Quote of the Day: Central Banking Heroics Produced a Parallel Universe in 2012

Central banks proved, once again, the world’s hero.  Heightened fears that global central banks had largely expended their bullets were supplanted with childlike enthusiasm that they essentially retain unlimited ammunition.  And with traditional inflationary pressures well contained throughout much of the world, the view held that there was essentially little risk associated with extraordinary monetary stimulus.  Whether it was Europe, the U.S. or Japan, the risk vs. reward equation was viewed as strongly supporting aggressive central bank reflationary measures.  Along the way, global risk markets decoupled from fundamentals.  A critical facet of the “right tail” scenario unfolded before our eyes:  the historic Bubble strengthened and broadened – global risk market prices inflated and risk premiums deflated - even as the economic backdrop turned increasingly problematic.

The U.S. economy and corporate profits disappointed in 2012, while stock prices posted the strongest gains since the policy-induced rally of 2009.  The German economy disappointed, although slightly positive GDP equated with a 29% gain in the DAX equities index.  The French economy badly disappointed, so the CAC40 was limited to just a 14.6% advance.  The Italian economy faltered, yet stocks were up almost 8%.  Spain was a near disaster; stocks fell a mere 5%.  

The big divergence between fundamentals and stock prices was not limited to the U.S. and Europe.  India’s growth slowed sharply, while the Sensex Index gained about 26%.  The South Korean economy disappointed, although stocks almost posted double-digit gains.  Eastern European economies nearly fell prey to the European crisis, although most equities markets posted big advances for the year.  In Latin America, Brazil’s economy slowed markedly, although stocks gained 7%.  Argentina became a bigger mess, yet stocks were up 15%.  The resilient Mexican economy spurred a 17% advance in the Bolsa Index.

It is well worth noting the 2012 dynamic where growth slowed in the face of ongoing Credit excesses.  In this regard, Brazil and India were notable among major economies demonstrating late-cycle Credit dynamics.  In the “old days,” the confluence of rampant Credit expansion and waning economic expansion would have provoked destabilizing capital flight – and a rather abrupt end to booms.  But the new world paradigm is one of unlimited “quantitative easing” and currency devaluation from the world’s major economies.  This global Bubble Dynamic sees unleashed central banks promoting unleashed “developing world” Credit systems.  

This is from last week’s Credit Bubble Bulletin outlook by fund manager and outstanding financial analyst Doug Noland at the PrudentBear.com

Quote of the Day: The Myth of Deleveraging

Doug Noland of the Credit Bubble Bulletin at the Prudentbear.com spectacularly demolishes the popular notion that the US has been deleveraging by delving into the nitty gritty of US systemic financing [bold mine]

The three Trillion-plus contraction in FSCMD did reduce Total System Market Debt – in the process seemingly improving debt-to-GDP ratios.  It is not, however, indicative of true system deleveraging and surely doesn’t reflect an improvement in our nation’s overall Credit standing.  Far from it.  From a Macro Credit Analysis perspective, the decline in FSCMD is instead reflective of fundamental changes in both the type of debt now fueling the boom and the corresponding nature of system risk intermediation.

First of all, mortgage debt is about to wrap up its fourth straight year of post-Bubble contraction.  Problem loan charge-offs have played a significant role, as have individuals using lower debt service costs (and near-zero returns on savings!) to speed the repayment of outstanding mortgages.  And, importantly, the decline in home values and the steep drop in transaction volumes have reduced demand for new mortgage debt – hence the need to intermediate mortgage Credit.  That said, the biggest factor behind the drop in FSCMD has been the activist Federal Reserve.

The Fed’s balance sheet is separate from the Financial Sector.  Federal Reserve Assets ended 2007 at $951bn.  Fed holdings ended Q2 2012 at $2.882 TN, up $1.931 TN, or 203%, in 18 quarters.  The Fed essentially transferred $2 TN of Financial Sector liabilities to a secure new home on its balance sheet.  Some may refer to this as “deleveraging,” but I won’t.

Importantly, the Fed’s moves to collapse interest rates and monetize debt (in conjunction with mortgage assistance programs) incited a major wave of mortgage refinancing.  And through the refi process, large quantities of private-label mortgages (previously included in FSCMD as ABS) were essentially transformed into sparkling new GSE-backed mortgage securities – and many then conveniently found their way onto the Federal Reserve’s rapidly inflating balance sheet.  This provided critical liquidity that allowed highly-leveraged Wall Street proprietary trading desks, hedge funds and banks to de-risk/de-leverage.  This bailout accommodated deleveraging for the financial speculators, yet for the real economy the boom in Non-Financial debt ran unabated. 

