This morning I woke up in the dark to do a 7AM spot with Alexis on Fox Business Money for Breakfast. Our topic was Geithner’s first trip to Beijing to meet with the Chinese officials on U.S./China economic issues. What issues would be on the table?

That’s easy. They want to know what the U.S. is going to do to protect their $2 trillion in U.S. Treasuries and other dollar-denominated securities from inflation and a falling dollar. Doogie is going to try to convince them that we have it all under control—we will get that deficit down soon as the economy starts to grow again. They won’t buy it.

A few weeks ago I received a request for a private meeting with Vice Premier Zeng Peiyan to discuss economic issues between our countries. He was most eager to understand two things. First, why was the U.S. government spending so much money on the stimulus packages. (China’s stimulus package was not as big as advertized, mainly accelerated infrastructure projects that were already in the budget.) Second, why was the Federal Reserve flooding the market with dollars? Bank reserves in the U.S. have increased from $85 billion one year ago to roughly $1000 billion today.

I explained that the crisis first became visible in June 2007 when banks revealed they were holding some $300 billion of toxic (covenant-light) leveraged loans. From then until August, 2008 the Fed talked stimulus but walked tight money–bank reserves grew only 1% during this period–because the Fed acted to sterilize the impact of their newly-announced liquidity measures (Bear Stearns, AIG,…) by selling Treasury bills from their portfolio (idiots!). But in September, after the near run on money market funds, after depositors began to take money out of their banks in earnest, and after Lehmann died the Fed panicked and started shoveling reserves into the banking system, which is why reserves have increased 10x in 8 months.

Explaining the budget explosion was not so easy. Some economists in Washington actually believe that increasing government spending raises GDP growth like it says in the textbooks. (I am not one of those economists.) But most of the spending increase was the result of Hank Paulson’s ($700 billion) power grab last fall and the change in administrations that allowed the Obama team to come in and take advantage of the crisis by adding every program they have ever dreamed of to the Federal budget. As a consequence, Obama’s first (2010) budget will spend $1.8 trillion more than revenues and the CBO projects deficits of roughly $1 trillion per year, basically forever. (And the budget does not yet include national healthcare!)

To a holder of $2 trillion in U.S. securities all this isn’t the best news. He then asked a third question: what can china do to protect the value of its assets from U.S. inflation and a falling dollar? I told him that if I were in his shoes I would have a quiet conversation with Geithner and arrange a private transaction in which he would swap all his Treasury holdings for inflation-protected Treasuries, or TIPS.

I wonder what they are talking about at the meetings in Beijing today?

JR

The amount of currency people hold in their pockets and under their mattresses is the single best indicator of the level of fear on main street. Since last summer, when people first got the wind in their nostrils that banks might fail in big numbers, individual depositors have withdrawn roughly $90 billion from their bank accounts “just in case.”

To put that number in perspective, the total reserves of the U.S. banking system last summer before people got spooked was $85 billion.

In recent weeks, however, people have stopped taking $100 bills out of their bank accounts. Total currency held by the public was $849.4 billion on May 18, less that it was a month earlier ($850.1 billion on April 20.) I think it is a sign people are beginning to unclench their buttocks and become a little less afraid. That’s a great sign for spending. When people became frightened last August/September they slammed their wallets shut and stopped buying everything. That’s when the economy fell off the table, inventories spiked up and employers began laying off workers in a hurry.

When the public exhales and put their money back in the bank there will be a rebound in spending. There will also be a further $90 billion spike in bank reserves, which will eventually show up as lending. I don’t know about you, but I can’t wait to see this happen.

JR

Last week we had reports on both producer prices (PPI) and consumer prices (CPI) for April. The headlines were about flat and falling prices. So why are interest rates going up?

April PPI showed finished goods up 0.3%, 0.1% ex food and energy and -3.7% from 12 months ago. Intermediate goods ex food and energy were -0.9% for the month of April and -10.5% over the last 12 months. Crude goods were -0.6% in April and a stunning -40% from a year earlier.

Consumer goods in April were flat (0.0%), and -0.7% from 12 months earlier. Energy costs were -8.5% over the past 3 months, and -25.2% from year earlier. 

So then why are interest rates going up? Not at the short end where the Fed is keeping fed funds and T-bill rates low, but at the long end as shown in the above chart of the 10 year Treasury yield. Rates have popped up by roughly one percentage point in recent weeks.

You can see the same bump in the 30 year Treasury yield above. Looking at the 30 year yield has fallen out of fashion due to the interruption in supply and thinness of the market compared with the ten year. But I think it is especially important because its duration is much closer to the duration of the stock market, roughly 25-30 years at today’s rate levels. In rough terms that means a one percentage point increase in the long Treasury yield (currently 3.17% for the 10 year and 4.18% for the 30 year) will reduce the intrinsic value (the expected value of free cash flow) of the S&P 500 by 25-30%.

So why are rates rising? Because bond market investors can see the end of the financial crisis that still dominates the headlines and the talk in Washington. They are looking beyond the credit crunch at the inflation implications of the Fed’s unprecedented tsunami increase in bank reserves (roughly +800%) since last September. They are right to do so.

I don’t think many economists would argue with the statement that an 800% increase in bank reserves, if allowed to remain in the market permanently, would increase the price level by about 800% over a few years. To clarify, that means the price of a quart of milk would go from $2 to $16! I don’t think that is going to happen because I believe the Fed and the political system would not allow it to happen. But it does mean that the Fed is going to have to start taking steps very soon to clean up their mess before it hits prices in a big way.

Here is the catch. The guys who are going to be in charge of cleaning up the mess by vacuuming up the 800% bank reserve increase (and an additional $90 billion that will come back onto reserves when consumers finally unclench their buttocks and re-deposit the $90 billion worth of $20 and $100 bills they have taken out of their bank accounts over the last year) are the same guys (the Federal Open Market Committee) that created the mess in the first place by first under-printing reserves in the year before last September, then over-printing reserves since then. The odds that they will handle this mopping up exercise with grace and agility are approximately equal to zero.

I’m not smart enough at this point to write the story of what happens when they try to do so. But I do believe we will see further increases in long rates as we approach the Fed hoover exercise, which could start to take place as early as the end of the year.

This has two implications to me: First, long-term bonds are the riskiest component of people’s portfolios in spite of what all the textbooks say. Second, the strong gains in the stock market caused by the Fed tsunami are real but temporary. There is no surer way to kill a long-term stock market that to increase bond yields.

JR