Deflation: Least Expected, Most Likely...

Since it's been a while, I wanted to review the case for deflation while there is still time. Too many think that the U.S. is the new Japan and that this debt expansion program can continue indefinitely, ultimately leading to hyperinflation. Unfortunately, as always, the least discussed and prepared for scenario, is the most likely to occur. For those who have not yet read Prechter's "Conquer The Crash", I highly recommend it. His arguments are flawless, irrefutable and inescapable. No, I don't get paid to flog his book...

In this post, I compared the hyperinflation v.s. extreme deflation debate. I also introduced my decision flow diagram, which is every bit as relevant today as it was when I first created it. In fact, subsequently we have endured one debt ceiling debacle which saw the comfort seeking politicians of the day back down in favour of their special interest groups. And as I write, they are voting on another extension of time for the latest debt ceiling battle. The idea that politicians will ever say no to more money, is a joke of the first order. Extend and pretend, to the very end...

Liquidity Preference 101

Next, in this post, I explained that there truly are no safe havens anymore, but that Treasury bonds are likely the least worst house in a bad neighbourhood. Recent trading patterns in T-bonds have done nothing to suggest otherwise. Meanwhile, the dollar is really the lynchpin in this entire equation, because per Precther's well laid out logic, the money supply will collapse, leading to a shortage of dollars, hence a repatriation of cash flows which have to go somewhere - i.e. T-bonds. It's exactly what was happening in 2008 on an accelerating basis, before the Fed stepped in (with Quantitative Easting) to buy T-bonds and reverse that trade. Had they not done so, all liquidity would have flowed out of risk assets - stocks, corporate bonds, muni bonds, commodities etc i.e. they narrowly avoided extreme asset deflation, in that instance, saving the crash for a later date...

Along the same lines, I recently discussed this bastardized idea of "going to cash" - the term "cash" being the most misused term in finance. Unfortunately, that's something a lot of people are going to find out a day late and many dollars short...

Mind The Output Gap - A World Without Money
Next, I addressed the fundamental driver behind extreme deflation - the output gap. The unfortunate, yet obvious gap between our current lifestyle and a more sustainable long-term way of living, that is less resource intensive and less expensive to maintain. How we get there, is anyone's guess, but we all know that the longer we play this game of 'Extend and Pretend', the harder will be the adjustment.

Anyone who wants a glimpse into the future can just look at what is happening right now in Greece as unemployment approaches 25%.  We can kid ourselves that we are different than them, and they are more profligate, however, the real difference is that they were cut off from the credit markets and can no longer borrow to prop up their way of living. Once the rest of the world can no longer borrow to prop up our unsustainable lifestyle, we will find out very quickly what it's like to be Greek.