Tag Archives: deflation

Commodities running out of steam.

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The trend was smartly broken back in January, and now this bounce looks like it’s exhausting right about where the old support line would be. These are the various popular commodity indexes, from Bloomberg:

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You can see this loss of momentum in the former leaders: gold, silver, oil, copper, sugar and cocoa have all failed to make new highs as stocks have surged over the last month.

This is a strong sign that the urge to speculate is fading. Without that, there is nothing to keep prices up, since demand is very low for everything from oil to wheels of parmesian cheese (remember the cheese bailout in Italy?) compared to the 2008 commodity peak. When commodities fall, they often drop straight down. No class of assets declines faster. See this weekly chart of sugar for a case in point:

futures-tradingcharts.com

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If you are looking for short ideas among commodity stocks, this is a neat tool: miningalmanac.com (I think so anyway, but then I’m part of the team that’s building it).

Select the exchanges you trade on, then look for stocks without a lot of “burn time,” in other words those that may be running out of money. Or look at the “financial strength” tab to see who has too much debt and too little cash. Right now this beta version has mostly Canadian companies, but it’ll have almost every mining stock in the US, Canada and Australia before long.

Marc Faber and Mish Shedlock on inflation vs. deflation

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View on the Yahoo! Tech Ticker by clicking here.

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I’m with Mish in this debate of course, since a credit implosion trumps a money printer, I but have the utmost respect for the adroit Swiss. The two of them have much more in common than either has with most other money managers or commentators.

I totally agree with Faber that the US is not a civilized nation anymore, entirely due to the expansion of the state. I could say the same about the UK, Canada, Australia and most of western Europe. The whole region feels like a big kindergarten where the teacher wears a .380 and a bulletproof vest.

Is the Yen making a giant top?

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Deflation has kept a bid under the Yen for 20 years, since the huge load of bad debt denominated in that currency creates demand. The Japanese government took advantage of that bid and ridiculously low long-term rates and has issued unpayable quantities of debt, squandering the nation’s current and future wealth on government jobs and bridges to nowhere, when all they had to do instead was turn their backs on the banks that enabled the 1980s Rising Sun bubble.

Now that sovereign defaults are finally looming on the public consciousness, export markets are shrinking, and the ratio of workers to retirees is still shrinking, it would make perfect sense if the market started to tack a risk premium on all things Yen.

Technically, you can see the weakness of each advance against the USD for the last two years:

Prophet.net

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USD and US T-bond bears take note: the Japanese are a generation ahead of us in the Kondratieff / credit cycle, and theirs may foreshadow our own experience in winter.

I’m with Hendry

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Taleb thinks hyperinflation is a strong enough possibility to justify way OTM bets on gold (long) and bonds (short). The one bit I agree with is the long gold / short stocks play (though I think gold is likely to fall with stocks, just not as much), and I suspect that deflationist Hendry would concur.

Hendry thinks that deflation is here to stay, that nations will start to default, and that the market will at least start to worry about sovereign defaults by nations like Germany and the US (even if they don’t actually default, he’ll make money in that situation as the price of insurance goes up).


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(The video cuts off when Hendry passes the mic, and I don’t have a link to the rest. If anybody else does, please post it.)  (EDIT: http://2010.therussiaforum.com/news/session-video3/ Minute 24:00 and after. Thanks Charles!)

Hendry makes a point I’ve made myself: the euro is like gold for countries like Greece (they can’t print it) so it will have to default.

Hendry says his porfolio is inspired by Nassim, but basically the opposite. He’s fed up with other people’s opinions. The hedge fund guys are “so uncool.” He doesn’t talk to brokers, and he reads nobody else’s research.

Debt loads are bound to squeeze all of the vitality out of the risk takers in the market.

UK interest rates are at the lowest since the Bank of England was established in 1692. He is betting that the central banks won’t raise rates in the next 4 months and he will make 4x his dough if right.

He thinks the sovereign default scenario today is like the mortage bond situation three years ago.

