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The Coming Deflation Scare

Below is an extract from a commentary originally posted at www.speculative-investor.com on 6th April 2005:

In the 5th January Interim Update we said: "...if the various markets do roughly what we expect them to do then another big deflation scare is probably on the cards for 2005-2006. In particular, if a) gold and gold stocks experience normal mid-cycle corrections over much of this year, b) the stock market peaks during the first quarter of this year and then declines into the next 4-year cycle bottom (due in the second half of 2006), and c) commodities trend lower between the second quarter of this year and the third quarter of 2006 in synch with reduced global growth expectations and a strengthening US$, then deflation fears will once again begin to dominate the financial landscape. However, it's a very good bet that the end result of the 2005-2006 deflation scare will be the same as the result of every other perceived deflation threat of the past 70 years -- more inflation, one of the main effects of which will be currency depreciation."

We are now into the fourth month of the year and at this stage the financial markets are doing roughly what we expected them to do, that is, the story is unfolding in a way that makes another big deflation scare a likely prospect within the next few quarters. As mentioned in previous commentaries, these deflation scares are quite useful as far as the Fed is concerned because they provide the justification for more inflation. In fact, inflation confers no benefits whatsoever -- not even the transitory kind -- if the public recognises the inflation problem and takes action to protect itself. However, when most people are unconcerned about inflation or believe deflation to be the bigger threat then the Fed is free to inflate to the fullest extent of its powers. That the Fed retains this freedom to inflate is critical because for every dollar in the world there are several dollars of debt, the result being that inflation is the lifeblood of today's monetary system. Or, putting it another way, the current monetary system is effectively the world's largest-ever "Ponzi scheme" in that new money must be continually brought in to allow earlier obligations to be met.

The main difference between genuine deflation and a deflation scare is that the former is a contraction in the total supply of money whereas the latter is a psychological reaction to falling prices. In particular, although a fall in prices that is not preceded by a reduction in the total supply of money has absolutely nothing to do with deflation, many people wrongly think that falling prices and deflation are one and the same. Therefore, whenever there's a broad-based sell-off in the commodity markets the idea that the country is headed towards deflation becomes popular and the call goes out to the Fed to inflate-away the looming threat. The Fed then answers the call even though genuine deflation was never a serious threat in the first place.

If a deflation scare did eventuate it would likely have short-term bullish implications for the dollar and bearish implications for gold. The reason is that inflation expectations would almost certainly start to fall BEFORE the Fed had completed its rate-hiking campaign, meaning that there would be a brief period -- a few months, perhaps -- when real US interest rates* were rising quite sharply. However, gold would likely begin its next major advance as soon as the market sensed that the Fed, in response to the deflation scare, was about to shift from a modestly restrictive monetary stance to an extremely loose one.

As far as the debt markets are concerned, the thing we can say with the greatest amount of confidence is that the outcome of a deflation scare would be a flight to quality. In other words, a highly probable outcome would be an across-the-board widening of credit spreads (under-performance by emerging market debt relative to US Treasury debt, high-grade corporate debt relative to US Treasury debt, and low-grade corporate debt (junk bonds) relative to high-grade corporate debt). We can also confidently predict that the Fed would make an about-face soon after the markets began to agonise over the prospect of deflation. In fact, the way things are panning out there's a good chance that the next official rate-CUTTING campaign will begin before year-end.

Although US Treasury bonds would likely perform well relative to almost all other bonds during a deflation scare, we don't have a strong opinion on how they would perform in absolute terms. A lot, we suspect, will depend on what the market does over the coming 2-3 months. A sharp sell-off in the T-Bond market during the next couple of months, for example, would set the scene for a powerful rally over the remainder of the year.

*The real interest rate is the nominal interest rate minus the EXPECTED inflation rate

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