supply, and to replace inefficient capital stock (8 miles/gallon guzzlers), and to implant consumer conservation. Climate activists do not understand how long it will take to wean us from carbon, and especially do not grasp that artificial shortages of current supply will result in extremely unpleasant inflation.

The US 10-year T-note, five years back, the last two trading days added in red:

One reader wrote in this week to say that our price-pop in the last year has been the work of those awful, big corporations. This chart from the NFIB survey in October says that small business is driving as much as any sector, and also suggests that the 2021 price increases are mostly a rebound from 2020:

CPI All Items since 1950. The two spikes after 1980, in 1990 and 2007 were followed quickly by a resumption of downward trend, and then three touches at zero:

US bank deposits. If you extend by eyeball the growth trend pre-Covid, deposits should be no more than $15 trillion... but we have almost $18 trillion, and not declining via spending:

Oil, inflation-adjusted. We have been accustomed to $60-ish oil, as today. However, we can’t tolerate $150 for long -- let alone the far higher result of decarbonizing before replacement sources:

The 10-year US T-note. Note extreme sensitivity to oil upsets until the mid-1980s, and none since. But we have not had a durable super-spike, either:

Henry Hub prices for US natural gas, inflation-adjusted. Guess when fracking took off:

Kuwait, December 1990:

Think of this baby as an inflation-extinguisher. Or a monument to bored boys playing with abandoned Soviet stuff. This is the original on a T-34 chassis, later upgraded to T-55.