First Comes Deflation, Then Comes Inflation 17 comments
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The key to my fundamental analysis of the markets is money supply: is money supply going up (inflation) or down (deflation)? As I've noted in a previous article I wrote for SeekingAlpha, I'm very much in the inflation camp.
While I am still an inflationist, it is clear we are in a deflationary environment, which I was not expecting; I was simply expecting the ongoing expansion of money supply to find is way into an asset class (stocks, commodities, housing, etc) and push prices up in that asset class, as is normally the case. Instead, the market's attempts at deflation -- at purging the overinvestments and malinvestments that have been created through excessive expansion of the money supply, thus returning money supply to the level that the market demands, have proven to be dominant. This results in falling prices, a rising currency, and deflation. The Federal Reserve has tried to inflate the markets with all its might, as recent money supply calculations suggest, but banks have been refusing to lend that money, and thus the deflationary forces have been winning.
Analyzing Where We're Headed
So how much longer will deflation lasts? Depends on what happens:
- If the Fed resists the temptation to increase the money supply, it will likely be very sharp but relatively short. The dollar bubble is a 37 year bubble, which started once the dollar fully abandoned the gold standard in 1971. Here in my opinion is an excellent article on the implications of that.
- If the Fed continues to intervene but deflationary forces prove to be stronger, it will likely be steady deflation for a long time. This is similar to what happened in Japan when the Bank of Japan tried to resist deflation. However, Mike Shedlock chimes in with some key differences if America goes deflationary.
- If the Fed is able to successfully inflate, it will need to find a market to put a bubble into. Given that the US has terrible economic fundamentals -- GDP is faltering, high private and government debt -- it is hard to foresee a bubble in US markets. Perhaps international markets, like commodities, precious metals, foreign stocks, foreign currencies, etc -- will get an influx of US dollars, thus creating bubbles in those markets. This will result in significant dollar devaluation, as those newly created dollars will just be sold and put into non-US markets. This will push the price of US imports up, and thus will result in lots of price inflation for consumers. It could create an opportunity for US export-based businesses.
- If the Fed inflates but the market realizes the Fed is just printing with no signs of self-constraint, we'll see hyperinflation. In other words, the Fed will have tried to purge the toxic debt by creating junk money, which devalues everything. Just as banks don't want the toxic debt and are not trading with each other because of it, no one will want "the toxic dollar." In other words, there will be a massive run on the dollar in this scenario, which will send dollar-denominated prices through the roof. This is the Argentina scenario.
My Opinions
I think there's going to be a combination of #3 and #4. It is critical to note, though, that foreign markets are experiencing a similar problem, and they are taking the central banking solution of trying to inflate the solution away. We are seeing bubble-type activities in certain markets, such as the Japanese Yen, evidenced particularly by big moves in EURJPY. Dennis Gartman has stated he views EURJPY as a great indicator of the global economy, which I found to be a compelling insight. EURJPY volatility has been huge of late.
In the US, deflationary forces are winning, as evidenced by the rallying dollar, falling commodity prices, and MZM as a money supply indicator, which former inflationist-turned-
I do not expect deflation reign for much longer. Government's desire to inflate markets, which is essentially a way of taxing those who hold the currency of the respective economy and transferring wealth to the recipients of the newly created money, is why I'm generally very biased towards viewing inflation as the primary concern. Bernanke has admitted deflation is not really possible, which suggests he will do whatever it takes to inflate the market. Bernanke has also acknowledged inflation is a tax, so he seems to favor this viewpoint with the knowledge that he is taxing the public.
Meanwhile, members of Congress have reported that they were threatened with martial law if they did not pass the Paulson Plan, which was eventually passed. Furthermore, we do not see government spending being cut. So, the diminishing tax base is coming as government spending is increasing, which will either require further inflation of the money supply or the sale of additional US debt. As debt is now largely held by foreign countries with tenuous geo-political relationships with the United States -- namely China and Iran -- there is the possibility of economic warfare; foreign debtholders can refuse to continue buying debt, which would also fuel inflation, as the debt would be paid for through further expansion of the money supply.
The always insightful Agora Financial has stated that it expects oil to go to $50 and then $200 within 36 months. I like that assessment quite a bit.
Thoughts on Trading This Environment
My primary concern is wealth preservation. With that in mind, I'm primarily looking to protect against dollar devaluation. As a result, here's what I'm doing:
- I'm viewing deflation as a great opportunity to accumulate precious metals. Gold and silver are great hedges against inflation, and even in deflationary environments, they fall less than other asset classes, and thus still offer opportunities for those who own gold and silver to gain purchasing power (i.e. gold and silver may be falling in price, but everything else is falling faster). I don't trade precious metals, but I "invest" in them -- meaning I accumulate them and don't plan on selling until at least a few years out. Stock market traders should look for precious metal ETFs and mining stocks as well.
- I'm particularly concerned with dollar devaluation, and thus look for markets in which excess US dollars would find their way into. For a while, EURUSD was great for this. Now the Eurozone clearly has its own problems, though I think Asian currencies are going to pick up some dollars, and thus I've been trading the Yen. Stock traders will want to look for corresponding ETFs, like the FXY.
In deflationary environments, I'll be trading less, and will largely be out of the market, instead looking for opportunities to accumulate precious metals and cash. If you're into trading deflation, markets where the money supply is being pulled from may prove to be great short opportunities. As money supply contractions have a natural tendency to come from bubble markets, financial instruments and the US housing sector are natural opportunities. For those who believe the US recession of 2002/2003 was not complete -- meaning the NASDAQ bubble was not fully deflated -- US tech stocks may have some room to go down.