Now, who is the true contrarian? Is hyperinflation really a black swan right now? Every chat board on the net has been buzzing about it for years. When Taleb said every human being should short treasuries, every human being agreed with him!

Some thoughts on government debt during deflation

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A question of Keynes vs. Kondratieff

Until recently, the sovereign debt of nearly all governments would rally during panic episodes as stocks and commodities fell. This makes sense, as strong sovereign debt is cash for big boys, and investors are forced to reach further and further out for yield as short-rates are driven to zero or negative. However, starting with Greece, this pattern may change, as bonds are likely putting in a secular top in the 2008-2016 window. Their last bottom of course was the early 1980s, and their last top was 1946-47. The indebtedness and unabashed Keynesianism of all of the world’s governments seem to virtually guarantee higher interest rates in the coming years, even though US, German and Japanese bonds are still finding a bid during panics.

We have already seen the beginnings of this development in municipal bonds and the crappiest sovereign debt, but the market may slowly realize that it is all crap, beyond the short-term credit of the strongest governments.

Prechter makes the point in Conquer the Crash that higher rates on risky long-dated sovereign debt are part and parcel of deflation, an increased preference for the safest cash and cash alternatives. Steepening yield curves fit right into that trend. If the long bond sells off hard, this does not mean the end of the dollar, but the opposite. All else being equal, if T-bonds fell with stocks this year, it would just mean that the US government would finally feel the same pinch as everyone else.

Now for the tricky part. We have to keep in mind that interest rates are more than just a mechanical product of fiscal deficits, savings rates and politics. They are a kind of natural social phenomenon, a reflection of forces I can’t fully understand. They are not rational: why were short-term rates in the low single digits during the second world war when the US had just abandoned the gold standard, had a debt:GDP ratio of over 100% and inflation was running at 8-12%? Why were they still double-digit in the mid-1980s when the economy was good and inflation was 3-4%? (For some charts and discussion of the long-term rate cycle, see this post). The only answers that make any sense are that it was time for rates to bottom and then it was time for them to top.

We are certainly entering what *Kondratieff described as winter, when debts are called in and defaulted upon and cash is at a premium. This is associated with low interest rates, reflecting a low demand for credit, provided that the monetary unit retains value, which it tends to do since this unit is how debts are denominated and settled. And with deflation very much a reality, low rates can provide a high real yield so long as the credit is sound. With housing and wages falling by large percentages and every consumer good on sale, what is the real yield on a 10-year note priced at 3.6%?

There is no telling how long rates will stay low or how low they will go. See Japan, 1990-

Those are the market rates on the credit of a horribly indebted nation with terrible demographics that has been trying to spend its way out of recession for 20 years. Is there a better way to explain this than Kondratieff winter?

If social forces demand that governments start to shift towards frugality and default like the rest of society (and government is a reflection of social mood), this would be very supportive of the current fiat regimes. Think about it: what would happen to the Euro if Greece defaulted (which is what they should do)? Billions in euro-denominated balances would go “poof” and the remaining euros would be worth more.

What if younger generations of Americans, the ones who most enthusiastically support Ron Paul and even phonies like the new senator from Massachusetts, start to exert pressure for the rolling back of that $70+ trillion in retirement and health-care promises? Those are contracts that the government can’t honor, so by definition, it won’t. It will try to pretend otherwise, but it won’t. In effect, much of the debt will be repudiated.

There are huge caveats to the above, such as radical socialism or expanded warfare, but there are going to be real deflationary undertones to social mood that may effect policy and prolong the current paper regimes for longer than almost anyone suspects. Kondratieff winters are not short episodes, but generational, and if the last two turning points in the interest rate cycle are a guide, there could even be another ten years to the bottom.

That is hard to believe right now, but it is possible if social forces demand default. I can’t gauge the odds very well, but I have to consider this longer-term bull case for treasury bonds and a few strong currencies. Bottom line — history has not been kind to paper money and government bonds in times of crisis, but the nature of deflation may give them a longer life than we have assumed.