As noted above, Total Non-Financial Market debt ended this year’s second quarter at $38.924 TN and 249% of GDP – both all-time records.  Garnering all the focus from the deleveraging crowd, Total Household Debt has indeed declined since 2008 – having dropped $787bn, or 5.8%, to $12.896 TN.  At the same time, Federal debt has increased $4.689 TN to $11.050 TN. Non-Financial Corporate debt increased $434bn since ’08 to end Q2 2012 at a record $11.990 TN.  State & Local debt has expanded $101bn since ’08, ending Q2 at about $3.0 TN.   The data is the data - and Deleveraging is a Myth.

A 100% increase in Federal debt and 200% growth in the Federal Reserve’s balance sheet are surely not indicative of system de-leveraging.  Such extraordinary Credit developments do, however, have profound effects throughout the markets and real economy. The ongoing Credit expansion has inflated incomes, spending, corporate earnings and securities prices, in the process sustaining for now the U.S. economy’s Bubble structure.  And I would argue strongly that the data support the thesis that our system remains dominated by Bubble Dynamics. 

Also keep in mind that, in contrast to risky mortgage debt, federal debt requires little intermediation.  The marketplace absolutely loves it just the way it is, conspicuous warts and all.  For now, at least, it is “money” and shares money’s dangerous attribute of enjoying virtually insatiable demand.  The only alchemy necessary is to keep those electronic “printing presses” running 24/7.  It is, after all, the massive inflation of federal debt that is inflating incomes, cash-flows and profits, equities and fixed-income securities prices, and government tax receipts and expenditures – in the process validating the “moneyness” of the ever-expanding level of system debt (Ponzi Finance).

To validate Mr. Noland’s point, here are some charts from the US Flow of Funds for the period ended September 28, 2012 (courtesy of Dr. Ed Yardeni’s Blog)

Total US Debt as % of GDP

Non financial debt broken down into domestic sectors as % of GDP

Transformation of US debts from the household to Federal Debt and…

…and the US Federal Reserve’s balance sheet. (also from Dr. Ed Yardeni’s Blog on Central Banks and QE)

And the Fed balance sheet assets has increasingly been concentrated on US Treasuries.

Systemic deleveraging has indeed been nonexistent.

Crack-Up Boom Spreads To Asia And The Philippines

``But the administration does not want to stop inflation. It does not want to endanger its popularity with the voters by collecting, through taxation, all it wants to spend. It prefers to mislead the people by resorting to the seemingly non-onerous method of increasing the supply of money and credit. Yet, whatever system of financing may be adopted, whether taxation, borrowing, or inflation, the full incidence of the government's expenditures must fall upon the public. With inflation as well as with taxation, it is the citizens who must foot the total bill. The distinguishing mark of inflation, when considered as a method of filling the vaults of the Treasury, is that it distributes the burden in a most unfair way, overcharging those who are least able to bear it.”-Ludwig von Mises The Truth About Inflation

I received 4 text messages and 2 telephone calls anew this week from different banking institutions offering me loans. This seems like a defining activity since the start of the year. I don’t recall of such persistency to promote access to credit even prior to the Asian Crisis in 1997.

Yet I assume that this could be a national dynamic. Nonetheless, I can’t help but associate the actions in the Phisix to such anecdotal evidence.

Obviously, the domestic banking system which functions as the primary source of funding, has only been responding to regulatory policies.

While we don’t have available national data yet as proof for our assumption, a prolonged accommodative monetary environment will imply further space for mass speculation and a greater degree of consumption growth-that is likely to be reflected on our economic statistics.

And this seems to be the case for Asia, see Figure 1.

Figure 1: Danske Weekly: Recovery Gets More Visible

As Danske’s Fleming Nielsen wrote in his Weekly Focus, ``June’s economic data confirmed that Asia is experiencing a pronounced upswing, with strong industrial production numbers across the board. Countries such as South Korea and Thailand, which were hit exceptionally hard by the global financial crisis, are seeing industrial production recover to pre-crisis levels at a surprising clip. There are also signs throughout Asia that domestic demand is picking up – especially private consumption, with rising retail and car sales in the past couple of months.” (emphasis added)

For us, aside from the government policies, such intense reaction has been a manifestation of the “anomalous” collapse in the last quarter of 2008, which had been due to the seizure in the US banking system which rippled globally- a shock we called as Posttraumatic Stress Disorder (PTSD) [see What Posttraumatic Stress Disorder (PTSD) Have To Do With Today’s Financial Crisis].

