What Is Not Seen

U.K house prices fell by 1.1% during April, the first year-on-year decline since 1996. Compared to the long term trend, real U.K. house prices is currently 25 % higher.

The last time U.K. house prices peaked was in Q2 1989. Back then, prices reached a level of 33% above the historical trend. Even if current levels are not as high relative to the long term trend as they where in the early 90’s, economic conditions are arguably worse this time.

Like U.S., the U.K. economy are now only starting to experience the effects of historical credit expansion, that has been fueling the housing sector since the late 90’s. This is primarily the result from lax monetary policy in the past, that has created economic dislocations, especially in the financial and manufactoring sector.

Housing cycles are often long lasting. After prices had peaked in 1989 it took 13 years until prices had reached the same level again. If we take into account that prices tend to overshoot the trend, we should prepare for quite a long lasting slowdown, this time.

A real interest rate is an interest rate that is adjusted for inflation. Since inflation is hard to measure, we get a rough estimate by subtracting consumer price inflation from nominal interest rate.

The real interest rate is usually measured for long term government bonds, like 10y Treasury Bonds, but it can also be estimated for any other interest yielding asset.

Looking at historical U.S real interest rates, we see that they have been negative since November 2007. Compared to Euroland, real interest rates in U.S. have been significantly lower since September last year. During this time the dollar lost a significant amount of value compared to the euro.

Why then are low real interest rates sometimes bad for a country’s exchange rate? First, it is important to realize that the value of one currency is always in relation to the value of other currencies (or assets, like gold).

There are two main reasons for foreigners to be holding dollars, either they are holding dollars to buy American goods and services, or they are holding dollars to earn interest on their savings.

For any investor, both of these objectives are discouraged if real interest rates are low, especially if they are lower than real interest rates in other countries. This is because low real interest rates suggest high inflation and smaller potential real return for foreign investors, which result in decreasing demand for dollars relative to other currencies.

For example, if a foreigner deposits money in a U.S. bank account, where real interest rates are negative, he would be experiencing a net loss, as the rate of inflation are higher than what he earns in interest, urging the investor to stay away from dollars. This is why a negative real interest rate often coexist with a falling exchange rate.

Looking at the long term picture for dollar/euro, real interest rates are an important factor to monitor. Until the divergence between the U.S. dollar and other currencies decrease, I don’t expect to se much change in the long term negative trend for U.S. dollar.

Although, short term corrections will always occur sooner or later as they are drive mostley by investor sentiment, and not by fundamental factors. For short term guidence I rather rely on the supply and demand analysis provided by Point & Figure charting.

Because of a business trip to Luxembourg, I have not been able to comment on some important news during the week. Looking back, we saw that:

(1) Euro/Dollar traded for the first time in history above the 1.60 level. We are now starting to see additional signs of a European economic slowdown. According to the Manufacturing Purchasing Managers Index (PMI) released by the NTC Economics, manufacturing weakened in April. The strong euro affected New Export Orders as they contracted for the first time in almost three years, from 51.1 to 49.8.

Some countries and sectors in the Euro Zone will likely cope better than others, as the euro strengthen against the dollar. Strong Chinese demand will primarily benefit the exporting sector related to capital goods and high tech consumer goods, mentioned here.

(2) Chinese foreign exchange reserves recorded a record increase in the first quarter. China added $153,92bn to their current reserve, compared to $94,63bn in the forth quarter of last year, making it a total of $1682,18bn.

So far in 2008, the renminbi has appreciated 4.5 % to the U.S. dollar. If Chinese policy makers continue their present currency interventionist program, domestic inflation will get an additional shot of adrenalin, as foreign capital continues to flow into China.

I recently came across a balance sheet of ‘Amsterdamsche Wisselbank’ or ‘ The bank of Amsterdam’(1609 – 1820). The Bank of Amsterdam was the last bank in history that operated without fractional reserves.

Compared to modern banks, where bank reserves only amounts to a fraction of outstanding debt, The Bank of Amsterdam kept close to a 100 % reserve ratio between the years 1609 and 1720, as you can se below.

In 1610, total liabilities reached 925,562 florins. By looking at coins and other precious metals held in vault, we can se that 100 % of the banks liabilities constituted bank reserves.

By adherence to traditional legal principles and accountability to all its liabilities, the bank thrived as total assets grew 31 fold in the next 150 years, and totaled 30,835,194 florins in 1764.

As U.S. are currently digging it self deeper into a recession, with employment in decline, manufacturing on a slippery slope, inflation on the move, and large banks are on the verge of bankruptcyt, perhaps it is time to take a look in the rear-view mirror for future guidence.

Source: van Dillen (1925), A compiled collection.

Paul Kasriel, from Norther Trust, has written a great article about How Housing has Affected the Economic “Ecology”, where he provide lots of important data worth digesting. He writes that

In sum, the economic “ecology” has been disturbed first by the recent boom in housing and now by the current bust in housing. As a result, the current recession is likely to be more severe than the last one because it will be concentrated in the household sector, which accounts for about 75% of real GDP.

Thus, the economic recovery, which is likely to emerge late in 2008, will be muted due to the lack of credit creation from financial institutions. So, don’t expect a V-shaped recovery, but rather a U-shaped or even L-shaped one.