If you just can’t wait to short some sovereign debt, try Japan before America. They may be a generation ahead of the west in the rate cycle, and really, how much lower could they go?

*Kondratieff waves in the US (click image to expand):

welling@weeden, 1.23.09

One thing that strikes me in the above chart is how huge the latest wave is compared to the others. At 60 years and running, it is the longest, and prices, rates and stocks have gone up so much more than during any of the previous three. Just out of proportionality, it would be perfectly fitting if rates and prices fell for another 5-10 years.

Here’s a clearer view of the Aaa corporate bond rate from 1919 to 2010:

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Also see Rothbard and then Mish on Kondratieff theory. As Rothbard makes clear, winter is not necessarily an awful time to be alive, judging from the strong economic growth of the 1830s-40s and 1880s-90s. This means that prolonged unemployment and war can’t be blamed merely on the credit cycle, but that fingers must be pointed at the socialists, Keynesians and fascists who’s actions directly brought about the nightmare of 1929-1945.

Yen and bonds, two of a kind

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I don’t know exactly what to make of this pattern, but it is not unusual to see these two move together. As forms of cash, they each tend to do well when the deflation trade is on. In fact, other than short positions, they are the only things that beat the dollar when everything else falls.

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I don’t know what it means that the Yen has been doing so well even as stocks have risen over the last year. Perhaps it’s a vote of no-confidence.

Even if stocks and commodities roll over hard, I actually wouldn’t count on the Yen rallying as powerfully as of 2008, or even at all. Its long-term trend has been weakening.

Keep an eye on the junk:quality ratio

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Put this down in the list of no-fuss, no-brainer, long-term trades. Simply buy 10-year Treasury notes and short junk bonds. There is no purer deflation play than this. It doesn’t even matter if Treasury yields rise (unlikely anytime soon IMO), since you’re playing the spread and junk yields will always include Treasury yields plus a risk premium.

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What are some other such no brainers for deflation? The closer something is to cash, the better.

- Long gold, short stocks. (Remember, I’m a gold bear for 2010).

- Long gold, short a basket of commodities (silver, platinum, copper, zinc, lead, oil, sugar, lumber, grains, etc).

- Long Treasuries (2, 5, 10), short stocks. This bet is safer the shorter the duration of the treasuries, but to make it work with short-dated notes, you’d have to go long a greater notional value of Treasuries than stocks. This is easy with futures: for example, for every $1M short in ES (S&P500), go long $3M ZF (5-year notes).

- Long US dollar, short hot “developing nation” or commodity nation currencies (Brazil, Australia, Canada, Russia, India, South Africa, etc).

- For later, not just yet: long 5-year treasuries, short 30-year.

- The most hard-core deflation trade of all: long stacks of $100 USD notes, short everything else, or safer yet, don’t even bother with the trading. Just wait for the market to make you an offer you can’t refuse, like a 10% dividend yield on the S&P, or $0.30 copper, $20 oil or $0.05 sugar.

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To make the spread trades work, you’d have to watch your margins, set loose stops and then just leave the trades to do their thing for the next 2-5 years.

Kevin Depew interviews Robert Prechter

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This is from a month ago, but it is a wide-ranging discussion from a long-term point of view. Depew is a very sharp guy who saw deflation coming himself, so this is one of the best Prechter interviews I’ve seen.


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“Yes, a depression is a period that’s difficult for many many people, but it’s not the apocalypse, it’s not the end of the world. It’s just a tough period that’s gonna last, you know, five to seven years and then we’ll come out the other side.”

For a speculator, “there’s no better time than a bear market — they’re fast, they’re violent, they’re great.”

Eric Sprott: new lows ahead for S&P 500

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From Bloomberg:

Dec. 29 (Bloomberg) — The Standard & Poor’s 500 Index will collapse below its March lows as an expected rebound in economic growth fails to materialize, according to hedge fund manager Eric Sprott.

The Toronto-based money manager, whose Sprott Hedge Fund returned 496 percent over the past nine years while the S&P 500 lost 32 percent, said the index’s 67 percent rally since March reflects investors misinterpreting economic data. He’s predicting the gauge will fall 40 percent to below 676.53, the 12-year low reached on March 9.

“We’re in a bear market that will last 15 or 20 years, and we’ve had nine of them,” Sprott, chief executive officer of Sprott Asset Management LP, which oversees C$4.3 billion ($4.09 billion), said in an interview Dec. 18.

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Here’s what a 20-year, deflationary bear market looks like (Nikkei 225):

Source: Yahoo! Finance

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Sprott also still likes gold, and from his perch in Canada he picks up smaller mining and exploration stocks. Although I like gold for the long term, I do take issue with the idea expressed here:

“If you get into this thing where you’ve got to keep printing more and more and more, who knows about the price of gold?” he said. “It will be the new currency in due course.”

Japan of course tripled its money supply and debt load in the aftermath of the bubble, but the central bank’s refusal to let bad debt and bad banks go under has locked the country into deflation and the Yen has remained strong. The debt situation in the US is much worse than in Japan, so our deflation should be even stronger. Japan was also bouyed through the ’90s and ’00s by strong exports as the rest of the world continued to grow, whereas the current bust is global. I do agree that after this deflationary stage clears the way, the government and central bank are bound to destroy the currency. The same could be said for the euro, pound and all of the rest, since none have any gold backing anymore.

The issue is timing — I have been saying since before the crash that deflation would be the situation for longer than almost anyone anticipates, myself included. This is because we have a credit system, not a cash system — in our economy it is credit issuance that controls the value of the currency unit, and credit will be contracting for years to come.

Congratulations to Mish Shedlock, star deflationist and gold bug

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I want to offer a little praise here for Mish Shedlock, an investment advisor for Sitka Pacific and proprietor of the hugely successful blog, globaleconomicanalysis.blogspot.com. I owe Mish a debt of gratitude as one of the writers who helped me understand our credit money system and anticipate the events of the last couple of years. He was a deflationist back when CPI was ticking in at 12% annualized (June/July ’08), and he has made a series of very prescient market calls.

Robert Prechter of course is the original deflationist who has seen this depression coming since the late 1970s (when he was a lone “bearma bull” and anticipated a great bull market followed by a giant crash and long secular bear market — his mistake was that failed to anticipate just how manic and levered-up society would get in the 1990s and 2000s — he called for a bubble, but not the greatest bubble of all time), but Mish’s writing has been on par with Prechter’s and he has lately bested him when it comes to gold.

I believe Mish has only been following the markets intently since the early 2000s, when he lost his job as a programmer. He used his free time and the internet to educate himself on economics and markets, and thanks to an intelligence uncluttered by a formal economics education or Wall Street voodoo, came to understand that we were experiencing a credit bubble — a business overexpansion and misallocation of resources due to easy access to debt. Debt was cheap because under our fiat money central banking system, bankers had created a cartel for themselves and a safety net. They had a license to blow enormously profitable bubbles and a get out of jail free card in the Federal Reserve, which of course is their own creation. Politicians love this system because it allows them to grow the government at a pace far in excess of the economy, since the Fed can just print money to buy T-bonds.

With his excellent understanding of debt, Mish came up with what I consider to be the best definition of inflation and deflation: inflation is an expansion of money and credit, where credit is marked to market; deflation is a contraction thereof. Rather than looking only at various money measures (M1, monetary base, M2, etc), Mish’s definition is most useful in our system since credit acts like money and dwarfs actual cash.

