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It seems that these days most everyone has an economic forecast. Most of these forecasts can be categorized according to three broad potential scenarios playing out: Deflation, inflation, and double dip recession.

For many observers, the current shape of the economic recovery has been steeped in frustration. The source of the frustration comes from the fact that after an unprecedented globally concerted tidal wave of fiscal stimulus and some of the most accommodative monetary policies on record, unemployment is stubbornly high and the US housing market is making tepid steps (at best) towards righting itself.

Confusing the picture is that at one end, some economists are inferring that deflation (falling prices) is a step away and governments and central banks must continue to stimulate the economy. At the other extreme are those who say that inflation is already rampant and point to the run up in commodity prices and rising gold prices as a central plank of their thesis.

The major central banks (the US Federal Reserve, the Bank of England, Bank of Japan and the European Central Bank) have indicated through both their actions and words that they are going to take the side of the “deflation fighters”.

Most consumers will look at the price of gasoline, food prices and the general cost of living and express a certain degree of astonishment at those who would argue that deflation is the biggest danger. The markets are arguing that inflation is already here and central bank policies are to blame. It would seem that the inflation side might have won the day if we look to the record high price in gold. Despite this potential danger, many individual investors are still putting enormous sums into bonds and bond mutual funds.

Deflation & Distortions

US Federal Reserve Chairman Ben Bernanke has taken center stage in the debate between these two factions. Guided by his belief that policy errors by the Federal Reserve in the 1930s made the Great Depression much more prolonged than necessary, he seems to be throwing nearly thirty years of central bank orthodoxy to the wind. In 2002, Bernanke gave a speech titled "Deflation: Making Sure It Doesn't Happen Here" In that speech, Bernanke stated that:

The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse … in spending so severe that producers must cut prices on an ongoing basis in order to find buyers. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending--namely, recession, rising unemployment and financial stress.

click to enlarge images

S&P 500 - Versus West Texas Intermediate Crude Oil Prices

It is often argued that central bankers were too successful in their fight to stamp out the inflationary threats that were so prevalent in the 1970s and early 1980s. In turn, the financial markets have not had to fear the threat of inflation for nearly thirty years.

Many investors have long been suspicious of Bernanke and even gave him the title “Helicopter Ben”. This was in response to Bernanke’s statement that deflation can always be fought by the printing press and money could be dropped from helicopters – a most puzzling statement for a central bank chief if ever there was one. To that end, the inflation wary crowd has never forgiven Bernanke and have always maintained their suspicions of him.

This historical backdrop then sets the stage for the events transpiring in recent months. It is our contention that the Federal Reserve’s fight against the forces of deflation (real or imagined) is causing significant distortions in the financial markets. What do these distortions look like?

Distorted Oil Prices

For one, we can look to the oil markets. As we have highlighted in our weekly comments before the laws of supply and demand have been rendered worthless. Despite the fact that most storage facilities in North America are stretched to the breaking point, oil prices remain stubbornly high. Some are of the opinion that these high oil prices reflect Chinese or Indian oil demand. While it is true that the emerging nations are increasing their oil consumption, it should be noted that India and China combined account for less than 60% of US oil demand. Further, this demand is not exactly exploding to the upside but instead rising gradually.

The chart above shows that oil prices are moving closely with the stock market. As investors take on risk in response to improved optimism, oil prices go along for the ride. This is in part being made possible by ample liquidity sloshing around in the financial markets and the belief that the monetary authorities will do nothing to rein in the threat of inflation. The central banks seem to be signaling that they will have a tolerance for inflation – at least until the economy can gain better traction.

US Dollar Index Bullish Sentiment

Distortions in Gold

Gold prices provide a better illustration of distortions. As the financial crisis began to wind down, the overwhelming consensus was that inflation would be quick to rise and the measures from the injections of monetary stimulus from central banks would cause an outbreak of inflation. Nearly two years later, the debate has shifted to deflation vs. inflation and whether or not a recession was once again possible.

The Bond Market’s Response

As investors became fearful of the potential for a double dip recession, they unloaded stocks and piled into bonds. Bond investors until now have been playing ball with the Fed. Essentially, they have helped to keep interest rates low by resisting the temptation to dump their bond holdings in response to Fed induced inflationary fears. As the Fed and other central banks have periodically been stepping in to buy bonds in order to try to keep interest rates low, the bond market’s cooperation can no longer be taken for granted.

Amazingly, some investors were willing to buy recently issued 10 year bonds from corporations such as IBM for interest rates of 3% or less for ten years! After witnessing corporations being able to borrow from bond markets for record low interest rates, the bond markets have switched gears. As the bond market looks forward, it is seeing higher inflation and a monetary policy mindset focused squarely on greasing the skids for the economy. So to recap: Despite central bank bond purchases and those by skittish individual investors, bonds are falling and rates are starting to gain traction.

Warning From Within the Fed

Only one voting member of the Federal Reserve has warned against the potential consequences of current economic policy. Kansas City Fed President Thomas Hoenig has voiced dissent against current US monetary policy. He has voted against the majority decision six times this year - tying a record for most consecutive dissents at regular meetings since 1955.

In a speech several weeks ago, Hoenig, the Fed's longest serving member of the policy making committee, cast doubt on the effectiveness of a new round of bond purchases. He believes that the costs are likely to outweigh the benefits. One of those costs is the distortions that we are observing in the various markets.

Currencies Are Distorted

Perhaps the single greatest distortion has been in the currency markets. The US dollar has been sent tumbling since fear peaked with respect to the European debt crisis. The euro has stunned the world with respect to how quickly it has been able to bounce back – despite the fact that it has many flaws in its conception.

At its worst, the bullish outlook for the euro was about as low as it is currently for the beaten up US dollar. As the chart of the daily sentiment index for the US dollar shows on the previous page, each time that bullish sentiment has gotten down to the levels it is at now, a US dollar rally has ensued and usually risk taking activity has decreased. As a result, the rising US dollar means commodities such as gold, oil, base metals and risk taking instruments such as stocks tend to retreat.

According to a report from Credit Suisse, based on the net speculative positions betting against the USD there is a 100% chance (based on past occurrences) that the dollar will rally from here on a three month time frame.

Fighting to Employ the Unemployed

As the world’s monetary policies grapple with trying to get their respective economies to the point that they are able to create enough jobs to bring down unemployment, they seem to be willing to tolerate the distortions in the commodity and currency markets.

The importance of unemployment and the labor market cannot be underscored as it is the yardstick that policy makers are measured by. The problem, however, is that using this benchmark comes at a cost. In efforts to stoke employment, each major currency is being devalued in the hopes of gaining a greater share of exports. After all, a “cheap” currency means cheaper exports, and cheaper exports mean more domestic production. This “Beggar Thy Neighbor” approach has sent many to scurry for the value of gold with the thought that it is the only currency in the world that cannot be devalued.

It cannot be argued that gold and other commodities have no more room on the upside – as we all know, markets can continue their upward momentum far after the last naysayer has gone home. But the data shows that at the current juncture, it may be time to reassess the flight to commodities and seek new opportunities elsewhere.

Disclosure: No positions

Source: Central Banks Battle With Deflation