No Deflation! Disinflation then Lots of Inflation
The "Ka" phase of "Ka-Poom" has officially begun
by Eric Janszen
There will be no deflation. I repeat: there will be no self reinforcing spiral of debt defaults, an irreversible collapse in the money supply and a decline in the general price level. Central banks will never again allow the rate of inflation to fall below short term interest rates, nor fail to supply sufficient liquidity to meet the demands of financial markets. There will be no repeat of a 1930s US depression or the grinding 1990s Japanese deflationary recession. Instead, we will experience something new, with elements of deflations, and inflations and stagflations past – rhymes of past verses of economic misfortune – but unlike any of these past episodes except equally unpleasant. I call this new process "Ka-Poom Theory."
In 1999, in anticipation of the collapse of the stock market bubble, the Fed under Alan Greenspan vowed to never allow a deflation to happen in his back yard, and he kept his word. As a side effect, we got real estate and other asset bubbles, and soaring commodity prices. Bernanke has made numerous similar promises, and I strongly recommend that readers take him at his word. He made these promises because he expects these new asset bubbles to collapse, too. His famous speech about dropping money from helicopters earned him the nick name "helicopter Ben." He's not kidding.
The trick to avoiding deflation is to not be too slow on the draw. Once the rate of inflation falls below short term rates, as happened to the BoJ in Japan in 1992, the economy is an airplane flying with no forward air speed. The flaps flap uselessly in the stillness and quiet of a stall. The pilot of the economy, we'll call him Ben, needs to quickly drop the nose and head for the ground and pick up airspeed, although he'd better not be too close to the ground before pulling the maneuver. Ben is now flying a relatively comfortable 4.25 thousand feet in the air. But as we'll see, he has other problems that previous pilots didn't have.
Object lesson: Japan 1990s. Don't let this happen because, if you do...
...you get this.
Not deflation, but certainly disinflation, a slowing in the rate of inflation. Evidence of it is popping up everywhere.
Oil, Gold Tumble as Economic Slowing Threatens Commodity Rally
Sept. 11, 2006 (Bloomberg)
The period of disinflation, as shown in the Ka-Poom chart below, will likely last for a relatively brief period.
Oil fell for a sixth day, its longest losing streak in almost three years, and metals declined as negotiators reported progress to resolve a dispute with Iran and concern mounted the world economy is slowing.
"There's some talk that this could be the beginning of the end" for the five-year rally in commodity prices, said Ron Cameron, a resources analyst at Ord Minnett Ltd. in Sydney. "Tensions seem to be softening" in the dispute with Iran, he said. "That's giving the traders an excuse" to sell.
Gold for December delivery dropped $22.80, or 3.7 percent, to $594.50 on the Comex Division of the New York Mercantile Exchange. The metal is down 18 percent from a 26-year high of $732 an ounce in mid-May.
Movements in oil and gold prices are 81 percent correlated, Merrill Lynch & Co. said in a Sept. 8 report. A correlation of 100 percent would imply the two were moving in lockstep.
"The mega-run for commodities has run its course,'' Stephen Roach, chief global economist at Morgan Stanley, said in an interview Sept 5. Roach in May said the surge in oil and metals was a bubble about to pop.
Ka-Poom V2.0 (Dates represent estimated, approximate relative time intervals, not precise events)
The "Ka" phase of "Ka-Poom," the decline in the price of leveraged assets, as shown has begun. It has been kicked off by the collapse of the housing bubble. Ka-Poom leaves holders of inflation hedges, such as precious metals ETFs or bullion, with two options: 1) trade them, or 2) ride it out.
There are three problems with trading Ka-Poom: timing, transaction costs, and the risk of the wrong kind of random exogenous event. Getting the timing right is art, not science; transaction costs can easily consume your profits via taxes and fees; and an event that sends everyone after inflation hedges at once can leave you locked out of the market, high and dry.
