A Few Thoughts On The Inflation / Deflation Conundrum

By: Captain Hook | Mon, Jul 18, 2005
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There are lots of various topics that are pertinent we could talk about today. And I know you are expecting coverage on precious metals markets, which we will cover specifically in our conclusions. On balance however, its likely more important we center on some 'big picture' considerations that are set to dramatically affect all things equity not too far off now, and since the inflation / deflation conundrum is such a hot topic these days. Along these lines, we were watching Bloomberg television yesterday where they had a technical analyst on espousing sectors that have outperformed this year (she didn't mention the bubbles, although many are now in an attempt to demystify them) continue to look good, and that just like the period between 1966 and 1980 when stocks were range bound, you had to know what sectors to be in and which ones to avoid.

We find the degree of ignorance in the markets these days astounding considering the amount of information available out there, but then again, why should we be that surprised when our entire societal fabric is disintegrating right before our very eyes and the masses don't see that either. Anyway, in a round about way, what she was saying is that 'stagflation' should prevail in coming years, just as it did in the last larger degree secular economic adjustment period experienced through the 60's and 70's. Unfortunately for this person, the world is about to be sending out a rather rude wake up call soon, because stagflation, which is brought about by expanding the money supply against a predominantly deflationary macro environment, will most likely not be the final result this time around. Why? Because we are dealing with 'end game dynamics' in terms of growth, where grand scale trends are set to expire, like the people. Therein, many ignorant academics are about to get the surprise of their lives as well, because it's least likely the positive effects of Echo Boomers will be able to overcome the challenges we face regarding peak oil.

This understanding will become clearer to growing numbers as time passes for various reasons that will be triggered along the way. Even today these reasons are showing up, reasons that are central as to whether a predominantly inflationary or deflationary environment will dominate the financial landscape moving forward. And while we do think absolute levels of monetary aggregates will continue to expand for some time within the global fiat currency nexus, which of course is the true definition of inflation (we are not talking about price increases), signs are now appearing that confirm growth rates in credit expansion have likely topped out on a secular basis (maybe longer), meaning by definition, 'inflation' is decelerating and will likely reverse course at some point in the not too distant future. The clearest evidence of this is found in the break down of US bank stocks against the broad market, as measured by the capitalization weighted S&P 500 (SPX). (See Figure 1)

Figure 1

Perhaps this is the true conundrum Alan Greenspan sees before him now, as despite all his accommodative efforts throughout the past few years, the Fed's actions have been unable to get people borrowing money at an accelerating and buoyant rate. We know this because the growth rate in the US monetary base high-powered money appears poised to decelerate further, meaning the traditional multiplier effect is defunct. (See Figure 2)

Figure 2

Source: The Chart Store

Opening this vein a little further, we find more disturbing trends developing in key measures of future growth potential, such as the growing absence of cash in the system as measured by Money At Zero Maturity (MZM), which is the official measure of large denomination liquid deposits. Here, growth rates are already threatening to enter a 'deflationary' state, which is perhaps a result of higher living costs associated with growing debt service ratios and commodity / input prices. (See Figure 3)

Figure 3

Source: The Chart Store

Further to this, we have little doubt consumers and corporations are feeling the pinch in both of the aforementioned respects, as in spite of a modestly recovering economy over the past few years, money market fund growth rates have been unable to regain pre-stock market bubble crash levels seen prior to 2000. In fact, and as you will see bellow, balances continue to contract, which is evidence macro-degree 'deflation' is a very real possibility as time passes. Lest we forget money market funds are key elements of 'high-powered money', and if this trend persists, our suspicions mentioned above will become a reality, meaning deflation will grip the macro. (See Figure 4)