Apparently the current actions in the financial markets and economic stats have strongly been validating our views.

Moreover, we see other national and regional quirks posing as significant influences that can electrify the pricing of regional financial assets.

As discussed in Philippine Phisix at 2,500: Monetary Forces Sows Seeds Of Bubble, ``it is likely that high savings rate combined with loose monetary policies to induce speculation, fiscal stimulus applied, largely unblemished banking system, and low systemic leverage that has impelled a bidding war in the stock markets and commodity markets.”

The Growing Inflationary Bias Of Asia’s Markets

For the longest time we had been advocating that in a world of central banking and virtual free lunch money polices, bubble cycles emanating from these are likely to be imbued more by Asia and emerging markets since developed economies have debts that have been “hocked to their eyeballs”.

Doug Noland in his Credit Bubble Bulletin says the same, `` The most robust inflationary biases are today domiciled in China, Asia and the emerging markets generally. The debased dollar has provided China and the “developing” world Credit systems unprecedented capacity to inflate (expand Credit/financial claims without fear of spurring a run on their currencies). Asian and emerging markets are outperforming, exacerbating speculative flows. Things that the “developing” world needs (energy/commodities) and wants (gold, silver, sugar, etc.) should demonstrate increasingly strong inflationary pressures. Their overflow of dollars provides them, for now, the power to buy whatever they desire.”

And the transmission mechanism from US Federal Reserve policies into global assets have nowhere been more explicit see figure 2.

Figure 2: Stockcharts.com: US dollar Index’s Inverse Correlation

As we pointed out in Asia Sows The Seeds Of The Business Cycle, a breakdown in the US dollar index (USD) seem likely to propel a reacceleration of the asset bidding wars.

The USD indeed broke down last week which likewise brought many global stock market benchmarks to new post crisis highs (the Philippine Phisix nearly touched the 2,900 level). However, Friday’s announcement of the US unemployment data, which showed a modicum of progress, may have incited a USD short covering.

The fun part is identifying the apparently synchronized inverse correlation of oil (WTIC), Emerging Market stocks (EEM) and Asia ex-Japan (DJP2) where the crucial inflection point has been vividly demarcated in March (see the red horizontal line).

So those arguing on the basis of the traditional fundamentalist metrics seem to be looking at the wrong picture. Inflation appears to be increasingly the principal moving force behind the motions of the progressively interconnected global financial asset markets.

The Global Crack-Up Boom

Where financial markets once functioned as signals for economic transitions, it would now appear that financial markets have become the essence of global economies, where the real economy have been subordinated to paper shuffling activities.

What was once a feature dominated by the West, seem likely to get assimilated rapidly by the East as government policies appear to be directed at either juicing up or controlling the “animal spirits”.

Nonetheless today these dynamics have been “globalized”.

Proof?

We pointed out last week (see The Inflation Cycle Accelerates; Asia As Chief Beneficiary) how China has been dithering over the explosive rise of its stock and property markets wherein policymakers signaled intentions to rein the markets by restricting flow of credit. However, the violent response in the stock market compelled a retraction from authorities.

This week we see more of the same.

Publicly listed state owned China Construction Bank President Zhang Jianguo reportedly resolved to materially prune its credit expansion. According to Bloomberg ``the nation’s second-largest bank will cut new lending by about 70 percent in the second half to avert a surge in bad debt.”

The result had been the same, after a reaching a new high, China’s Shanghai Index crumbled over the last 3 sessions to end the week down 4.4%.

In the US, the path to serfdom continues, the Federal Trade Commission has issued new rules to ``crack down on fraud and manipulation that can drive up prices at the pump.” (Bloomberg) Oil prices which had been on a tear mostly reflecting on the US dollar’s earlier breakdown, had been tempered anew by the realized regulatory actions (more than just threats), aside from the sharp rally in the US dollar.

Still the WTIC rose by over 2% the week.

In the UK, the Bank of England (BoE) surprised the markets when it announced additional quantitative easing measures. This means that the central bank will be issuing ‘money from thin air’ to acquire domestic sovereign instruments (Gilt) as well as “high” quality corporate debt (Marketwatch). While directly such policies are aimed at propping up the financial system, implicitly it further implies support to financial asset prices. The British pound fell .21% over the week.

