Why would anyone want to borrow when prices are going down?

If you would like my thoughts on a daily basis I write a comment every evening (Sunday-Thursday) around 10pm that discusses specific forecasts for short-term traders and long term investors.Tuesday’s CPI number will show retail inflation fell at a 1.5% rate in October confirming that a dangerous bout of DEFLATION has entered the U.S. economy. This disease is a rare occurrence as inflation has been the best friend of investors for the past 70+ years. Debt has been used to increase spending and leverage asset purchases that have created billions in profits for real estate investors but created unrealistic expectations about the future based on our own past history. When inflation has increased price levels far above the growth rate of wages the Fed has stepped in and increased short-term interest rates making the “real” cost of borrowing high enough to temporarily change investor expectations about the future. If inflation is 10% the Fed can easily raise the overnight cost of funds to 15% but in a deflationary environment where prices and asset levels are declining it is impossible to lower interest rates to negative levels. The past couple of weeks have seen short-term T-bills trade at minus yields of a few basis points because today the return of capital is more important than the return on capital.

The business news each day covers recent government capital injections to banks and a hope these institutions will lend to businesses and consumers who will spend and invest in projects that will create jobs for the unemployed and raise income levels for those struggling to survive. But it takes two parties to complete a loan and borrowers must have expectations of profit or a fear of future inflation before they will entertain more risk on their balance sheet. When price and asset levels are increasing our view of the future is created by extending today’s trend forward and this is exactly why so many made billions in real estate. Values rise each year at a faster rate than the interest one is paying and with a deduction for depreciation and a small increase in rents it becomes a perfect recipe for leverage to the max with little perceived risk because prices never decline. If there is an expectation of increased inflation borrowers will also rush to their local bank because of a fear that if they don’t buy at today’s prices they will not have the funds to purchase at tomorrow’s higher prices. Unlimited credit and an expectation of higher home prices fueled this real estate debacle and now expectations are beginning to seep in consumers’ and investors’ minds that prices are declining every month and it is better to wait for lower prices.

This is a very dangerous phenomenon because once the “negative feed back loop” begins it is hard to break because the Fed can’t use the same tools it does when it is trying to curtail inflationary expectations. Tuesday the FOMC will announce another cut in the overnight Funds rate by 50 basis points to 0.50%. This move will have very little impact on financial markets as expectations have already been reduced to near zero for inflation over the next 10 years. The inflation component derived from subtracting the TIPS yield from the on the run 10-year is now at 13 basis points and the 5-year inflation component is at negative 42 basis points. Markets clearly are expecting DEFLATION over the next five years and little or none over the next 10 years. Unless the Fed can find a way to reduce interest rates BELOW the rate of inflation there will be no incentive for anyone to borrow for the purchase of an asset declining in value. If prices decline for the next 5-10 years why would anyone borrow money at positive interest rates? That is the key question the Fed, Treasury and new President must deal with and the sooner the better.

Confidence

Every day I am faced with a challenge in dealing with the homeless that my non-profit serves in Hollywood. They face the same obstacle that investors, consumers and financial markets must overcome this year: lack of confidence. The hundreds we see each week lack the confidence needed to hold a job, housing and manage a life as a productive member of society. The difference between having the confidence to know you can do it or walking the streets aimlessly is very thin and once the confidence is obtained it feeds on itself if nourished and supported which is what we do at Food on Foot. The U.S. economy is just as fragile today with deflation the equivalent of a lack of confidence. The negative feed back loop is the same as the homeless congregating on a street corner reassuring each other that losing in company is far safer than winning alone. Giving jobs or housing to the homeless is not an effective solution if they don’t have the desire to sustain or the confidence to know they can achieve. Government jobs will initially create employment but do nothing for borrowing as deflation continues to tear away at asset values. This country was built by risk takers that were willing to see past today and take a chance at big future profits tomorrow. One of my favorite expressions is to be careful what you wish for because you may get it and today’s lower interest rates were seen as the answer to all of our economic ills just a few years ago. Lower long-term interest rates are at all time lows due to the realization DEFLATION has arrived but very few will profit from it in the next few years. Soon the press will be filled with stories about how to bring back inflation but not before the wealth of many successful investors is destroyed because of high levels of debt.

Are you prepared to change?

History does repeat but not when we expect and this recession/depression is being compared to an era in the 1930’s that few remember or were alive to see. It was named the Great Depression and didn’t really end until the war began in the early 40’s. Very little is mentioned of what is now called the Long Depression that occurred from 1873-1879 and is the record for the longest contraction in U.S. history although there really aren’t very many other comparisons. We have a need in this country to always believe things will get better and then search for a part of history we can hold on to while we wait for things to turn around. The good part of this is that we never give up and are always seeking ways to improve but the bad news is that we often miss obvious signs that conditions are deteriorating as we have witnessed in the past two years in the financial and real estate markets. The lack of stop losses by investors and following the theory that stock prices always come back has put a serious dent in portfolios that won’t recover for many, many years. The inability of real estate professionals to be objective about price levels and always seeing higher values made it impossible for home buyers to resist the calls for immediate action. The real problem is the fear of change and unwillingness to stand apart from the crowd. Whether it be “this is all I know” or “I can’t make this much money doing anything else” or “everyone said to do this” we are a nation of followers and that has led to massive destruction of wealth this year and next year will be no exception. How much more financial pain do you need to suffer before saying enough??? A business that loses $$$ is forced to change or go out of business. Isn’t it time you begin to run your assets like a business? You can’t go back a make a brand new start to your finances but you can start now and make a brand new ending for your hard earned savings.