-->Artificial High

The Daily Reckoning

Paris, France

Thursday, 15 May 2003

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*** What morons these Japanese be...house prices still
going up, LA County over $300,000 level...

*** Bond yields at record lows...mortgage refinancing
soars...

*** Retail sales down...pile-up of auto
inventories...transport strike continues...and more!

"What morons the Japanese must be!"

We quote ourselves from nearly 4 years ago.

That was when everyone knew the Internet was making us all
rich in America...and the poor Japanese couldn't seem to
figure out how to get on-line.

Now, everyone knows the way to avoid recession and
deflation is to inflate the currency...and the Japanese
can't seem to find the 'on' button to the printing press!

As we left our story yesterday, the Japanese had had a huge
stock market bubble...which put more than a few bulges into
the rest of the economy, too. Ditto for the U.S..

The Japanese then had a bear market in stocks...followed by
a long period of on-again, off-again economic slump. So
far, America seems to be reading the same script.

Despite the best efforts of the Japanese central bank and
the government, people in Japan gradually began to think
that things wouldn't get much better anytime soon, so they
began to save their money, just in case. They noticed, too,
that prices weren't going up...in fact, they were going
down. So, even when they felt like they might want to buy
something, they were inclined to hesitate; it would only be
cheaper later on.

Will that happen in the U.S. too?

No way, say investors, we have Alan Greenspan.

It cannot happen, say economists, we have Milton Friedman.

It will not happen, say our central bankers, we have a
printing press.

Says Eisuke Sakakibara:"Oh yeah?"

Here at the Daily Reckoning,"who knows?" is the best we
can do. But we say that with such an impertinent twinkle in
our eye, we are sure it inspires confidence.

Against all odds and all apparent reason, bonds soared
again yesterday. Investors bought bonds at the lowest
yields since Eisenhower's second term. Few economists could
explain it. For they are counting on the Fed's printing
press to boost inflation rates in order to avoid"the Japan
Scenario." Economists said it should do so...Bernanke said
it could...and foreigners have been dumping the dollar in
the anticipation that it would...Ergo, bonds ought to go
down, not up. Who wants to own a long bond when the
currency in which it is denominated is being destroyed by
the very people who are supposed to protect it?

But judging from the spread between inflation-indexed bonds
and regular 10-year T-notes, bond investors don't seem to
get the message. The gap is only 1.7% - precisely the
current rate of increase in the CPI. For the next 10 years,
Mr. Bond Market seems to be saying, you can expect nothing
more.

Only Eisuke Sakakibara seems to have any idea of what was
going on. Of course bonds are going up in the U.S., he
explained to the Financial Times earlier in the week; in
trying to dodge the"Japan Scenario," the Fed was doing
just what Japan's central bank did - driving down yields.
Since U.S. monetary officials do the same things as their
Japanese counterparts - though 10 years later - is it any
wonder they get the same results?

Bin gespannt, ob das überhaupt jemand liest ;-)
Nothing is ever exactly the same as it was. Lower rates in
the U.S. have stimulated a bubble in the bond market...and
another bubble in the mortgage refinance market. Mortgage
rates hit a record low of 5.27% yesterday, and the latest
reports show refinancing activity up 20% from its already
hyper-active levels. Home prices are still rising, reports
MSNBC...and the median house in LA county has edged over
$300,000.

The Chinese economy is said to be growing at a phenomenal
8.9% annual rate. This, says Sakakibara, is a major
structural reason why prices are falling. China can make
almost anything cheaper than the U.S., Europe or Japan. And
since the Chinese peg their currency to the dollar...a
falling dollar does not hurt their sales to the U.S. - and
actually helps their exports to other parts of the world.

While China gets a competitive advantage from a falling
dollar, America gets the disadvantage of a falling currency
at a time when it desperately needs imported capital. Japan
was never in such a bind. It could survive a period of
moderate deflation with only moderate damage. It never had
to destroy the yen, though it tried.

How this will all turn out, we don't know. But maybe the
Japanese will turn out not to be such morons after all.

Eric...?

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Eric Fry in New York City...

- Another day, another spectacular rally...in the bond
market. The 10-year Treasury note, which has rallied seven
out of the past eight trading sessions, soared again
yesterday, driving its yield down to 3.53% - the lowest
ever seen during the 43-year life of your New York editor.
Meanwhile, over in that"other" financial market, stocks,
the Dow fell 31 points to 8,647 and the Nasdaq slipped 4
points to 1,534.

- Rapidly falling bond yields are stirring up a lot of
chatter about deflation. Suddenly, deflation-mania has
arrived on Wall Street...This hot new monetary phenomenon
is the talk of the town. Just about everyone thinks we
should be worried about it. After all, Chairman Greenspan
says he worries about it.