Figure 4

Source: The Chart Store

Central to the problem of decelerating money supply growth rates is the American consumer's inability to meaningfully increase aggregate debt levels much past current thresholds. America is up to it's eyeballs in debt, its population is aging, and trends in debt accumulation could be set to reverse. Can you blame people? Never mind servicing all the debt out there right now must be a growing hardship for growing numbers, especially as they age. I don't know about your views, but the less debt one has in retirement the better in my opinion. Central Bankers would have you take on more debt such that you can never afford to retire. They do this because they know no good measure of work themselves and prefer to keep a stupefied populous enslaved in usury. (See Figure 5)

Figure 5

Source: The Chart Store

Their most recent campaign of excessively accommodative monetary conditions have blown real estate values up into a speculative bubble, one where participants not only view appreciation potential as a source of retirement income, but where in fact many immediately spend any new equity provided by rising prices. Charles Ponzi would not believe his eyes today, and would undoubtedly bow to Alan Greenspan as his maestro. As you may know however, once any Ponzi scheme runs out of fools ready to surrender their hard earned money, the game collapses. We find it humorous so many so-called 'professionals' in a wide variety of concerned enterprise / fields seem to think there is no problem in this regard right now, and that even if prices are too high, they will deflate slowly. There is only one problem with this view, all bubbles in past experience have ended with a bang once popped, and to think this one will not once momentum in the opposite direction is established is loose thinking. Of course there is a lot of loose thinking going on out there these days, but as I say, that should change when momentum indicated in the chart below reverses, which could be any time now. (See Figure 6)

Figure 6

Source: The Chart Store

In our view, the system is undergoing a significant test in this regard right now, and based on our interpretation of what's happening beneath the surface, the real estate boom in the States is in serious trouble. How will one know for sure before it's too late to protect yourself from potentially rapid price declines as we move into 2006? Well, for one thing, you can simply watch the US Dollar (USD), where if it breaks lower from here, we will know the relative rate of debasement is exceeding that if its trading partners once again. Why is this so telling? Because, for example, economic conditions in Europe are not exactly rosy either, and if the States is accelerating money supply growth rates, that means other drivers in the economy, with real estate at the center these days, must be suffering. Thus, traders will take the USD down, which of course provides relief to the key driver of the global economy, which is the States. The unfortunate part of this equation is other relationships involving gold are telling us this may not help. More on this as we wrap things up below.

Of course we will be looking for government spending to take off once again if the consumer is on the skids, which should also reinforce a move lower in the USD. The only problem is if embattled consumers abroad are demanding more accountability from their governments with regard to purchases of US Treasuries (UST), where recent TIC data shows foreign government demand for UST's is plunging, market rates will shoot higher, which of course would support the Greenback, but derail the economy, a development sure to spark a deflationary scare, at a minimum.

Either way this conundrum is resolved, it's bad from an inflationary perspective because even if money keeps coming out the Caribbean to maintain a bid under US paper, debt levels are still on the rise all right, which is inflationary, but at a slower relative rate than is needed to sustain buoyant economic conditions. Here, one worries about a slowing, never mind a contraction, where if Central authorities see a potential contraction approaching, the money supply spigots would be opened wide. (i.e. remember, a plunging USD would confirm this scenario.) The key question then would be 'are there sufficient takers of new debt to make a difference?' If not, and after a brief bout of further counter measures, remaining reminisces of inflation would evaporate, because without debt inflation the entire formula breaks down. (See Figure 7)

Figure 7

Source: The Chart Store

This is why we think the whole 'inflate till you drop' mentality is quite dangerous right now, and that a continued stabilization of the system past this point should be considered a blessing because heaven knows things are poised to go the other way. One could be doing the 'chicken – egg conundrum thingy' with regard to above mentioned factors and the stock market right now for example, where I can assure its continued buoyancy is critical in terms of keeping the economy afloat, and visa versa. Oh, what a tangled web we have weaved Mr. Greenspan. (See Figure 8)

Figure 8

Source: The Chart Store

The question then arises, “are we on the cusp of deflation, or at a minimum a deflationary scare, one where prices decline, but monetary aggregate measures continue to expand such that prices eventually stabilize, albeit at an increasingly slower velocity?” Or, is this vein of thinking poppycock, as our associate Dave Petch would have you believe? To begin with, we want you to clearly understand that we completely agree with Dave regarding his views on continued commodity price inflation in that as long as demand exceeds supply, prices for increasingly scarce commodities will continue to rise. We believe this will prove true in the end even if macro price levels across a broad spectrum are falling, and defining aggregate conditions.