Let's start by looking at the timing question. Using myself as an example, I purchased silver, gold, and platinum 1999 - 2002, mostly in 2001, during the previous disinflationary cycle, based on my first crack at Ka-Poom Theory–was buying gold from the dot com bubble until the Fed started fretting aloud about deflation, 1999 - 2001.
Exhibit A is receipt for purchase Sept. 25, 1999 of 20 PCGS and NGC graded MS63 $20 St. Gaudens at $445 each. Today, per PCGS, these are priced at $935. This was one of many purchases. In those days, ETFs did not exist. You had to buy the stuff. Now you have many more options.
Before you read on, ask yourself: What kind of freak was buying numismatic gold coins in quantity in September 1999, during the peak of the NASDAQ bubble?
So... consider the source.
No, not for Y2K . iTulip.com was anti-hysteria on that non-disaster.
In August 1999 we said: "What the heck's gonna go down after Dec. 31, 1999? Do we at iTulip.com envision a world in chaos ruled by tribal warlords marauding the strife torn land in ox drawn Rolls Royces, plundering suburban America for precious caches of bottled water and canned tuna fish? Time to invest in a bomb silo apartment?
Nah. After the clocks roll over into 2000, a lot of crappy software that doesn't work very well and breaks all the time will continue to be crappy and not work very well and break all the time."
Should I sell now? If I do, when should I buy back in? Am I sure I'll be able to? At what price?
To trade Ka-Poom, you need to time the inflection point of the end of the disinflationary phase and the start of the inflationary phase of the Ka-Poom process. The question is, how?
The disinflationary phase will last as long as it takes Ben to get and keep short rates a point or two below a falling rate of inflation. Before Ben can pull the "print" lever and head for the ground to pick up air speed, the bond market needs to be worried about deflation. Ben will hold off rate cuts and liquidity injections as long as is necessary to avoid causing a sell-off in the bond market. Can't look too eager, but can't be too slow on the "pull" either.
One way to try to time a trade is to take a good hard look at the rear view mirror. For this I provide two charts.
One comment before getting to these two charts: Money at Zero Maturity (MZM) is the only reliable published measure left to determine the level of the broad US money supply. MZM data have been collected and analyzed in a consistent way for decades. "M3 does not appear to convey any additional information about economic activity that is not already embodied in the M2 aggregate," said the Fed when they stopped reporting it last year. Fact is, the Fed has for many years used MZM, and so should you.
Likewise, the Producer Price Index (PPI) is the only remaining reliable published measure of prices. The Consumer Price Index (CPI) is continuously re-composed and fiddled with for political and other reasons. The PPI is imperfect because it is heavily skewed by energy prices, but the inflationary impact of energy prices on the economy is more or less proportionately skewed, and the Bureau of Labored Statistics messes less with the PPI than with the political football, the CPI, to which many government liabilities, such as TIPS and Social Security payments, are tied.
Chart I above shows MZM and PPI from 1990 and today. There are many other factors influencing the movement of the PPI other than MZM, such as the dollar exchange rate. To keep the analysis simple, but I hope without negating its value, I focus on the relationship between PPI and MZM only.
A. The 1994 - 1995 period is the last recent reported decline in MZM. This coincided with dysfunction in the commercial banking system following the end of the last real estate boom. That resulted in a near cessation of commercial lending in 1994. The Fed worked the problem and got things going again, as explained in "What (Really) Happened in 1995?"
B. After about a one year lag, after MZM had already started to recover, the PPI declined from mid-1996 to the end of 1999.
C. Following the stock market crash in mid 2000, MZM grows rapidly from mid 2000 to mid 2002 as a result of application of the Keynesian economic cure, including boosting the money supply. Other policies moves: tax cuts, deficit spending and dollar depreciation. The dollar price of gold, as show in (B) of Chart II below, rises during this period.
