Summer school

There are still a lot of people out there who didn’t absorb last year’s course on the credit cycle, particularly the chapter on inflation and deflation. To remedy this gap in your elementary economic education, before buying resource stocks or saying that any market will go to the moon on Fed-powered rockets, you are required to read this refresher by Mish Shedlock. An except is below:

…there are practical as well as real constraints on what the Fed can and will do. Nearly everyone ignores those constraints in their analysis.

Congress in theory and practice can give away money. Indeed, Congress even does that to a certain extent. Extensions to unemployment insurance, increases in food stamps, and cash for clunkers are prime examples.

However, those are a drop in the bucket compared to the total amount of credit that is blowing up. Take a look at the charts in Fiat World Mathematical Model if you need proof.

The key point is it is the difference between Fed printing and the destruction of credit that matters! As long as credit marked to market blows up faster than handouts and monetary printing increase we will be in deflation. Deflation will not last forever, but it can last a lot longer than most think.

Also ponder this missive from the dean of Deflation U, Robert Prechter:

“The Fed’s balance sheet ballooned from $900 billion just five months ago to more than $2 trillion, by buying outright, or swapping the pristine credit of U.S. Treasury debt for the questionable paper held by troubled banks, brokerages and insurance companies. One of the marketplace’s most strongly held beliefs is that the U.S. dollar is on the verge of an imminent collapse and gold is set to soar because of the Fed’s historic and irresponsible balance sheet expansion… We agree about the irresponsible part, but not about the near-term direction of the dollar and gold. Our forecast is being borne out by the dollar, which has soared straight through the Fed’s most aggressive expansion to date. Just as Conquer the Crash forecasted, the Fed is fighting deflation but, as the book says, ‘Deflation will win, at least initially.’ The reason is that there are way more debt dollars than cash dollars, with about $52 trillion currently in total market credit. As this enormous mountain of debt implodes, it is swamping all efforts to inflate. Of course, the Fed has explicitly stated that it will keep trying. Its initial effort was akin to trying to fill Lake Superior with a garden hose. But $2 trillion still won’t do the trick of stemming a contracting pool of $52 trillion. The only real effect is that taxpayers get hosed. Obviously not all of the $52 trillion is compromised debt, but the collateral underlying this mammoth pool of IOUs is decreasing in value, placing downward pricing pressure on the value of related debt, which won’t show up in the Federal Reserve figures for many months. A reduction in the aggregate value of dollar-denominated debt is deflation, which is now occurring. Eventually the value of credit will contract to a point where it can be sustained by new production. At that point, the U.S. dollar may indeed collapse, as gold soars under the weight of the Fed’s bailout machinations. But deflation must run its course first. In our opinion, it has a long way to go…”

Also consider an oldie from yours truly  (Some Basic Points on Inflation and Deflation):

#1 The business cycle is the credit cycle.

#2 Inflation is a net increase in money and credit, not just prices (mainstream opinion) and not just money (common misconception among contrarians).

#3 Deflation is a net decrease in money and credit.

#4 There cannot be both inflation and deflation at once.

#5 The central bank and the government bring about inflation by absolving banks of the responsibility for their actions. 9:1 fractional reserve lending would not be rewarded in a free market devoid of FDIC insurance and a central bank to print the money to pay for it and other bailouts for bankers.

#6 Price increases themselves are not inflation. If you have a fixed expense budget and your grocery and energy bill goes from $500 to $700, you must cut back $200 somewhere else (for instance, many are deciding to forgo eating out).

For points 7-11, click here

Also see, Why Bailouts will Not Stop the Depression

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13 thoughts on “Summer school

  1. This is an exhausted market. I have the feeling it could open down tomorrow and keeping going. Each advance has been weaker than the last, and today’s was without confirmation from Treasury bonds, the dollar, precious metals, oil or junk spreads.

  2. Zero Hedge pointed out that there was high volume to the downside after the close yesterday (upside volume was puny during regular trading).

    http://www.zerohedge.com/article/after-hours-new-330-pm-volume-spike

    I am looking at this week’s rally as a potential bear flag: low volume, low breadth rise at a low slope after a high volume & breadth rapid decline. The rise is unconfirmed by Asia, bonds, credit spreads and precious metals. This is all part of a topping process — it is supposed to be frustrating. If this is a bear flag, it will be resolved with a high-breadth & volume drop to about 950, and soon.

  3. Am I the only one that thinks Oil is going to make like Nat Gas and go down? Take out the highs from last summer and the current price is a high even by 2006 standards. Even if you give credence to the weakening dollar as a reason for Short Term higher prices in oil (long term is a given), surely the global demand destruction would drive prices down. Besides, anyone producing oil currently would likely realize this and keep production high to milk these premiums… adding to supply, and resulting in lower price. Furthermore, aside from long term inflation hedge by getting commodities, surely oil can’t go much higher for the time being (1-2 years) — if it does, costs for business and consumers will rise, thus de-stimulating the economy, and thus drive oil prices down through renewed demand destruction. I say Oil is going <$55… Your thoughts?