As Professor Steve Keen has shown, credit expansion precedes monetary expansion. In a fractional reserve world were credit can be created out of thin air with practically no restraints on reserve ratios, commercial banks and other “shadow banking” institutions are in the driver’s seat, not central banking committees. Even as the Fed’s balance sheet (like those of other central banks) has grown from $850 billion in early 2008 to nearly $2.5 trillion today, this increase in cash has been dwarfed by the contraction in private credit (which started out at $50 trillion for the US and is surely much smaller today). This is why cash has been king on Main Street, the recent stock and commodity rally notwithstanding.

Back to the story of the bubble, so long as debt got cheaper and easier, people could afford to take on more, which they did because it allowed them to keep up with their neighbors and feel good about themselves. Also, when credit is expanding, levering up is a fast way to get rich — asset prices soar, since you don’t actually need cash to buy things. A bubble mentality forms: when the only reason to buy a class of asset is because you can sell it to someone else for more (there is no reasonable prospect of sustainable cash-flow), you have a bubble. The bubble bursts when marginal buyers fail to show up and relieve the last round of speculators at a profit, since everyone is already stuffed to the gills with debt and debt-financed assets. When there is nobody left to buy and prices stall, that class of asset becomes a burden (taxes, maintenance, interest), and a crash is imminent. That was 2006 (a clear warning then was the inversion in the yield curve, as demand for credit started to abate and savvy Treasury traders bid up long-dated bonds in anticipation of a drop in short-term rates).

Anyway we all know the story now, but thanks to Mish and others of the Austrian school of economics (Ron Paul, Peter Schiff, Prechter, Marc Faber, Jim Rogers), a large segment of the internet-using public was forewarned. I single out Mish here for praise because he has arguably the best record of anyone for calling the shots since 2007.  Of course he was bearish on stocks going into the crash, but as a deflationist he was also bearish on commodities and foreign stocks and currencies, as was Prechter. Like Prechter, Mish called for a turn in the stock market early in 2009, though Prechter has been more prescient in anticipating its duration and magnitude. Mish was bullish on long-term Treasuries in 2008, when Prechter’s EWI was not, and I was glad to be on his side there.

Where Mish has really stood out has been in his understanding of gold. He has always said that gold is money, and he correctly anticipated its strength during deflation. I understand that this may have come from reading or reading about Professor Roy Jastram’s “The Golden Constant,” a study of 400 years of gold’s purchasing power during periods of inflation and deflation under both gold standards and fiat regimes. Jastram’s conclusion is that gold decreases in real value during inflations and increases in value during deflations — in effect, it acts like money. Now, Prechter has always said that gold is money, and he has always recommended holding gold and silver for the depression, since it is likely that the fiat system breaks down in the advanced stages, but he has failed to anticipate that the precious metals bull market would power through these first years of deflation (though he did anticipate the latest manic phase this fall after gold broke upwards in September).

Now solidly over $1200 per ounce, to my eye the gold market looks like a full-blown mania. DSI bullishness has been over 90% for a month now, and has been over 70% for much of the last six months. There have been no significant corrections. Every commercial break on cable TV seems to have an ad from one bullion dealer or another, and former Nixon plumber G. Gordon Liddy is touting it. That said, even if this parabolic rise is followed by a crash of $300 or $500, gold will likely still be leagues ahead of every other asset class since 2007 or 2000 (if gold hits $700, I bet the S&P will be 700 and oil will be $35 again). It truly is acting like money, high-powered, robust money, and it should continue to increase in relative terms even faster if credit strains worsen, as I think they will in 2010 and 2011. And as the US and other governments proceed in the following years to destroy their currencies through continued war and Keynesianism/Socialism, it will truly be a life-saver.

In addition to his excellent market analysis, Mish deserves our thanks for his consistent efforts to fight the bailouts and other thievery and stupidity in Congress. He has also no-doubt played a strong role in advancing Ron Paul’s bill to mandate an audit of the Federal Reserve and to defend it from those who would water it down.

Mish’s success goes to show the power of a geek with broadband connection. Since the formal education system and old news media have become propaganda outfits for the political and corporate parasite classes, if there is any hope for capitalism and a free and prosperous future, it lies with independent nerds.