Loosening Correlations: A Possible Reprise Of The 1970-80s “Stagflationary Era”?

``The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists."-Ernest Hemingway, September 1932

When we try to distinguish from what could be real and what could be an illusion, we do this by listening to the markets or heeding on the messages transmitted by the markets.

So what does the markets tell us today?

Figure 6 tell us that we are at a crossroads as seen with several breakouts.

First, the US dollar trade weighted index has officially closed BELOW the 80 level (see topmost pane), a multi-year low (!), following the weakest Jobs report since 2003 as discussed above. We previously discussed this last July 9 to 13 [see US Dollar Index Sits At Multi-Year Lows, Risks of Disorderly Unwind Heightens] and in July 16 to 20 edition [see US Dollar Index At 35 Year Support Level; Gold is Your Best Friend Now].

Second, aside from rampaging grains and rising oil, gold BOLTED out of its 6 month trading range [main window] and seems on path to test May 11, 2006 high at $726 dollars.

Third, US treasuries as we have said above BROKE DOWN OF ITS SUPPORT LEVEL signifying the market’s expectation of a steep deterioration of the US economy.

Let me borrow an incisive explanation of Professor John Succo or Mr. Practical in Minyanville.com (highlight mine),

``This is why the Fed has lowered interest rates at the discount window (emergency room): private money is no longer willing to lend to banks holding crumbling and risky mortgage debt and the Fed and other central banks have become their only source of liquidity. Banks have little treasuries in inventory to exchange for new credit from the Fed; this is why the Fed is now accepting more and more risky collateral like mortgages and consumer loans. Ironically this may allow banks to not write down those assets to market prices: they exchange in REPO those assets at some artificially high price and the Fed carries it at that price through the term in the REPO.

``If the REPOs are continually rolled, the banks may not have to take losses on those assets for some time. If this is so (I am investigating this), it is just another shell game to buy time. In trying to get normal longer term funding, I know of a sterling deal floated by a major European bank that failed; it pulled the deal and funded through Euro debt at egregious terms (imagine what that will do to its earnings). This tells us, by the way, that it is not just a dollar debt problem (although dollar debt is by far the largest), but a global debt problem.

``A force weakening the dollar will be (may be acting now to a small extent) the final destruction of that debt manifested by foreclosures and prices of assets like land and houses (and yes, eventually, stocks) that act as collateral, falling domestically until foreign savings buys them at lower clearing exchange rate (this is likely to be much lower given the meager amount of world savings relative to dollar debt). It is when a significant portion of the dollar debt (I don't know the number) is destroyed (defaulted upon) that the forces working to strengthen the dollar are overwhelmed by the forces weakening the dollar. Remember, the dollar is not backed by real money, but by debt. When that debt is destroyed, the dollar becomes worth much less.

``This is when gold will rise precipitously against the dollar and other currencies as well. Those currencies backed by real savings will do relatively better.”

Borrowing the kernel of Mr. Practical’s exposition; the ongoing “debt destruction” in the US implies for a WEAKER dollar, which could be what we are witnessing today. Yes, there are reports that the China has initiated to unload some of its US treasury holdings, but the impact to further undermine the US dollar’s position depends on it’s the continuity of its actions.

And a weaker dollar means inflationary forces gaining an upperhand, despite the debt destruction “deflationary” process. The rise of gold, oil and grains could be supportive of this view. This also suggests of higher interest rates which possibly mean that the US treasuries could reverse, fall (rising yields) and undergo an inflection, even as the US economy deteriorates. This outlook goes distinctly against the views of depressionists.

Figure 7: Chart of the Day.com: September’s Travails

Earlier we stated that we are at the crossroads of possible formative major trends. If gold continues to rise alongside a weakening US dollar supported by flanking increases in the price of oil or other commodities in the face of declining US stock market and a potential US recession, then important divergences could be unraveling: a possible reprise of the 1970-80s “stagflationary era”.

Of course, one week does not a trend make, albeit Figure 7 (chartoftheday.com) tells us that September has been a cruel month for US stocks, today’s inspirational leaders for global equities including the Phisix. And it appears that events are playing out the September theme well.

Friday’s softening of the US markets in the face of an unexpected deterioration in the US job numbers could be the start of the unwinding risks of a US recession.

Recently, even authorities such as Reserve bank of St. Louis President William Poole see “higher chances for an economic downturn in the US”. Likewise former Fed Chair Alan Greenspan was even glummer with his comments comparing the present scenarios with that of the 1998 LTCM and Oct 1987 crash:

``The behavior in what we are observing in the last seven weeks is identical in many respects to what we saw in 1998, what we saw in the stock market crash of 1987"

Timesonline.co.uk quotes further Mr. Greenspan, `` The human race has never found a way to confront bubbles,” he said, suggesting that the manipulation of interest rates offers little control to central bankers.”

``Bubbles cannot be defused until the fever breaks.”

While we are not impressed by Mr. Greenspan’s forecasting capabilities, the fact that Mr. Poole and Mr. Greenspan raised the issue gives credence to the heightening risks concerns on the health of the US economy.

So what to do?

First, we need to spot for continued divergences. If the present weaknesses in the US markets persist on to spillover to global equity markets, then we remain on the sidelines.

Second, if, however, in the face of faltering US stocks, precious metals continue to rise (confirmed by rises in other commodities as oil and a weakening dollar) and likewise reflected in global mining issues, then a gradual reentry into the MINES should be considered.

Third, if, however, in the face of swooning US financials markets, global markets manifest of strong signs of decoupling then one should consider repositioning back to the general market.

Where we do not see any confirmations, we remain seated at the gallery.

Finally, I’d like to borrow Dr. Marc Faber’s conclusion from Tomorrow’s Gold (emphasis added),

``I am leaning toward the view that some sectors and regions will deflate-either absolute price falls or currency depreciation-while those already extremely deflated will rise in price. So inflation and deflation could coexist for quite some time. Moreover, it should not be forgotten that, even in a strong deflationary environment, some commodities and assets can appreciate rapidly as their respective prices are determined not by the overall macroeconomic price trends, but rather by demand and supply forces specific to their particular markets.”

A Correlation is a Correlation Until it isn’t…Time for that much awaited Break!