D. From 2000 and mid-2002, during the (C) period of rapid MZM growth, the PPI declines sharply. However, looking below to Chart II for a moment, gold rises sharply over the period through the end of 2004. This is the period of rapid dollar money supply growth; gold is pricing in future inflation which picks up in 2002. Gold and PPI rise together thereafter as the dollar is allowed to depreciate against other currencies. (This is detailed in the Inflationary Bias #6 chart below).
E. Returning to Chart I above, in 2001, the US economy goes through a recession even as MZM rises rapidly (C) and the PPI declines (D).
F. After the period of rapid MZM growth (C) ends, the PPI begins a rapid increase.
G. From mid-1996 to mid-2000, MZM returns to its trend growth rate, in line with GDP growth, as between 1990 and 1994 and 2003 to now.
Moving on to Chart II above for a further look at the rear view mirror, the rapid rise in gold (C) coincides with concerted rate cuts and liquidity injections by global central banks. In 2002, gold begins to rise in all currencies, not only the dollar.
In fact, the price spiked. Some analysts, such as Roach quoted above, characterize this rise as a "bubble." It is not. Bubbles are widely held belief systems, and to date very few people "believe" in gold, or any commodity, for that matter. Go look at the shelves of the Investing section of your local book store and you'll see what I mean. It's all stock tips and FOREX trading, although the Get Rich in Real Estate! books have thinned out. The spike is not a bubble but it does represent a phase in the Ka-Poom cycle that is likely to lead to a correction in this disinflationary period.
As the housing and other global asset bubbles end and the commercial banking system comes under pressure, trend MZM growth rates can't be supported and the disinflationary "Ka" period begins. The falling price of gold leads a falling PPI.
How long and far will gold fall during the disinflation "Ka" phase? No one knows, but my best guess is that it is likely to fall below $500 and perhaps even test $400.
Short Term Timing versus Long Term Trends
How will we know when Ben has pulled the lever and the Fed has begun flushing the system with liquidity, and the disinflationary part of the Ka-Poom cycle is about to end? Due to time lags there are no reliable data indicators but there are perhaps a couple of reliable anecdotal tip-offs.
The first is that the Fed will begin to worry aloud about deflation. When Ben starts to talk about deflation again, it will likely mean the presses are already running full tilt and first gold and later commodity prices will soar again within six months.
The previous mini-"Ka-Poom" 2000 to 2006 delivered the disinflation I expected, but not the level of inflation. To hold that off a while, The Three Desperados came to the rescue.
Original Ka-Poom Hypothesis – V1.0 – 1999
My current hypothesis is that the inflation I expected in the first iteration is likely to show up in the second. Here's why.
Unlike in the year 2000, reflating the economy today involves pouring liquidity into a system that is already riddled with inflationary biases left over from the previous Keynesian cure of rate cuts, tax cuts, liquidity injections, deficit spending and currency depreciation that followed the stock market bubble collapse.
Let's compare 2006 to 2000.
Inflation Bias #1: High energy prices. Oil is at $65/bbl today vs $25/bbl in 2000, and OPEC is talking about lowering production to maintain the oil price above $50.
Inflation Bias #2: Current account deficit of 1.75% of global GDP today, 30% higher than 1.25% of GDP in 2000.
Inflation Bias #3: Deepening US dependence on global capital flows to fund trade deficits, up to 80% of all global capital flows today from 60% in 2000.
Inflation Bias #4: Largest fiscal deficit today since the 1990s recession versus a fiscal surplus in 2000, which was the largest since 1940.
Inflation Bias #5: Taxes were generating revenues of 21% if GDP in 2000 against outlays of 18.5% of GDP. Today, taxes are generating only 17.5% of GDP against outlays of 20% of GDP, the largest spread since the recessions of the early 1980s. Additional tax cuts will further explode fiscal deficits.
Inflation Bias #6: The dollar has depreciated 15% against the yen and 25% against the euro since 2002.
