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Posts Tagged ‘deflation’

This has been an interesting debate to watch.  Until about a few months ago, inflation was the “in” thing.  The notion has been that since the Government has been printing money and flooding the economy with stimulus inflation would be created. 

My stance has been all along that we will not see inflation for a long time for a few important reasons.  First deflation is often the result of too much debt in the system.  Second, the government can print all the money it wants and not create inflation because the money that is printed is going to absorb losses in the system.  The key is that money is not circulating. 

If you introduce money into the economy and that money circulates through buying and selling of goods and services and is being lent out, you can definitely create inflation.  That is not happening.  That circulation of money is measured by the velocity of money.  If money is circulating at a high rate, we have expanding velocity.  Today we have been watching velocity contract instead of expand.  As the losses on debt continue to mount, it will be tough to expand the velocity of money.  We are on the toxic path of debt.

All of the sudden, it is as if economists are starting to recognize deflation.  Now the “in” word is deflation and not inflation.

Consider the definition of deflation.  Deflation is a decline in general price levels, often caused by a reduction in the supply of money or credit. Deflation can also be brought about by direct contractions in spending, either in the form of a reduction in government spending, personal spending or investment spending. Deflation has often had the side effect of increasing unemployment in an economy, since the process often leads to a lower level of demand in the economy. (Source: Wikipedia)

This is pretty much what we are seeing.   Ironically, during a period of deflation, the dollar is actually strong and gold weakens.  We are also seeing that trend. 

The Federal Reserve Board is now acknowledging we might have a deflationary problem.  Ben Bernanke is regarded as an expert on deflation.  Expert or not, it is happening on his watch. Inflation is something the Federal Reserve Board can tackle head on.  Think of deflation as aggressive cancer whose only cure is experimental medicine. 

This last Federal Reserve Board meeting illustrates how they are shooting in the dark.  In fact, some economists fear that these new steps they are taking could actually backfire and make the situation worse.

Even more amazing is that we could pump 100’s of billions of dollars into the system and almost 2 years later have the same problems on a much larger scale.  As I have said many times before, the politicians and the Federal Reserve Board are useless in this scenario. 

The only solution to our economic mess is letting the system detoxify on its own allowing consumers and businesses to work through it.  In that process you stop creating more debt and allow the losses to occur.  You support small business in an attempt to rebuild what has been destroyed. 

Unfortunately, we are getting the exact opposite out of Washington.

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Over the past few months the economic data has fallen off a cliff.  Personally, I think that we are seeing deflation really start to settle into the economy.  Over the past few years, it has slowly infiltrated everything.  Deflation occurs when the prices of everything decline.  Inflation occurs when the prices of everything rise.

When I say the prices of everything I mean the prices of investments, real estate, etc.  I also think that gold will be a good indicator to watch for deflation. Gold should not do well in a deflationary environment.  Gold may have seen its high. 

A debt crisis is also one of the primary contributors to a deflationary environment.  Think of deflation as the process of wiping out excess debt. 

It seems like the media is slowly catching on to the deflation theme that has been in then numbers for a long time now. I happened to catch a series of articles in the Wall Street Journal’s Ahead of the Tape column that I felt served as a great example.

June 10, 2010
Deflation is Worrisome but not a certainty.
“Yet investors shouldn’t confuse current conditions with outright deflation.”

June 17, 2010
Deflation isn’t a concern, at the moment.
“But it is only if the recovery stumbles that outright deflation becomes a real concern.”

June 30, 2010
Deflationary Mindset Makes Itself at Home
“The bigger worry is that a deflationary mindset has taken hold in the housing market.”

What we have been seeing in the housing markets for 3 years now is classic deflation.  It was the first part of the economy to get hit.  Deflation should be a real concern and should be here in full force in the event that we do fall back into a recession.  The media and most of Wall Street will not recognize it as a problem because of one huge issue.  There is no cure for the cancer of deflation except time.  The Fed has no weapons against deflation.

Stock Market

We are coming up to one of those “line in the sand” periods.  Over the next few weeks, we should quickly figure out whether this decline since April was nothing more than a correction or the start of a new bear market phase.  Stay tuned…

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Bloomberg had an article posted today entitled – Bond Traders Declare Inflation Dead after Yields Fall!  The article surmises that interest rates are low and well contained.  One trader states that he is not concerned at all about rising interest rates.  He doesn’t think that rising interest rates will be a threat.

I believe that interest rates will rise for one simple reason.  Let me show you an illustration of something that ran in the Chicago Tribune.

(related image) 

Debt will probably be the reason that interest rates go up.  If you have been staying up on the news, you know that Greece and many of the other European Union countries are in financial trouble.  Greece, in particular, needs to borrow money or are seeking a bail-out just so they can make their debt payments to their creditors.   So if you are going to lend money to someone in trouble, shouldn’t you get rewarded with higher interest rates for taking the risk?  When Greece issues bonds (read: borrows money), they are forced to pay higher interest rates because they represent a risk.  I think that we will start to see the same thing in this country.  In fact, I think that we already are seeing this occur.  At some point, investors are going to demand much higher interest rates on US government bonds which forces interest rates to rise.  One other point to make about the article is that rising interest rates does not automatically equate to inflation.  We need prices to go up all across the board for inflation which brings me to the title of this piece.

