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How do you tell someone that has seen the dollar lose 80% of its value over the last 10 years that there is no inflation?

This sounds extreme to many, but to others it is the reality as they see it. Most of us have watched Congressman Ron Paul challenge Fed Chairman Ben Bernanke regarding the devaluation of the dollar in reference to precious metals prices.

In 1971, President Richard Nixon cancelled the direct convertibility of the U.S. dollar to gold. To many Americans, gold is still seen as real money vs. paper (fiat) dollars. Prior to 1971, the U.S. dollar was pegged to gold at $35 per oz. Now gold is at about $1575 per oz.


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On the other hand, Bernanke and most in the financial industry see the dollar, as measured by the dollar index (DXY) as relatively stable, especially considering the radical monetary easing measures taken by the Fed over the last few years. The Consumer Price Index or CPI, which is used to measure inflation, is within reasonable bounds. In January 2013 the CPI showed an annualized gain of 0.32%, hardly run-away inflation.


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Given that most people don't pay for gas, groceries or food with gold, we should examine where this feeling of inflation is coming from and why it is on the minds of so many people.

It just so happens that the feeling of inflation is not imaginary, there is a real explanation for this perception and it shows up in the spread between incomes and commodity prices. While inflation measures are tame, real wages have been declining and incomes have recently fallen sharply. Friday's income number showed the largest drop in incomes in 20 years. This widening spread has the effect of inflation on the consumer.

Falling incomes and declining real wages are putting increasing pressure on the consumer. Meanwhile, the Fed continues to attempt to stimulate the economy and lower the unemployment rate by means of monetary easing. However, it seems that the real effects of the Fed's actions are starting to show up in commodity prices being propped up while incomes and wages stagnate and fall. Rising taxes are a part of this equation.

As we dig into this a bit further, it appears that an economic cycle may be starting to develop:

The Fed eases to stimulate the economy, this props up asset and commodity prices. Fewer people, especially those with lower incomes, can then afford these necessities. This causes those people to seek government assistance. Ballooning government assistance programs then add to the deficit and national debt. Higher taxes are then needed to close the deficit gap. Higher taxes and high debt to GDP drag on the growth of the economy and then...more stimulus is needed. See start of paragraph to go through the cycle again.

This does not appear to be the beginnings of a virtuous economic cycle. In fact, this cycle, and more pointedly the growing gap between incomes and consumer prices, could force the Fed to rethink its current monetary easing actions. In its 2012 annual report the Bank For International Settlements warned the central banks of the developed world that imbalances of this nature could result from the over-use of monetary easing tools.

The BIS report also warned that the independence of the central banks could be at risk if imbalances such as those described above go too far. In other words, the central banks could come to be seen as the consumer's enemy rather than a friendly economic force.

Most of the economic indicactors, from GDP growth (0.1%) to U.S. Treasury Bond Yields and the CPI, do not point to any significant inflation. This lack of inflation and persistently high unemployment has allowed the Fed to feel comfortable in moving forward with aggressive monetary easing actions, in an attempt to reinvigorate the broader economy.

The monetary easing actions of the Fed flow through specific channels in the financial system -- first to the money center banks, from the money center banks the hope is that the money then trickles down through the regional banks and businesses where it will eventually stimulate the broader economy. In practice, the liquidly injected by the Fed has the tendency to find its way into more specific areas rather than a broad-based even distribution. One of those areas that seems to have benefited the most is the U.S. stock market.

As we are now several years into very aggressive monetary easing actions, we can now start to discern more clearly where these liquidity flows go. It appears that wages and incomes are not being positively affected in proportion to assets and commodities.

Seventy percent of the U.S. economy is based on consumer spending, should incomes continue to decline while unemployment stays relatively high and prices continue to be supported, the likely result will be layoffs and yet higher unemployment.

Historical Data Chart
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Conclusion:

Should it be seen that the tide is reversing and that the Fed's actions are starting to have a negative effect on the all-important consumer, it would stand to reason that current aggressive Fed policy would have to be adjusted.

It is likely that as we go forward a shift from a focus and dependence on Federal Reserve monetary policy actions to fiscal and legislative economic actions will take place. This shift has been made difficult by a sharp political divide which still exists. The necessity of a shift of this nature will be made clear should it be shown that the Fed's easing actions are reaching the point of diminishing returns.

If the Fed is forced to scale back its monetary easing actions without reaching its stated goal of low unemployment (6.5%), it would likely be attributable to an economic imbalance such as the one described above that may be taking shape right now. A policy shift by the Fed in such a situation would likely signal a deflationary environment.

In a situation of this nature I would look at shorting U.S. equities as their incredible multi-year run has been largely predicated on real inflation starting to take hold. A necessary ingredient for inflation is that the consumer has extra money to spend. Falling incomes and rising prices are not likely to lead to a true inflationary environment. In other words, people have to have money to spend in order for real inflation to happen.

U.S. Equity Index ETFs and ETNs include: (NYSEARCA:SPY), (NYSEARCA:SDS), (NYSEARCA:DIA), (NYSEARCA:DXD), (NYSEARCA:IWN), (NYSEARCA:TWM).

In a deflationary situation like this, the already crowded bond market could see even further increases and falling yields. Going long bonds during a time of deflation could be a profitable trade.

Bond ETFs and ETNs include: (NYSEARCA:BND), (NYSEARCA:TLT), (NYSEARCA:LQD), (NYSEARCA:HYG), (NYSEARCA:JNK).

The past performance of Treasury Inflation Protected Securities or TIPS ETFs indicate that going short these ETFs in times of deflation is likely to be a profitable trade.

TIPS ETFs and ETNs include: (NYSEARCA:TIP), (NYSEARCA:SCHP), (NYSEARCA:IPE)

For guidance on when to exit positions given the scenario above, I would look for legislative and fiscal action that would start to aggressively take the place of monetary stimulus. For a historical guide, the actions taken by the FDR administration to lower the unemployment rate in the late 1930s and '40's should be considered as somewhat of a historical norm that governments have tended to follow to correct rising unemployment and a generally deflationary situation by fiscal means.

Source: America Divided: Inflation Felt By Many While Bernanke Fights Deflation