Sunday, June 20, 2010

Deflation Station

They gave you life
And in return you gave them hell
As cold as ice
I hope we life to tell the tale
--Tears for Fears

From a macroeconomic standpoint, the great debate at present concerns whether inflation or deflation lies directly ahead. Despite recent government stimulus initiatives, I continue to favor the deflation side of the ledger.

An important pro-deflation observation over the past year or so is that the massive stimulative monetary and fiscal policies have yet to result in significant credit creation. Sure, the Fed is lending free money to banks, and the banks are subsequently buying longer dated Treasuries to rejuvenate their balance sheets in classic carry trade fashion. But little of this 'stimulus' is making its way into the rest of the monetary system in terms of credit expansion. Without the 10:1+ pyramiding effect of new credit, then inflation is dead in the water.

Long time deflatonist Bob Prechter recently was the subject of an informative interview in this regard. He notes that broad monetary aggregates and money velocity continue to decline in the face of all this stimulus.


He also observes that commodity indexes such as the CRB have yet to claw back to even 50% of their pre-2008 highs. In a serious inflationary environment, commodity prices would surely be trending much higher by now, he suggests. For whatever reason this observation particularly resonated with me--perhaps because I recently put on a bullish commodity position. When I look at a 3 yr chart of the CRB (above), the recent rise in commodities does look pretty pathetic.

Inflationists counter that, because the US government owns a printing press, at some point they'll merely start printing dollars and dropping them from helicopters per Ben Bernanke's early 2000s promise. Prechter suggests that darkening social mood may drive voters to exert pressure on politicians to keep them destroying the currency in this manner. After all, in many ways printing a paper blizzard constitutes the 'nuclear option.'

I've been wondering the same thing myself. It does seem that whether or not government resorts to the actual printing of physical currency (a la Weimar, Zimbabwe) is the ultimate 'endgame' issue in the inflation/deflation debate. Inflationists think it is a layup. Deflationists like Prechter don't think it's so obvious.

Prechter suspects that the April stock market highs may be multi-year highs, and that we're about to commence a 'super cycle' deflationary contraction that will carry markets to generational lows by 2016.

To him, the proper asset allocation is all cash--spread across various instruments to hedge against default risk. If one considers gold a form of cash, then Prechter's recommendation align well with Richard Russell.

Have to admit that this interview edges my needle a bit more to the deflationary pole. And it has me wanting to lighten my long commodity and stock exposure on any strength in the next few days.

Regardless of whether you favor an inflationary, deflationary, or even a neutral bias, listening to the case presented by Prechter seems a worthy endeavor. At the very least, you will have tested his arguments against your power to reason, and you'll be managing risk in a more informed manner.

position in SPX, commodities, gold

No comments: