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February 11, 2006

The Other Shoe
by Ron Ellison

Nearly everyone is familiar with the other shoe concept.

With the inflation outlook, the other shoe, at least for a while, has been labor costs or wages. In the eyes of many it has yet to fall. Given the recent jobs report that may be about to change.

Unemployment slipped to a four-and-a-half year low, sending ripples of concern through the market that labor costs could jump. It is true that such numbers get revised all the time. But revisions hardly attract the attention and rarely have the impact of the initial report. And revisions for the most part are like retractions in the mass media. They get buried on the back roads of media coverage that initially reported them

The reappearance of the 30-year Treasury bond is still another example, albeit one many may disagree with. When the long bond got relegated to the mothball heap four years ago, budget deficits were the thing of the past and budget surpluses were the rolling tide of the future. Well, the future is here.

In 2001 when the long bond got retired interest rates had already over a 20-year period cycled down from 15 percent to one-third of that. As in a game of limbo, how low did officials at the time think interest rates could go? And when do you most want to lock down long-term obligations, at 15 percent or 4 percent? Even most fixed rate mortgage borrowers can easily answer that one. The first offering of long bonds since the hiatus just hit the market. Investors remained indifferent to so-called risk premiums, accepting a yield 80 basis points below what the long bonds paid last time out in 2001.

During the same period inflation declined from 13-14 percent to 2 percent, though it has actually not been calculated exactly the same. Think hedonics here. Now the over-capacity, excess-labor crowd resembles all the signs and symptoms of a bad case of conventional wisdom. Is there anyone left, even on some remote desert island, who hasn't heard the story? It's become in most circles the accepted mantra. You can hear the chanting daily on almost any financial program. And it yet might prove correct. Good contrarians and other card-carrying skeptics, however, might put a big emphasis on the term might as in probabilities.

Long bond yields and the Fed Funds rate drop to 2 percent and globalization changes everything and someone figures out how to put Humpty Dumpty back together. Commodity prices joined the party in the long decline in inflation and interest rates. Some argue that the run-up in commodity prices and the inertia of the long T-bond yields is a symptom of the hot-money hordes sort of like the old Elvis Presley hit "His Latest Flame." Others cough up the correlation argument. Commodities offer a way to seek returns not correlated to the usual financial asset suspects like bonds, equities and bricks and mortar.

Another excuse (Forgive us our trespasses of conventional thinking!) for the return of the 30-year bond and its demand is owing to pension funds and their need to match their liabilities to the duration of their assets. Apparently these pension funds, heretofore not noted for their economic prescience, can now suddenly espy the future better than the rest of us.

So what we have here is a classic case of opposites butting heads, creating what usually happens when opposites clash, tension. Tension often leads to volatility, a feature the market was seemingly, like a long time celibate, getting accustomed to doing without. Just now with the recent Davos meetings we are hearing more details about imbalances globalization is causing. The little nations according to many are still sucking hind teats. In other words, the trickle-down benefit is not trickling very far down. Some believe that's because of a conspiracy of the big boys.

One need look no further than the European Union, now 25 strong and soon to be 27 with the ascension to membership of Romania and Bulgaria. Smaller members want their piece of both the political and economic pie. When it comes to negotiating many are taking their cues from their old, larger brethren. But the big boys are understandably reluctant to give ground without a fight.

Perhaps the media in some of these underdog nations should start publishing cartoons poking fun at the subsidies, almost all nearly sacrosanct icons in their own right, many of these big boy countries refuse to give up. Otherwise that other shoe could drop from a quarter, like seemingly subdued inflation, many may have taken for granted.

Ron Ellison
Blasingham and Ellison Financial Group

Ron Ellison is a principal of Blasingham and Ellison Financial Group, a money management firm in Newport Beach, California, and can be reached at www.Befg1.com.

Copyright © 2005-2007 Ron Ellison

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