Inflation would be a welcome sign.  The opposite of inflation is deflation.  That is what Japan has been mired in for decades and what the US went through in the 30’s.  I believe that is what we face today. Unusually high levels of debt create deflation.  So, once again, we come full circle to this enormous debt problem in America.  Our politicians can pretend it is not there.  We can also think of it as our children’s problems.  In reality, it is driving force behind all financial problems in this country.

Low Volume

Will Deener wrote an article in the Dallas Morning News this morning debunking the views of those of us who are bearish.  He quotes a trader that states the low volume in the stock market is actually a bullish indicator.  He says that you want to buy stocks when no one wants them.  I don’t think that I would go this far.  There is something else that usually occurs when the volume is this low.  You typically see low volume when you are getting to the end of a bull market run.  Further, investors are unusually spooked right now about the stock market.  I don’t think that this kind of fear is a good thing.

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There is no question that seeing a positive sign in front of the employment numbers is an encouraging sign.  It has been a very long time since that has occurred.  On Friday of last week, the Department of Labor announced that 166,000 jobs were created last month.  As always, let’s drill down into the numbers and look at the real story.  In order to get on the road to strong economic recovery, we need to start seeing a creation of 250,000 to 300,000 jobs each month.  In fact, we need to see those numbers for a very long time just to get the millions of unemployed workers back into the workforce.

Of the 166,000 jobs created last month, 48,000 were temporary hires by the government in order to take care of the census.  Then there is my favorite government accounting methodology which is the birth/death ratio where the Government “estimates” the number of people who were hired and were not counted in the employment survey.  It is always dangerous to give politicians the license to estimate.  They “estimated” 81,000 jobs were created.  This leaves us with roughly 37,000 that were full time hires.  Temporary hiring is better than nothing at all.  Although any positive number is a welcome sight, this is not a solution to the longer term problem. 

There are a few other items worth noting.  I have written in weeks past that I felt we are in a strong deflationary environment.  Deflation, as you might recall, is an economic phenomenon that causes prices of almost everything to decrease.  Along with deflation, we do have some undesirable inflationary pressures.  Most people are not aware that the cost of oil is now $86.34 a barrel (as I write).  It continues to slowly creep up.  Of course, this ends up being reflected at the gas pump.  The other thing worth noting is the rise in interest rates.  Rising interest rates in a debt-plagued environment is not a good thing, especially when we still have an ongoing foreclosure crisis were people desperately need to refinance at lower interest rates. 

It has often been noted that 4% on the 10 year treasury bond yield is a level that you want to stay below because of its effects on mortgage rates.  As of this morning, we are dangerously close to hitting that level.  The current level is 3.98% as interest rates are soaring upwards this morning.  Yet, all of these issues face the stock market and it looks like no one will be satisfied until the Dow can hit 11,000.  So, once we arrive at that level (19 points away) do we break out the party hats?  We would only if it is sustainable.  The market would need super human powers to sustain these levels with these headwinds.

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Please excuse any typos.  My assistant is out today and she normally proofreads my writing. 

There are so many facets of a debt crisis.  Unfortunately, there are many categories of debt that make up a debt crisis.  We have looked at the potential debt crisis in foreign debt.  Next week I am going to write an update on what is happening with mortgage debt.  This week I want to talk about municipalities.  Cities and states appear to be in trouble when it comes to debt. 

Last week, Jamie Dimon of JP Morgan made the statement that California was a worse problem than the country of Greece and is closer to being on the brink.  Of course, the big difference between a debt problem with Greece and a debt problem with California is that we can print money and save California (as if that is a good long-term solution).

Cities and states are feeling the financial squeeze.  The Rockefeller Institute of Government recently confirmed that state revenues fell through the first 3 quarters of 2009, the largest drop in 46 years.  The fourth quarter report showed even deeper declines in tax revenue, extending the decline to 5 straight quarters. 

California faces an estimated 20 billion dollar plus budget deficit.  California represents the 8th largest economy in the world.  By the way, Greece only represents the 34th largest economy in the world.

It is estimated that 43 of the 50 states are in financial trouble right now.  Twenty-one states have already put a number on their 2010 budget shortfall which totals over 60 billion dollars thus far. 

Some of the more noted states that are in trouble:

Budget Shortfalls

New York        $5.5 billion

Florida             $5.1 billion

New Jersey      $2.5 billion

Arizona            $2 billion

Nevada            $1.2 billion

The money has to come from somewhere.  States cannot claim bankruptcy.   As with any type of debt scenario, if the money cannot be paid back, a loss must be created.   Who is going to take that loss?  This is where it might become tricky for municipal bonds.  Bondholders could be at risk.  Through a municipal bond, an investor has essentially become a creditor by lending the city or state money and in return receiving a bond for it.

