, I attempted to lay out how I thought 2011 would play out in terms
of the value of the United States dollar. I argued that the general
outlook for United States monetary and fiscal policy was more of
the same policy stance that the government had taken for the last
50 years: Credit inflation. (For more on this, see the Financial
Times/ Goldman Sachs business book of the year,
by Raghu Rajan.)
The year 2011 will follow the pattern of large fiscal deficits
and monetary ease, and this will carry into the foreseeable future.
As a consequence, the long term direction of the value of the U.S.
dollar will be downward. I focus on this initially because it sets
the stage for how financial market participants view the actions of
the United States.
This downward movement, however, will be interrupted in the
short run by the continued problems relating to the sovereign debt
of various countries within the European Union. The United States,
in 2011, will still be seen as a refuge from risk, which will
result in the dollar being supported by a "risk averse" investment
community through much of 2011.
The turmoil in Europe is taking the pressure off of the policy
makers in Washington, since they will be free of any criticism that
might come their way because of a declining value of the dollar. As
a consequence, the Obama administration will not need strong
leadership to execute an "unpopular" monetary or fiscal policy, as
was the case in the late 1970s/early 1980s when Paul Volcker,
leading the Federal Reserve, put the brakes on the economy and the
value of the dollar rose significantly, and in the 1990s, when
Robert Rubin, leading the Treasury Department, helped to bring the
federal budget from a deficit to a surplus, which produced another
significant rise in the value of the dollar.
So my basic expectation for the economy for the next year (and
for the near future) is similar to that being called "the new
normal." The new normal incorporates sluggish economic growth, high
unemployment, and weak inflation.
The sluggish economic growth of the United States will remain
around 3.0-3.5%, year-over-year, way below what ordinarily has
occurred in economic recoveries in the past. This modest growth
rate underscores the structural problems exhibited in the economy:
The unusually low level of capacity utilization on the part of
industry; the fact that the under-employment rate will remain in
the 20-25% range as employers remain reluctant to bring back
workers on a full-time basis; and the fact that the year-over-year
rate of growth of industrial production has been dropping off every
month since June 2010.
I do see three ominous clouds on the horizon in the financial
sector. First, the solvency problems in the smaller commercial
banks will continue to linger. I believe that the Quantitative
Easing on the part of the Federal Reserve is more to keep the
banking system afloat as the FDIC closes a sizeable number of banks
over the next year or so. This will keep a lid on bank lending.
Second, there are the financial problems being experienced by
state and local governments, which will spill over into the
financial markets for the bonds of these entities. The implications
of this situation for the reduction in budges are huge.
Finally, large corporations have accumulated a huge chest of
cash, both in the United States and in Europe. It is my belief that
this accumulation of cash is for "buying" purposes, and we will see
a sizeable pickup in mergers and acquisitions as the economic
recovery continues. But this restructuring of the economy will not
create more jobs and increase production. In fact, it will do just
the opposite. Large banks will also participate in this expansion
of mergers and acquisitions; the big will get bigger.
Overall inflation will remain moderate. The year-over-year rate
of increase in the implicit price deflator of gross domestic
product remains around 1.0% and will probably will not go much
above 1.5% this year, if it goes that high. Thus, general inflation
does not seem to be a near-term problem.
However, given the current stance of monetary policy, we see the
possibilities of bubbles forming all over the place. As we saw over
the past 25 years or so, general inflation was low and policy
makers felt in control of things. Yet we saw bubbles here and
bubbles there. Now, the actions of the Federal Reserve are being
picked up in a rise in commodity prices, rising stock markets of
emerging nations, and the buildup of inflationary pressures in
export-driven countries like China and Germany.
Putting this all together, my view of long term Treasury yields
for 2011 is up, with the 10-year Treasury security reaching
4.5-5.0% in the upcoming year, a rise from around 3.3% to 3.5% now.
The 30-year Treasury security will rise to the 5.5-6.0% range, up
from around 4.4% to 4.5% now. The spread between the yields of
these two maturities will be about 100 basis points, slightly lower
than it is at the present time.
Bernanke will not be able to keep long-term interest rates
This just puts long term Treasury yields back at the levels they
were for much of the 2000s.
From this, I argue that the long-run expectation for inflation
built into these securities would be in the 2.0-3.0% range. For
myself, this level of inflationary expectations over the next 10 to
30 years is low. But that is another story.
The major uncertainties in this picture? The first uncertainty
pertains to the stability of the banking system. I believe,
however, that the Federal Reserve will continue to flood the
financial market with liquidity in order to allow the failing banks
to be worked off in an orderly fashion. If this occurs, the
recovery will continue but at a slow pace.
The second uncertainty pertains to state and local finance. My
feeling is that the federal government will not allow this
situation to get out of hand. Welcome to the bailouts of 2011.
The third uncertainty pertains to the bubbles that have been
created or are being created. As we have learned, bubbles can last
only so long. The question will remain about how long the bubbles
created will last. Given that the Fed will continue to flood the
market with liquidity, it is unlikely that the world will be
I believe there will be another uncertainty, but only in terms
of timing: The increase in the amount of mergers and acquisitions
taking place. I believe that 2011 will see a continuation in the
acquisition splurge that has already started and will continue
beyond this coming year. The only uncertainty related to this is
the reaction of the federal government to the bigger companies. My
guess is that the new Congress won't challenge this -- and the
Obama administration will not have the will to challenge it.
10 Stocks Whitney Tilson Is Heavily Shorting