The inflationary "Poom" is what happens when the liquidity spigot is turned on with this set of six inflation biases already in place.
For these reasons, Ka-Poom theory asserts that we will experience a post-bubbles disinflation followed by a reflation program what will effectively prevent deflation–as promised by the Bernanke Fed–but create a period of high inflation and economic stagnation.
Back to our question, what do holders of inflation hedges like precious metals ETFs or bullion do in the face of Ka-Poom: 1) trade it, or 2) ride it out? Above, I attempt to address the question of timing. It's tough to get right. I also mentioned that in addition to the difficulty of timing Ka-Poom, trading Ka-Poom involves transaction costs and the risk of a Random Exogenous Event that leaves you on the wrong side of the trade.
I won't go into transaction costs except to say that here in the US, paying 28% capital gains taxes on profits from sales of "collectables" is unappealing, and that apparently applies to gold and silver ETFs as well as physical gold. Throw in the 2% premium on both sides of the trade when you buy and sell physical and it's not hard to calculate the trade-off.
As for Random Events, in the face of the disinflation in leveraged assets now in progress, given the inflationary biases, the Fed wants to wait before pulling the "print" lever in order to not tank the bond market or the dollar. But a financial crisis in China, a terrorist attack against the US, or a derivatives or other financial crisis may happen that puts immediate demands on the Fed for liquidity. The Fed will then immediately begin to supply it. And if there isn't a random event handy that demands a liquidity injection when they want to inject it, well, the Fed can always invent one, such as when the Fed used Y2K as an excuse to keep the NASDAQ bubble going a bit longer. Quoting the "old" Stephen Roach, "Although Greenspan & Co. began to take back their extraordinary monetary accommodation by mid-1999, by then it was too late–the damage had been done. Moreover, it was compounded by the Fed’s now infamous Y2K liquidity injection of late 1999." The result of the next "emergency" liquidity injection will be unpredictable short term but, as the inflationary biases above show, are more predictable long term. Short term, the dollar may strengthen, as flight capital heads to US shores, especially from China, assuming the Chinese government allows it (this is typically accomplished via Hong Kong banks). But the six inflationary biases are likely to determine the longer term outcome.
To me, this all adds up to a hold. Ka-Poom is a hypothesis that a long term trend is in place that supports holding inflation hedges long term. I'm no better at timing trades using rear view mirrors (charts) than anyone else. However, I remain confident that the antecedents lead inexorably to the medium and long term trends of a period of disinflation followed by a period of chaotic pricing of securities and currencies, followed by a declining dollar and rising US inflation in assets that do not need to be purchased with additional credits, resulting in new debts.
Two final observations. First, I realize that since I bought PMs near the bottom of the market, it is easier for me to be philosophical about their prices as they go through inevitable periods of volatility. I understand that buying at gold at $270, watching it rise to $380, fall to $320, rise to $580, fall to $460, rise $720, fall to $550, rise to $630, fall back to $580, and so on, is a different experience than buying at $700, watching it fall back to $580, and putter around $620 for years. It's a personal decision whether to try to trade these fluctuations, just as it's a personal decision to buy into this whole Ka-Poom Theory at all.
Second, watching PM prices day to day, or even month to month, and trying to see a trend is like sitting on a beach and trying to determine whether the tide is coming in or going out by measuring how far each wave laps on shore compared to the one before. Sometimes, even when the tide is coming in, one wave laps higher than the previous one. If you go away for a few hours and return, the direction of the tide becomes obvious. Markets are unkind to the obsessive, unless he or she is a professional trader and has put that character trait to constructive use. On the other hand, if you wait until the tide is either mostly in or out before deciding on its direction, you've waited to long–you've missed it.
A large part of the art of investing in trends is to watch long enough to know the direction of the tide, but not so long you miss the ride.
For a layman's explanation of financial bubble concepts, see our book America\'s Bubble Economy: Profit When It Pops
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