  4. Also, Bernanke, AKA The South-Compass, is predicting yet again that the economy is improving and that the worst is over and that he saved the planet.
    With his track record, you can safely consider that it’s just the other way around.

  5. @Daedal: Tom McClellan sums it up here:

    “August 14, 2009

    He said, she said. Two people disagree, with no other eyewitnesses, and then how do we tell who is right?

    There is a normal and understandable relationship between the price movements of natural gas and crude oil. Each commodity is found underground, and thus has similar costs profiles for finding it and extracting it. And each is economically sensitive, with demand rising and falling in sympathy with economic activity. More recently, with the advent of commodity index fund management gaining popularity in hedge funds, the investment properties of each are getting more alike than they were previously and thus the price correlation has increased.

    Oil prices bottomed in December 2008, and have almost doubled since then as prices have recovered from the crash selloff. But natural gas prices have fallen even further, breaking the correlation in terms of the big picture, but still making minor up and down movements in sympathy with crude oil prices. So if the two are actually related to each other, the question becomes: Who’s right, natural gas or oil?

    Seeing disagreements like this is not new. Back in 2007, there were a couple of notable divergences when natural gas prices turned down but oil prices made higher highs. Oil turned out to be correct about the direction for both commodities in those two cases. And in late 2008, natural gas prices made a brief attempt to move up, making a higher low. But oil prices kept on heading down, eventually proving right that both oil and gas were headed lower.

    Now we see oil making higher prices as natural gas prices are retesting the lows just above $3. Who’s right? If history is our guide, then oil ought to turn out to be the expert about where both are heading.”

    http://www.mcoscillator.com/learning_center/weekly_chart/gas_versus_oil_whos_right/

  6. Pej, there’s no need to taunt. I laid out a short-term case based on what I saw yesterday, and clearly it didn’t pan out today. Big deal. Over the last 2 weeks since I turned very bearish, the SPX is up less than 10 pts, bonds are up huge, silver is down a buck, oil is flat, and the dollar has rallied and only retraced part of its move. Choppiness is all part of the topping process — look closely at winter 2001-2002, July-Dec 2007, May-June and Aug-Sept 08: lots of chop on top of those waves.

  7. Well, we’ve got a 5:1 advance:decline ratio on the NYSE intraday. It was a shocker to come back to the screen and see ES printing 1025 on a huge ramp. I thought the shorts were all squeezed already, but as with AIG yesterday, there are a few more drops left in this lemon. But with sentiment stretching the high end of the range, there is only so much upside left.

  8. Don’t take it personally Mike. I’m on same trades, except the long-vs-short long bond. So it’s not me, you, prechter, and most of the “realists”.

  9. @Axclr8
    Re-read this:
    “Back in 2007, there were a couple of notable divergences when natural gas prices turned down but oil prices made higher highs. Oil turned out to be correct about the direction for both commodities in those two cases. And in late 2008, natural gas prices made a brief attempt to move up, making a higher low. But oil prices kept on heading down, eventually proving right that both oil and gas were headed lower.”

    Oil moved up until it didn’t. Then it collapsed. Another way of looking at it was that Nat Gas was correct in 2007, and was only dragged up by the same time of frenzied speculation that is driving the market now. Using the logic you quote, you could’ve justified buying oil at $149/barrel (UNG turning around and going up is a testament that Oil’s advance is correct).

    Instead of looking at relative relationships, I think it’s more correct to look at what drives prices. Inflation aside, prices are a function of supply and demand. Are you saying demand is going to outstrip supply? If so, then yes, prices will most definately go higher until an equillibrium betweent the two is reached.

  10. @Daedal

    I believe that eventually Natural Gas will head higher … from what level, that is the unknown but there are are a lot of smart rich people looking at UNG get ready to buy … Also, it depends on the kind of winter we may get …

  11. My Chicago roommates and I were using every trick in the book this last winter (which was brutal, by the way) to keep our gas bill down, and that was before the two of them lost their jobs. Natural gas is going to keep falling because more and more people can’t even afford to heat their homes. I hope those “smart rich people” do load up on UNG so they can share in the misery a little.

    In February there were concerns that storage space around Cushing would run out because there was literally nowhere left to put the oil — demand had fallen off a cliff. Given the stockpile figures that are coming out and all the supply that’s been stored and sold forward to capture the “reflation”-driven price contango, I’d say we’re gearing up for a spectacular repeat performance.

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