CPI Reading Gives the Economy Breathing Room

Yesterday's CPI buys more time for the "free money" cycle. Buying time can be expensive.

Keith and I talk about history frequently. I know a bit about a fairly broad range of economic and political history, in part because of my education and in part because of my interests. Like many students of history, I have a tendency to massively discount its importance in the decision making process. To my mind, the more you know about past events, the more you understand the unique factors involved with each and, as such, the less confidence you will have in drawing conclusion solely based on corollary. When discussing yesterday's consumer inflation data, I told Keith that the current environment seems anomalous to me, and those looking for clues in the reflation puzzle will be frustrated by historical comparisons.

At -1.28%, yesterday's CPI reading arrived at the lowest level since 1950 when the massive deflation/reflation cycle that followed the end of WW2 were wreaking havoc on global commodity markets (see chart below).

This reading leaves the Fed with ample room to keep easy money train rolling at next week's board meeting and also provides the market with clear signals that the return of year-over-year inflation growth will not arrive until mid to late Q4. This breathing room gives the economy more time to recover but that time may come at a steep cost: with the scales tipped so far in one direction, even modest catalyst could trigger inflationary pockets rapidly, providing a nasty "snap-back".

One of our core ideas coming into 2009 was the demise of correlation of returns for different asset types, and this will be critical in our approach as we position ourselves to profit when inflation does finally raise its head. We anticipate significant divergence inside the commodity matrix as overlapping demand factors and currency valuation throw the momentum mentality that worked perfectly in the 07-08 boom out the window in favor of market specific fundamentals. In other words, in the cycle that we see on the horizon, soybeans won't necessarily go up because Chinese demand for coal increases, and gold won't necessarily go down because the Brazilian cotton crop is larger than expected.

As such homework will be required and, if history is any guide, many investors will not do the assigned work and fail the exam.

Comments

[Larry House:]

Stop trying to impress and just speak clear English; it breeds confidence. Through how much history have you lived? It does make a difference.

Jun 19 02:46 PM

[Jason Rines...:]

I am more interested in the reflation trade comparisons of 1935-1937 to today then I am of the 1950's.

Jun 19 02:55 PM

[LilBob:]

Right now we don't have many of the factors that led to inflation in the fifties, such as meat shortages or factories that are operating at full capacity, or unable to do so because they are still in the stages of retooling. I'm also confident that Americans were burned bad enough by this last recession that they'll be holding the purse strings pretty tightly. I think anyone who honestly believes that the nation will just snap back to the sort of pre-meltdown spending habits that will bring significant profits and breed significant inflation is somewhat misinformed.

Jun 19 06:05 PM

[LilBob:]

typo, late forties not the fifties...

Jun 19 06:05 PM

[Mr. Ed, Jr.:]

I have no idea what is being said in this article. This is jibberish.

Also, do I know Keith ?

Jun 19 06:45 PM

[The Geoffster:]

History is an excellent guide. No fiat currency in history has survived.

Jun 19 09:44 PM

[Mad Hedge F...:]

Look at more than one data point. The current chairman of Morgan Stanley Asia (MS) is bearish on the economy and sees no chance of a “V” shaped recovery, just a very weak one at best. The “green shoots” are still underground. “The consumer is toast,” he averred, and he expects consumer spending to plummet from a record 72% of GDP to 67% in five years. Since a massive external deficit has to be funded by foreigners, the outlook for the dollar is “down, down, down.” There won’t be a crash, just a gradual descent, as we have seen for the last 38 years. China isn’t going to bail us out. The US has only 4.5% of the global population, but accounts for $10 trillion of consumer spending. China and India together have 40% of the population, but only spend $2 trillion. This disparity is 50:1. Steve was an early BRIC fan, like me, and since China is so overbought short term, India is his first pick. You want to buy countries that have to build infrastructure and a middle class, and China has already done that. India’s recent election of a more pro business government is the trigger. I aggressively pushed India at the beginning of the year (www.madhedgefundtrader...), and it has doubled since then. The humorous thing about all of this is that Steve has been spouting the same bearish line for the US for 15 years. The in-house joke at MS was that he was sent to China because his negative sentiments were scaring the firm’s conservative US institutional investors. Given the performance of the BRIC’s since then, it is Steve having the last laugh.

Jun 20 05:40 AM

[Dave Wrixon:]

Well actually that is patently untrue. All money systems today are Fiat, so whilst many have perished some have survived, even if, as in the case of the dollar, their continued existence is ephemeral. However, as there are no major examples of a Gold Backed currency units, we can reasonably assume that none of them were capable of enduring.


On Jun 19 09:44 PM The Geoffster wrote:

> History is an excellent guide. No fiat currency in history has survived.

Jun 20 10:16 AM

[sunnsea:]

The part of history you should be concerned with is 1930 to 1933. We are half way through 1930. What exactly was going on through June of 1930? How many had been fired from their jobs? How many banks had failed? Was there a feeling of panic or fear or did people think that a return to prosperity was "just around the corner?" Did the rebound in the market earlier in the year inspire any confidence for the future? Did any one have any money left? Was there "cash parked on the side waiting to come back into the market?" Were real estate values crashing as well? How about the number of foreclosures?

Answer these questions in detail and we will have some idea of history. You might also throw in the tax cuts on the wealthy in 1923-24 and 1927 that created the 1929 bubble in the first place.

Jun 20 10:41 AM

[logicalman:]

really, does any serious" investor" expect everything to just snap back in short order,i think not...what the uninformed think about the future shouldn't have any bearing on what you believe!!!


On Jun 19 06:05 PM LilBob wrote:

> Right now we don't have many of the factors that led to inflation
> in the fifties, such as meat shortages or factories that are operating
> at full capacity, or unable to do so because they are still in the
> stages of retooling. I'm also confident that Americans were burned
> bad enough by this last recession that they'll be holding the purse
> strings pretty tightly. I think anyone who honestly believes that
> the nation will just snap back to the sort of pre-meltdown spending
> habits that will bring significant profits and breed significant
> inflation is somewhat misinformed.

Jun 20 08:45 PM

[Moon Kil Woong:]

The Fed and soon Congress are being restricted by the lack of anyone else to buy their debt more than inflation, at least for now. Unless the Fed is planning on buying any further growth and blow its balance sheet up 400% more, this can't continue.

As for inflation, where bond yields go, inflation usually follows. Don't bet on the long bond, especially 30 year US Treasuries. If you do, just call up China. They have a lot they are looking to get rid of. I'm sure they'll even trade them for your house.

Jun 20 10:23 PM