The fact officials see fit to continue going to more extreme measures concerning perceptions of the economy these days is quite concerning with regard to a potential test of this view in the not too distant future. And if we had to pick a pin, a pin that is a bubble in its own right, but may also serve as the popping agent for other inter-related debt and equity bubbles, we would have to pick the stock market because its in a particularly vulnerable state right now. Why is the stock market vulnerable at this juncture? Well for one thing, and likely the key to unlocking Pandora's Box, bullish / unsophisticated investors have become very complacent regarding the prospects for stocks because volatility has all but vanished from the trade. In this regard, I have no hesitation in postulating that although this condition could be maintained throughout the summer, history has proven in similar past sequences that speculators who are losing money on negative bets against the trend will become exhausted soon, and they will cease this strategy as a top is established. A picture of the Relative SPX shows prices continue to vex into new high ground each passing day now, but that technical indicators suggest the trend is nearly exhausted, as the blow-off is nearing completion. (See Figure 9)

Figure 9

Perhaps more revealing however, and as alluded to above, gold tends to sense changes in the prospects for inflation well ahead of other asset / equity categories, where you may find it interesting to know its poised to continue slipping against commodities unless hyperinflationary (printing presses gone wild) conditions develop very soon. We will have more to say on this chart and topic in future work, so stay tuned in you are interested. (See Figure 10)

Figure 10

And further yet in the process of endeavoring to determine a reliable inflation / deflation signal these days, we think the relationship between commodities and US Treasuries is particularly important right now, above all others in fact, because if investors are willing to drive yields down further past this point considering the degree of price inflation out their, market participants must see something quite frightening on the horizon. Based on the generally bullish technical disposition of US Treasuries against the Commodities Research Bureau's (CRB) index at this point, where we are still quite a ways from throwing off official deflationary signals, again it appears a trend test is on the way however, meaning volatility in equities, all types of equities, is set to rise. (See Figure 11)

Figure 11

Given what we hope you view as a tight presentation flow above, we will leave you with only a few brief closing remarks today considering trend reversals are still ahead, which will provide us with ample opportunity to revisit the material contained on these pages soon anyway. Therein, this is in fact the primary message we wish to leave you with today, that vigilance and open minded observation of market(s) conditions across an array of pertinent variables will be key to ensuring you are on the right side of the trade moving forward, because it's a big a complicated world out there, and preconceived notions could prove to be fatal financially at this juncture. Further to this, we believe it would be a mistake to not realize current circumstances are quite different compared to past rough patches in the economy / markets, and in many important respects more profoundly disturbing than at any other time in history, making it a necessity to maintain an open mind to a plethora of intertwined outcomes as it pertains to the inflation / deflation conundrum.

And please do not misread our opinion regarding potential future prospects for precious metals moving forward, where in the end investors will be handsomely rewarded on a relative basis no matter what occurs. Of course it's nice to manage your risk on an informed basis at the same time, which is the primary service we endeavor to provide here at Treasure Chests.

Thank you for joining us in this regard today.

Good investing all.


Captain Hook

Author: Captain Hook

Captain Hook

Treasure Chests is a market timing service specializing in value-based position trading in the precious metals and equity markets with an orientation geared to identifying intermediate-term swing trading opportunities. Specific opportunities are identified utilizing a combination of fundamental, technical, and inter-market analysis. This style of investing has proven very successful for wealthy and sophisticated investors, as it reduces risk and enhances returns when the methodology is applied effectively. Those interested in discovering more about how the strategies described above can enhance your wealth should visit our web site at Treasure Chests.

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