Deflation v.s. Hyperinflation Revisited (yes, again)

The Deflation v.s. Hyperinflation debate continues to rage across the blogosphere, but for my part, for all the wrong reasons.  In my opinion, those in the clear majority who predict hyperinflation as the next likely outcome have a severe conflict of interest.  The next time you visit a blog predicting hyperinflation, take a look around for the gold and silver advertisements adorning the blog and/or question the current investment position of the blog.  As expected, the Idiocracy sees this current Deflation/Hyperinflation divergence as another opportunity to make a lot of money.  They see 'LTRO's' and 'QE n' programs around every corner.

GOLD IS MONEY PART 1

I wasn't intending to write this topic for several months, as I was planning to wait for my entry point for buying gold and silver, but events of the past several weeks have convinced me otherwise. With this entry I want to clarify my position on owning the precious metals and lay out my strategy for the long-term.

First off, let me start by saying that ALL predictions around the timing and price of commodities or any other asset class need to be taken with a big grain of salt. Regardless of the relentless descent of the economic fundamentals that we are now witnessing, financial markets will do what they do, which is to rise sharply, fall sharply, meander sideways and otherwise move in such a way as to confuse and torture as many investors as possible. The market is a casino, if you stay at the table long enough, eventually the house will get its money back.

That said, I believe, based on my deflation thesis, that there will be an entry point for gold and silver that is significantly lower than these current levels, and I am willing to play my hand that way. From the 2001 low of ~$250 to the recent high of $1000+ dollars, gold has risen 300% in what I believe is the "first wave" in a long-term secular move. Furthermore, based on the chart pattern and Elliot Wave analysis, I believe that we will see a deep pullback to roughly $500 per ounce (+- $50), which would be a 62% Fibonacci retracement.

I know, there are many who believe that gold is a "safe haven" and therefore will continue to rise, as the world stock markets fall. However, that common belief is also predicated on the view that the U.S. dollar will continue to sink inexorably into oblivion. In a deflationary environment, however, there will be a shortage of U.S. dollars and the dollar (beyond all expectations) will rally. Also, contrary to the "safe haven" theory, when global stock markets sold off hard into their January panic lows, gold fell in synch with the stock market. Therefore, one must surmise that this rally in gold is just another product of the credit bubble and the overall rise of all commodities. Once the commodity bubble bursts, gold will come down with everything else.

There is a somewhat risky assumption built into my prediction however, and that is in assuming foreign creditors will continue to sponsor the U.S. debt ponzi well into a deflationary downturn. If they don't, and there are reasons to believe they may not, then the U.S. dollar would collapse and gold would soar. Back in October, the Chinese raised the specter of using the "nuclear" option of selling off their U.S. dollar holdings. At the time, they were obviously just playing political games, but if they do eventually liquidate their U.S. holdings, then the only safe place in this country will be a bunker in Montana with 10 years worth of food and 100,000 rounds of ammunition.

Which gets us back to the title of my post, that in the long run gold is the only true money. They say money doesn't grow on trees, but in fact it does. Paper comes from trees and therefore there is literally an endless supply of "money". Paper currency has no intrinsic value; it has only notional value, based on the faith and trust people have in the Government issuing it. Once that faith and trust is lost, the value of paper currency will be lower than 4-ply toilet roll, and gold could easily be at $4000 an ounce (bread will likely be over $8 per loaf - maybe we should stockpile bread...).

How do I reconcile my short-term belief that gold is not currently a "safe haven" vs. my long-term belief that gold is the only money worth owning? Easy, based on the fact that most people still have faith in the U.S. dollar as their primary currency. Trying to determine when widespread recognition of the fallacy of this faith occurs, is obviously difficult to predict. For my part, as indicated above, I will trust the technical (chart-based) road map for determining my entry point for gold, unless I see something event-driven that changes my mind - which could occur at any time...

To be continued...

Fed already shooting blanks and Recession hasn't even started...yet

Since embarking on its rate cutting campaign last fall, the Fed has cut its interest rates several times in various increments bringing the Feds Fund rate from 5.25% down to 3%. Though seemingly Bernanke still has a few rounds left in the chamber, as I discussed earlier, if he cuts rates too low that would likely set-up a Liquidity trap scenario, negating the impact of the additional rate cuts.

It seems that my Liquidity Trap scenario has already been preempted by a transitory Stagflation scenario, which has rendered the Fed's latest round of rate cuts impotent. Since lowering rates twice in late January (.75% and .5%), long-term interest rates have been moving higher, not lower. The reason this is happening is due to the recent very high inflation readings - to wit, yesterday 's PPI print which was the highest since 1981.