Because financial institutions will experience large losses across a wide spectrum of credit classes and because there is the likelihood of increased regulation, the financial system will be capital “impaired,” probably through 2009. Even though the Federal Reserve is and will continue to offer “cheap” credit to the financial system throughout 2008 and into early 2009, financial institutions will have diminished demand for the Fed’s offer because they will not have the capital to support lending to the private sector.

It is not only spending on regular consumer goods that are in decline. According to Business Week:

[s]pending on vices is also dropping. According to the government’s figures, alcohol consumption and casino gambling have been declining since November. Indeed, Nevada gambling revenues are down by 4% over the past year.

How about that!

The latest economic reports, from the euro area and the US, show signs of worsening inflationary pressure. Consumer price inflation in EMU rose to 3.6 % since Mars last year, revised up 0.1 % from the earlier estimate. In US, consumer prices climbed 0.9 % during the month, and 4.0 % since Mars 2007.

Earlier in the weak we saw US producer prices surge to new highs, as index for finished goods increased by 1.1 % since February and 6,9 % since last year. The story is very similar, as energy, food and transportation are the goods currently experiencing the biggest gain in prices in both regions.

In the producer price report there is an interesting table that shows prices in different stages of the production process. By looking at how prices change from one stage to another, we can get a better understanding of where in the business cycle we are at present.

The PPI report looks at three stages, crude goods, intermediate goods and final goods. Crude goods are goods that enters the production process for the first time, as raw materials they have not yet been processed. Intermediate goods are goods that have been processed but require further processing, for example, supplies, steel mill products, lumber and diesel fuel etc. Final goods are goods that need not undergo further processing, but can be sold to either business or consumer for final use. The last category is very similar to the consumer price index as both indecies measure the final stage in the production process.

As “hot money” enters the economy in the capital goods sectors we should expect crude goods to be most affected by rising prices. This is confirmed by what we can see in the producer price report where crude goods together with intermediate goods are going through the roof, with an increase of 8 % and 2.3 % since February. Eventually, if monetary conditions are reversed or when prices reaches the breaking point, we will enter the last phase of the business cycle, when excess activity will have to be liquidated.

The resent buildup in consumer price inflation does to a large extent reflect the already present conditions in producer prices. To maintain profits, producers have for years wrestled with higher prices.

Companies have been implementing more efficient production techniques, outsourcing manufacturing to low cost countries and importing cheap labor etc. in order to adjustment to higher prices. However, because of escalating monetary inflation, we now see signs that higher prices no longer can be contained in the production process alone.

In the picture we see that PPI for crude materials have risen at a faster rate than finished goods, since 2003. This divergence is not sustainable and can not continue indefinitely. In the future we can expect prices for finished goods to rise, reducing the gap to crude goods. This will also result in accelerating consumer prices inflation and higher readings in the CPI.

Like the rings from a stone thrown in water, the effects of inflation ripples through the economy, raising prices as it moves. Presently, the rings have reached the final stage of production, namely consumer goods and consumption.

There is another sad story related to the 0.1 % year on year increase in the latest retail sales report. Considering the conditions for the US consumer, we can see that he is still heading in the wrong direction, with no signs of rescue.

Data from the St Fed show that the personal savings rate is at the moment hovering just above zero. With falling home equity values and a savings rate on 0.3 %, the average consumer has hardly any real resources to draw on. According to other numbers, showing the yearly percentage change in real disposable personal income, consumers have on average experienced a 2.1 % decline in income growth over the last year. This augurs ill for both the private- and the overall economy, and cast a shadow over the retail report.

It is not hard to guess where the money – that resulted in the 0.1 % increase in spending –came from. Consumer credit or consumer loans, increased with a total of 9.2% or $65 billion during the last year. That is, American consumers incurred on average 9.2% more debt. It is this debt that is presently financing the additional consumption.

What both households and business are in desperate need of, is not consumer spending, but real saving. Only then can the US economy eventually get up on sober feet’s.

Retail sales (nominal) for March came in stronger than expected, with a 0.2 % increase in sales since February. Despite the positive number, signs of economic weakness is prominent, as consumers are experiencing tougher conditions as food and energy prices are souring. While nominal sales are positive, inflation adjusted sales are likely negative.

Spending on gasoline products increased by a total of 18.9 % since March 2007. Other categories such as motor vehicles (-3.2 %), home furniture (-7.1 %) and building material (-6.9 %) all experienced negative changes. The decline in categories, such as, home furniture and building materials, were to be expected because of the ongoing deflation of the housing bubble.

With overall consumer spending on $380,177 million, up from $379,742 million of last year, a merely 0.1 % change, consumers have been shifting some of their spendings, away from other goods, to maintain their consumption of gasoline products. This has resulted in a decline in real consumption, and adding additional pressure to the average consumer. By this shift, it should be clear how elastic the demand for energy and food has been. (Something FED does overlook in their preferred measure of inflation.) With payrolls in decline and unemployment rising, a further surge in commodity prices will eventually result in squeezing margins and reduced spending for many households.

It should be remembered that the importance of retail sales are often blown out of proportion. The reason for this is that consumer spending consists of 70 % of GDP. However, GDP does only provide a part of the puzzle determining economic growth. Compared too total economic spending, consumer spending does merely constitute about 35-40 %. I have commented on this fact before, here.