Would you feel comfortable lending money to a municipality?  By investing in a municipal bond, you are lending money.  With the problems that we are seeing, I don’t know that municipal bonds are such a great bet.

Incidentally, what we are seeing with states and cities is classic deflation.  These budget deficits and debt potentially create enormous losses due to the destruction of debt.  Once again, it is tough to see where inflation is going to come from with all of these debts waiting in the wings.

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There is an intense debate on Wall Street about whether or not we are heading towards a massive inflationary problem or if we are stuck in a deflationary problem.  Inflation is when prices go up and deflation is when prices go down.

If you are investing money, it is going to be important to get this one right.  So many of the talking heads on CNBC are declaring that we are heading towards extreme inflation.  They cite that the printing of money by the government is causing it.   They also point to this “incredible” rebound we are seeing in the economy.

If you will bear with me, I need to put the KOOL-AID down so that I am not tempted to drink it.  On the surface, it is inflationary when the Government prints enormous amounts of money.  However, the story goes well beyond the printing of money.  I regard these financial hosts as pretty smart people.  I often wonder if these hosts are all told to always be positive no matter what?  After all, they do work for CNBC, which is owned by GE, a publically traded company. 

Here is the evidence of deflation:

The velocity of money – Dig out your economics book. The velocity of money measures the circulation of money throughout the economy.  The velocity of money would need to be running pretty high to potentially create inflation.  Currently it is very low primarily because banks aren’t lending money and consumers aren’t spending money.

A world overloaded with debt – Debt in itself is deflationary.  Deflation is brought on by a debt crisis. 

The money supply – The money supply has been decreasing and not increasing. You would need to see the money supply expanding at a great pace to see inflation.  

The CPI and the PPI – The PPI or Producers Price Index shows whether or not the prices or increasing or decreasing at the producers level.  In other words, are the widgets getting more or less expensive to make?  The CPI or consumer price index shows what is happening to consumer prices. Are they going up (inflationary) or down (deflationary)? 

The latest PPI numbers showed an increase in prices at the consumer level.  When that happens, typically those higher costs get passed onto the consumer and are reflected in the CPI number.  However, the CPI numbers released on Friday showed the first drop in 27 years.  That tells me that companies are getting hit with higher costs but are not able to pass them on because the consumer is so strapped.  That keeps a lid on prices.  In fact, companies are dropping prices to get consumers to buy items.  That in itself is deflationary.

To be fair, the CPI minus energy and food costs decreased.  Yes we depend on energy and food which have been going up.  I think that net effect is clearly deflationary.     

In short, the reason that the printing of money is not causing inflation is simply because the printed money is not circulating.  It is absorbing losses of all kinds due to the effects of the debt crisis.  Until you get massive circulation which would show up in the above indicators, I think that we are stuck with deflation.  Plus you better hope that it doesn’t turn into inflation.  That would force the Federal Reserve Board to start aggressively raising rates which would easily throw us into a double dip recession if we aren’t already heading that way.

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Did you ever wonder why mortgage rates have been so low this year?  Well, let me take you on a journey.  Mortgage rates are influenced by government bond interest rates.  Government bond interest rates are influenced by the price of Government bonds.  If bond prices go up, then interest rates go down.  In order to raise the money to pay for all of the irresponsible spending of the Government, the Treasury sells Government Bonds.  Institutions, other countries, investment firms, etc. buy the bonds from the Government.  That money then goes to work to pay for all of the spending created by the Government.

The Government has a lot riding on those government bond sales or auctions.  If they go well, the Government sells the bonds and gets the money, bond prices go up, and interest rates stay low.  Since most people don’t want to lend the US money because we are in so much debt as it is, someone had to step in and help buy those bonds.  Yes, the Federal Reserve Board has been buying bonds all year creating more debt and keeping bond prices higher and interest rates lower.  I will not even go into how incredibly irresponsible it is for the US to buy its own bonds.  That goes without saying – the problem is that program is coming to a grinding halt at the end of this week following the largest bond auction on record this week – 123 billion dollars worth of government bonds to be issued.  The Fed will get out of the way and the bond markets will be allowed to function freely again.  That might not be so good.

Interest rates started going up today and are at a 2 month high.  What happens when you suppress something that should be going up and then stop?  It is like compressing a spring.  If you let go of the spring, it takes off.  I think that the same thing could happen with interest rates.  If this happens it could disrupt the credit markets, consumer interest rates will go up, businesses will have even more trouble borrowing money, and homeowners will now have trouble getting low cost mortgages. 

The stock market would have a tough time with raising rates.  However, the rising interest rates should help the dollar. If the dollar is going up, the price of gold should take a hit.  Welcome to Deflation!  The economy might start the debt detox process that should have started when this crisis started. 

If you are looking for a catalyst, this could be it.  Interest rate risk is not something that the stock market is ready to face.  However, China and others would certainly like to see the value of our dollar go back up.

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