Wednesday, April 22, 2015

Phased Deflation

Fearless people
Careless needle
Harsh words spoken
Lives are broken
--Seal

Properly defined, deflation is contraction in supply of money and credit. In financial markets where security prices have been boosted by inflation (expansion of credit money), then a period of deflation is likely to follow whenever appetite for speculating with leverage declines.

There will likely be two phases to this deflation.

The first phase involves speculators moving out of securities deemed riskiest and into securities deemed less risky. Out of equities and junk bonds, for example, and into sovereign debt. Out of bonds and into cash. This phase is only slightly deflationary because, other than the decrease in debt capitalization caused by price declines, most of the inflated money and credit supply remains. It has merely been shifted from one asset class to another.

The second phase involves speculators closing out their debt-funded projects or defaulting on those projects. This phase promotes large scale deflation because credit money is being destroyed. Deep, correlated price declines are merely a symptom--not the definition--of this deflationary phase.

Note also that the natural direction of interest rates is higher, not lower, as bonds, by definition, get sold during deflation.

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