- Fanning the flames of the deflation talk was the news
yesterday that import prices fell 2.7% in April. While it's
true that a hefty 16.2% decline in petroleum prices may
have skewed the overall number a bit, it's also true that
ALL commodities (excluding petroleum) dropped 0.9%. Most
other import prices also fell or remained flat. In other
words, the data looked very deflationary. Nevertheless, the
New York-based team of the Daily Reckoning doubts that
deflation-mania will last long. The dollar's 20% slide
against the euro over the last few months should start to
show up in import prices eventually.

- Maybe it's the water, but here in New York, a few of us
can still imagine a world in which inflation seems more
plausible that deflation."What is wrong with all of us?"
fellow New Yorker James Grant wondered recently in a Forbes
magazine column."Government bond yields are low the world
over. In Japan they have never been lower...[Yet], in the
U.S., where the Consumer Price Index is 3% higher than it
was a year ago, there is no deflation. But there are plenty
of deflationary symptoms, and the Federal Reserve Board is
worried about a visitation of the real thing...

-"For months [Greenspan's] deputies and he have vowed to
whip deflation, even before it materializes. They have
described the dollar - their dollar and ours - as a piece
of paper of no intrinsic value that can be produced 'at
essentially no cost.' They have pledged that, if need be,
they will push down not only the funds rate but also
longer-dated Treasury yields...What would this mean in
practice? Lower government yields and more credit creation
to start with.

-"By pegging the ten-year note at, say, 2.5%, the Fed
would have to buy all securities offered at 2.5% or higher.
The Fed, of course, is no ordinary acquirer. It creates the
dollars it spends. For all intents and purposes, it waves a
magic wand. By vowing to meet deflation with inflation, the
Fed is only doing what it has mainly done since its
inception. Precious-metals funds...would provide protection
in case the Fed waved its wand a little too hard."

- Although MOST economic news these days may be"less bad,"
some of it is still just plain old"more bad." A
predictable result of the nation's dire employment picture
is that consumers are not consuming. (We may have mentioned
this phenomenon once or twice before).

- U.S. retail sales"unexpectedly" fell 0.1 percent in
April to $309.5 billion, according to the Commerce
Department. Excluding automobiles, sales dropped 0.9
percent, the biggest decrease since the September 2001
terrorist attacks. Sales at clothing and accessory stores
were especially soft, slumping 3.2 percent.

- What happens when over-extended U.S. consumers stop over-
extending themselves? The U.S. auto industry provides the
grim answer. In the month of April, General Motors boosted
its average incentives per vehicle by 16.7% to a hefty
$3,402.

-"Financing deals and cash rebates on new cars and trucks
rose to record levels last month," the Lansing State
Journal reports."Despite heavy incentives in April, Ford,
GM and DaimlerChrysler AG's Chrysler Group all saw their
sales decline compared with a robust month a year ago.
Nearly every automaker had some kind of incentive last
month, contributing to a rise in the average industry
outlay per vehicle to $2,508 from $2,207 in March...The
average Big Three outlay surged 13.8 percent to $3,310 a
vehicle."

- Unfortunately, automakers are stuck with their outsized
incentive programs. Eliminating incentives - like asking a
long-term houseguest to pack up and move out - could be a
tricky maneuver. Luring customers into dealerships, says
GM's CEO Rick Wagoner,"is getting more expensive and
requires even more creativity."

- Meanwhile, unsold cars and trucks are piling up in
inventory."U.S. automakers are sitting on an overflow of
unsold cars and trucks that appears to be the largest
backlog in U.S. auto history," the Miami Herald reports.
"About 3.93 million unsold vehicles are sitting on dealer
lots, in transit from the plants where they were made or at
hushed-up overflow sites like the Michigan State
Fairgrounds. All told, about 630,000 more unsold cars and
trucks are sitting around than a year ago. Since March,
inventories have been at all-time highs."

- The sky-high inventory levels are likely to mean hefty
production cuts and job losses...Can you say"vicious
cycle"?

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Bill Bonner, back in Paris...

*** The transport strike continues. The subways are
working....but not reliably. And Parisians are getting
weary of it.

At least, that is how it seems from your editor's point of
view. He spends 3 hours a day walking back and forth to the
office. It is a lovely walk, which he welcomed a first; but
he is getting tired.

Yesterday, walking home along the Faubourg St. Honoré, he
bumped into - literally - a group coming out of Sotheby's.
The bodyguards charged out of the door and acted as if they
were escorting a child molester through an angry mob with a
rope. The middle-aged man at the center of the entourage
was striking; he looked as though he might actually be a
child molester. He had straight white hair in a ponytail, a
black jacket with a skinny little tie, tight pants, and
large dark sun glasses.

"Snappy dresser," your editor commented to his daughter,
after the group was loaded into a large Mercedes.

"Dad," Maria explained,"don't you ever watch TV or read
the papers? That was Karl Lagerfeld. He is not just a
snappy dresser. He's probably the snappiest dresser in the
world."

"Well, I'm sorry I stepped on his shiny shoes..."

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The Daily Reckoning PRESENTS: Against the steep decline of
the dollar v. the euro, comparisons of the greenback with
other currencies seem much less exciting. And yet, says
John Mauldin, that's exactly where you should be looking...


ARTIFICIAL HIGH
By John Mauldin

Despite falling 25% against the euro over the past 12
months or so, the dollar is still artificially high.

By artificial, I mean the following things: first, the rest
of the world, and especially Asia, is hooked on selling
products to the American consumer. If prices were to rise
30%, Americans would buy less foreign products and more of
their own. If Asia, for example, were to sell less to
Americans, their unemployment would rises and their profits
would drop.

Secondly, there are those who hold dollars because it is
better than their local currency. Physical dollars are
desired in many Latin American and African countries, and
other parts of the developing world. The clear pattern is
that the dollar is a better value than the local
currencies.

Third, it should be obvious that if the dollar was not the
reserve currency for the world, it would not be as high.
The dollar would have less buying power. Foreigners look at
that buying power and are often jealous, seeing it as part
of so-called American hegemony.

But it cuts both ways. An artificially strong dollar has
meant that the American manufacturing base has slowly been
eroding as more and more jobs leave the U.S. for cheaper
production climates. It has created an imbalance in our
trading accounts and buying patterns. There is no free
lunch.

If the dollar is artificially high, is there reason to
believe it can (continue to) drop? A Federal Reserve study
seems to indicate there is. Fed economist Caroline Freund
did a study on what happens when the trade deficit gets too
big in developed countries. Here are the highlights: On
average, when the trade deficit widens to over 5% of a
nation's GDP, the currency starts to drop. It typically
drops 20% over three years, as the trade balance recovers.

Thus, at 6% and approaching 7% of GDP trade deficits, the
U.S. is in No Man's Land. There is real precedent for the
dollar to continue to fall, if the artificial props are
removed.

For the dollar to fall, however, it must have other
currencies to fall against. So far, it has most notably
found the euro. But what about the currencies of Asia - an
area attracting more and more attention as the potential
powerhouse of tomorrow?

So far, Asian countries have been working hard to keep
their currencies low against the dollar. Why? To keep their
exports up, which is what they believe will eventually
bring prosperity. Each nation feels that if their currency
goes too high, it will give the other nations an advantage
over them of selling products to the United States.

The Japanese, for example, have publicly argued for several
years that the yen is too high, and work aggressively to
lower the value of the yen even as it rises. A few Japanese
leaders have publicly stated the yen should be at 160, not
the 116 it is today (in mid-May). Other Japanese leaders
would clearly prefer the yen to be at 130.

Now, here is the heart of the matter: if each of those
Asian countries thought they could all get a stronger
currency against the dollar, they would be for it in a
heartbeat. It is not that they want a strong dollar, they
just don't want their currency to be stronger than the
other Asian currencies. If the dollar were to show weakness
against all the Asian currencies at the same time, they
would not object. They would be thrilled.

The 900 pound gorilla in this process is China. The Chinese
currency is pegged at a fixed rate to the dollar, so there
has been no movement. Since China has a very pronounced
advantage over other Asian countries in regards to labor
costs, these other countries feel forced to keep their
currencies low in order to compete. The Japanese have been
particularly vocal in their complaints about the value of
the Chinese currency.

Countries which sell to the U.S., especially Asian
countries, have a choice of two potential sources of pain.
They can either let their currency rise and sell less to
America, or they can take dollars, which will have real
downside risk.

When does the pain of taking over-valued dollars become
more than the pain of selling less to the U.S.? I think it
is when China allows their currency to float. Asian
countries do not necessarily want an over-priced dollar;
they simply want the price of their currency to be
favorable in relation to their neighbors. When the Chinese
allow the renminbi to rise, that will be the real end of
the dollar being over-valued, as the rest of Asia will feel
comfortable in letting their currencies rise as well.

There is an increasing call from many corners of the world
for the Chinese to allow the renminbi to float. They have
not responded to the pressure, but as do all countries,
they will act when they feel it is in their own best
interests. That will probably be when they think their own
consumer demand is growing and solid, and thus can sustain
a possible slowing of sales to the U.S.. When that will be
is anyone's guess.

China will be the surprise move which sets this set of
dominoes in motion. This is one area which investors must
watch closely, as it will be a surprise and will be the
transition to a much lower dollar fairly quickly.


Regards,

John Mauldin,
For the Daily Reckoning

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