As an inflationist, I'll be in foreign currencies and precious metals. I'll buy and hold metals, and will enter currencies when they look bearish for the US dollar, my home currency. I also previously noted some ETFs on the US stock markets that I thought would be worth considering in an inflationary environment.
Questions, comments? Agree or disagree? Leave your thoughts below.
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This article has 17 comments:
You also are not properly considering the two variables you simply cannot accurately predict: (1) how deep the deflation is during the deflationary period; (2) how long the deflationary period lasts.
Those factors drastically affect the likelihood of inflation following a deflationary period. For example, if a cyclical deflation begins resembling anything like Japan's liquidity trap, then even very-high inflation in the following decade will still result in net deflation, not net inflation.
It is that which keeps Helicopter Ben up at night.
Wages are down, employment is down and headed further down, demand is down and headed furhter down. To qualify for a house, car, etc. you have to have a +700 credit score and a down payment now, like the old days.
Inflation is not going to happen.
In the meantime Y'all just keep selling silver and platinum for me won't you. I'm looking for $600 in platinum and $4 on silver please.
One more thing though... I use the financial sector as "early warning radar".
The stock market is basically a big sponge for inflation. The banks churn out credit and it gets splurged in the market pushing everything higher... The banks stop lending and the market collapses.
So... Watch bank figures... The more they lend, the more money they make. When their figures falter there is trouble coming, step out into cash.
I thought the $145/bbl was too much too quick and would not last but have up to now thought that the decline to ~$70/bbl was a bit overdone as result of unwinding of hedge fund positions & etc....
However at this point I am wondering if as a short term hedge against a further delcine to <????> $50/bbl it might be time to buy some short-term calls on something like DUG ... perhaps right after Friday's announcements by OPEC?
Any thoughts?
Ideologues can't admit they are wrong and let go of their slander-script.
The error lies in thinking only the supply of money determines its value. Name any other commodity whose value depends only on its supply, and not on demand for it as well.
For the millionth time, demand for money is not a constant. It is money illusion in spades to think that it is.
Money is not wealth, it is not the "real" form of wealth with others being fake, nor is it a scam itself, with only "real" assets having value. Money is merely one asset among others, with a small and relatively stable *transactions* demand and a huge and quite unstable *safety* or investment demand.
When the investment demand for money changes dramatically, the objective exchange value of money changes too, if the quantity of money does not immediately change in exact proportion to that shift in demand. Even if the quantity of money is increased dramatically, its value can still rise, if the demand is increasing even more.
Why is the demand for money rising? Because real interest rates are rising, and doing so dramatically. This is making long dated claims fall in value compared to short dated claims. Risk premia are also rising dramatically, making safe claims rise in value compared to uncertain claims. Money is rising in value dramatically, compared to every kind of commodity that bubbles were blown in, making *nominal* claims more valuable than *real denominated* ones. (Being paid in dollars a year from now is worth *more* than being paid in steel a year from now, for example).
All of this is an entirely predictable consequence of too many people believing simultaneously that real assets would be worth infinity and dollars worth nothing, and every one of them being hopelessly wrong.
Who was going to pay them all if they were right? Were central banks ever going to print enough money to justify all the bubbles you-lot blew? No, it was pure slander on your part, and chutzpa.
From March of 2005 to March of 2008, the Federal Reserve did not allow the M1 narrow spendable money supply that it directly controls, to move one inch.
That broke all of your bubbles. Real estate first.
In case nobody has noticed, the whole trade that blew up and caused the credit crisis, was exactly this insane belief that any real asset - like a house - would always be worth infinitely more than any amount of nominal debt used to carry it. Sorry, no, untrue. Bid prices high enough and the debt is worth more than the real asset.
What will it take before you-lot get this slanderous inflationary brainstorm out of your system? How about grinding you to atoms for a decade? Whatever it takes.
Bonds at the current huge spreads are going to pay. None of your bubbles are.
Your unwillingness to simply lend on nominal claims to investment grade credits, will choke off all fuel for any of your bubbles forever, and they will not go anywhere. Not until bond owners are first *paid*.
Savings capital will be paid in full for its services ,and in real terms. Every attempt to avoid that will blow up in your face. Nobody is going to ride in and reinflate your cockamamie schemes. Not until you disgorge all of it and pay bondholders back every dime stolen from them, twice.
It isn't complicated. You just don't like it. Tough toenails, you are wrong.
Good comment, though much of your argument could be equally applied to a pretty rough patch of deflation -- longer lasted than 6 months.
When oil falls by 50% in 4 months and all other commodities follow suit, you'll get negative inflation rates for a while. It's a mathematical certainty. However, if they went up by 100% in the previous 9 months, does a 50% drop mean anything? Congratulations, we are back to where we were a year ago. Will zero percent inflation last? Perhaps if oil drops another 50% in the next 4 months. It could happen, but I admit that I don't have the guts to make that kind of bet.
I swear everything I read on this site basically says "what occured in the last 6 months will occur in the next 6 months." I guess it always appears that way.
Throw your money away on gold and commodities if you must. But dont tell others to do it.
Randy_H and css1971 noted that deflation can last a while. this is quite right. however, i think the budget deficits are what is going to really bring on inflation sooner rather than later. the US' income is falling, it is only a matter of time before it will not be able to sell more debt, at which point expansion of the money supply is the only way the debts will be repaid. i think we will see inflation resume in 2009.
the other factor to consider is central banks decreasing US dollar reserves, which i think will be a by product of the double deficit and corresponding decreased demand for US dollars. this would suggest inflation even if US banks are not able to lend to US consumers as dollars overseas will be unloaded.
Please...get rid of that photo of yourself. (Sorry, but had I not read your bio before reading your comments, I wouldn't have bothered reading your article.) It doesn't do justice to your insights and the many intelligent comments you ellicit from reasers.
MG