These higher borrowing costs in combination with higher costs for food, energy, clothing, medicine, tuition...i.e. everything, is putting the squeeze on already highly leveraged consumers.

Yet, that hasn't stopped the man behind the curtain from continuing the rate cutting campaign, as just today Bernanke "signaled" to the markets that the Fed was preparing to cut rates again at its March meeting.

Why you ask, would the Fed continue to cut short-term rates and risk higher borrowing costs and living expenses for consumers? Easy - the Fed is cutting rates to steepen the yield curve which will allow banks to borrow short-term cheap and lend long-term i.e. the banks can make beaucoup $$$ via yield curve arbitrage. By doing so, the Fed is apparently more than willing to risk annihilating both the housing market and the general economy. It's a simple choice between Wall Street and Main Street and as always, Main Street loses.

As a post script, I would add, don't worry about this recent bout of stagflation. The deflationary spiral will soon enough obliterate commodities and any other bloated remnants of the great credit bubble.

Deflation vs. Inflation vs. Both

Much has been written (here and elsewhere) regarding the rampant stupidity that caused us to reach this financially lethal point in history, but there remains one key unsettled question.

Among the few bloggers and individuals who understand the gravity of the current economic situation, there appears to be a growing debate as to whether or not to prepare for inflation or deflation. Most bearish observers seem to be leaning to the inflation/hyper-inflation scenario as the most likely outcome. Belief in the hyper-inflation scenario is abetted by the government's persistent under-reporting of inflation, the high price of gold (~$900) and the weak dollar - i.e. recent conditions.

I, and a few others, (EWI for example) believe strongly that the next episode will be a severe round of deflation leading ultimately to hyper-inflation. So, true, hyper-inflation will be the end result, but the circuitous route of getting there (via deflation) could see many bears wiped out, especially the current cohort of gold fanatics.

The reason to expect deflation has to do with the money multiplier and the expansion/contraction of credit. For the past 30 years credit has expanded to an unparalleled extent. Based on a fractional reserves system, banks take in deposits and then write loans against the deposits, holding only a fraction of the deposit in reserve. Once the loan is deposited at the next bank, then that bank makes additional loans against the same original deposit, holding again only a fraction in reserve. So forth and so on, until for each $1 in original deposit, there are now many dollars worth of loans outstanding. Therefore, the "money supply" consists of physical money (dollar bills, coins etc.) and derived money (electronic deposits). In precise terms, physical money is M0 and derived money is M2. M2 happens to be many times larger than M0, due to the money multiplier. The key issue is that once economic collapse goes into full motion (it's only in slow motion now), then the money-multiplier will actually go into reverse and not expand, but collapse. Here are the key reasons to expect a collapse in M2:

1) Bad Loans/Defaults, will cause banks to raise reserves and forestall making new loans to preserve needed reserve capital

2) Lack of new deposits: Due to general lack of confidence and highly public bank runs (think Northern Rock, recently), eventually people will pull their money out of the banks and stash it, which will cause a reduction in the reserves base

3) Repricing of exotic investments: As we are already seeing, there are many illiquid "assets" in the system that are "marked to model", not "marked to market". As each of these come to light, banks and other financial institutions will realize they are under-capitalized

4) Most importantly, a collapse in collateral values which we are already seeing in the housing market. This collapse will spread to all markets (commercial real estate, private equity etc.) and cause many borrowers to be upside down in their loans (owe more than the asset is worth), causing a downward spiral in asset values.

5) Borrowers won't be willing to borrow and lenders won't be willing to lend. Classic deflationary behaviour.

Bernanke and Co. will eventually realize that the situation they are facing is highly deflationary, but they will be slow to act, meanwhile the Ponzi deleveraging of M2 will be lightning fast. Ultimately Uncle Ben will throw cash from helicopters like he promised, but he will need a million helicopters to keep up with relentless unwinding of the massively leveraged M2 money supply.

The corollary: The money supply is massively leveraged, resembling an inverse pyramid with a very small deposit base and a very large derivative credit supply. Since it takes only $1 in deposits to support several dollars of loans, then each dollar removed from the deposit base will have a corresponding leveraged contractionary effect on the supply of outstanding credit ("money").

Strategy: In the short-term, it's time to own cash or short-term Treasuries (gold made a recent new high, but the dollar did not make a new low - very bullish for the dollar). The time to own precious metals for the long-term is down the road a bit: Once the current horde of short-term gold speculators has long vanished, and the deflation thesis becomes widespread, and the Fed has lowered Fed Funds several more times (and realizes they are pounding sand)... THEN THAT WILL BE THE TIME TO OWN PRECIOUS METALS