Put your head in the sand!

Wow. Lots of good stuff today.

Here's the Big Ben Bernanke report, which we were all waiting for. There's no news here, nothing's changed. Does this look like a man who's made up his mind?



What the market is really happy about are the "slower" inflation numbers. I find it hysterical that while CPI was up 0.2% for June, core CPI was actually up 0.3%. The last three months, core CPI has risen at an annual rate of 3.6%.

Stick your head in the sand, Wall Street.

The truth is much worse than that. Pre-Clinton era CPI numbers, which are much closer to the truth, are double core CPI numbers. The fed funds rate is in negative territory nominally.

The way I see it, (which is, unfortunately, blurry at the moment) is that there is a fundamental contradiction between what Bernanke is saying and what is happening.

The contradiction is this. Bernanke says on the one hand that inflation is feeding off high oil prices. On the other hand, he is saying that a slowing economy might rein in inflation. The problem with this reasoning is that the second proposition contradicts the first (and, I suspect, isn't true either, but more on that later). Let me explain what I mean in more detail. Both propositions cannot be true at the same time. If oil is causing inflation (I think it's more of a mechanism to spread inflation around), then inflationary pressure is coming from outside the U.S. If that is true, then a slowing economy won't necessarily lower inflation, because it won't lower oil costs.

That much is pretty clear, but here's where my insight gets blurrier. I think inflation is mostly an effect of the falling dollar, combined with huge budget and trade deficits. Because the dollar has been falling, even China has lately been slowing down its dollar purchases (in the form of Treasury Bonds). However, China still wants to keep its favorable exchange rate with the U.S. to increase exports. So China is printing money like crazy, with the result that their economy is accelerating rapidly. Soon it will overheat. I see the rise in commodity prices as an indirect result of the strength of the economy. We buy everything from China, and China needs commodities to supply us. Through borrowing our money back from China, we've been able to buy stuff very cheaply for a number of years now. We created a vicious circle that consisted of sending a lot of IOU and a little money to China for stuff. China used the money to make more stuff, so we sent them more IOU's. But now China has lots of money and has become a major consumer in its own right. At 3%, the debt service on China's $787+ billion in Treasury Bonds is over $2 billion per month. For 1Q06, the current account deficit was $218 billion, despite record inflows of foreign capital. When record foreign investment still doesn't bring money in, there have to be too many dollars out there, hence inflation.

The circle is still spinning, but starting to wobble. The problem with it is that as dangerous as the dollar becomes, it is still viewed as safe. So, what might happen? Here are my speculations, starting with the ones I'm most confident in.

• Commodities will remain strong until there is a global recession.
• Housing will be worse than Wall Street expects.
• The vicious circle will reverse when there is a U.S. recession.
• If China's economy overheats and collapses after a U.S. recession, their economy will implode.
• A global recession, preceded by a U.S. recession, might actually strengthen the dollar.

Lets move on to housing. Here are some quotes:

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Economists generally had been looking for a June 2006 starts rate of 1.9 million.The start rate for single-family homes was 1.468 million units in June, 6.5% below the May rate of 1.59 million. June starts on housing of five or more units were at an annual rate of 306,000, down 4.1% from May's rate of 319,000.
Issuance of building permits, an indicator of future housing construction, was down in June as well, falling to a seasonally adjusted annual rate of 1.862 million, 4.3% below the revised May rate of 1.946 million and 14.9% below the June 2005 rate of 2.188 million.Starts and permits are closely watched indicators, because housing and housing-related business account for about 20% of all U.S. economic activity. --Industry Week

Mortgage Demand Falls Despite Drop in Rates -- USA Today

Single-family housing starts in the Northeast plunged 32.8%... in June. -- USA Today

The National Association of Home Builders said sentiment among home builders was the lowest since December 1991 -- USA Today

The supply of previously-owned homes for sale rose to 6.5 months in May -- Bloomberg

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I think the USA Today headline says it all. So far, from worst to best, we have homebuilders' sentiment at the worst level in 15 years, housing stocks down about 40% from their highs, total home supplies at 5.5 months, home sales down about 17%, and sale prices still up 5% year over year. This is the last car on the roller coaster. The front car is completely over the edge.

The question is will housing gather enough downhill momentum to start a vicious cycle? When house values start to drop and people with ARM's are paying 50% more for a house that is losing value (and they put nothing down for) they will cut their losses and default. This will cause banks to tighten credit and raise mortgage rates. Higher rates will convince more people to dump the house-batross around their necks. And so on, etc., etc.

It might take until the middle of next year before it's clear, but I think it will.