In anticipation of prospective inflation, Australia will be resurrecting issuance of inflation indexed bonds as a hedge. According to Bloomberg, ``Australia will sell its first inflation-indexed bonds in six years as record stimulus spending worldwide prompts speculation price increases will resume once the global recession ends…

``Asia-Pacific governments including Australia, Japan and Thailand had signaled they may sell inflation-linked bonds as improving economies threaten to boost the price of goods and services. Australia, which considered scrapping its bond market in 2003, boosted its debt outstanding by 67 percent to A$101.1 billion ($85 billion) in the year ended June 30, about 10 percent of its gross domestic product.”

The significance:

One, when government and financial claims grow more than real output or available economic resources the outcome is materially higher prices.

Two, governments are in a predicament, while they want to see sustained elevated or high financial asset prices, to give the impression of economic growth and to further unleash “animal spirits” or expand risk appetite, the demand from excessive money has also diffused into scarce economic resources which has compelled them to impose price controls [as previously discussed in The Inflation Cycle Accelerates; Asia As Chief Beneficiary].

Price controls will only cause arbitrages into markets that are more open, it would also reduce market pricing efficiency by distorting them and enhance shortages which would fuel more volatility.

Here, as expected governments are bent to deal with the symptoms than the cause. The superficial nature of policy actions enhances nurturing the bubble cycle.

Three, bubble affected economies will likely prompt for more borrowing (see figure 3) and more money issuance activities as signified by Bank of England’s QE or Secretary Tim Geithner’s request to the US Congress to expand debt limit to $12.1 trillion (HT: Craig McCarty).

As Doug Noland aptly observed of the inflationary pyramid being erected (from the same article), ``The deeply maladjusted U.S. “Bubble” economy requires $2.5 Trillion or so of net new Credit creation to stem systemic (Credit and economic Bubble) implosion. Only “government” (Treasury, agency debt, GSE MBS) debt can, today, fill the gigantic void created with the bursting of the Wall Street/mortgage finance Bubble. The private sector Credit system is severely impaired, and there is as well the reality that the market largely lost trust (loss of “moneyness”) in Wall Street obligations (private-label MBS, CDO, ABS, auction-rate securities, etc.). The $2.0 Trillion of U.S. “government” Credit creation coupled with the Trillion-plus expansion of Federal Reserve Credit over the past year has stabilized U.S. financial and economic systems.” (emphasis added)

Figure 3: Bloomberg Chart of the Day: Addiction To Debt

The above chart shows that in the US it now takes about $4 dollars of debt to generate $1 of economic output (left window), while debt to GDP ratio has soared to 372%, which is clearly unsustainable.

Yet the policy direction is assuredly headed towards engaging in more borrowing and issuance of paper or digital money. Recently the US extended $2 billion “cash for clunkers” program which incentivize people to replace old cars with new ones supported by government subsidies (Bloomberg) is another example of debt addiction.

As Ludwig von Mises warned, ``But the boom cannot continue indefinitely. There are two alternatives. Either the banks continue the credit expansion without restriction and thus cause constantly mounting price increases and an ever-growing orgy of speculation, which, as in all other cases of unlimited inflation, ends in a ‘crack-up boom’ and in a collapse of the money and credit system. Or the banks stop before this point is reached, voluntarily renounce further credit expansion and thus bring about the crisis." (emphasis added)

The end result would likely be a nasty choice between that of market compelled deflation or hyperinflation.

The institutional bank run in the US that triggered the 2008 meltdown (in financial markets and global trade) was a classic example of the near “collapse of the credit system”.

In short, what is unsustainable won’t last. Artificial measures will only aggravate the imbalances.

In sum, all these account for the phenomenon known as the “crack-up boom” applied on a globalized scale.

Hence a bubble based boom equals a prospective bubble bust and another crisis down the road. So relish the fun while it lasts.

Interim Pause, The Bubble Blowing Dynamics At Least Until The 2010 Elections

Friday’s torrid bounce in the US dollar index could signify as a worthwhile pause for the vastly overheated Asian-Emerging Market stock markets (see figure 4)

Figure 4: US Global Investor: Asia Technically Overbought

According to US Global Investors, ``For the first time since mid-1999, stocks in emerging Asia are trading at more than 35 percent premium to the 200-day simple moving average, an overbought condition which historically has resulted in sizable corrections in the following months.”

So if this should hold true, then a correction would likely be in the range of 10-20%.

Nonetheless we can expect any material decline would likely be met by anxious officials who would hastily act to restore boom conditions.

Remember, in today’s era where policies are skewed towards favoring paper shuffling activities and where the financial sector acts as the principal growth engine of the economy, rising prices are construed as the norm (for statistical purposes) regardless of the substance of the growth. So lofty prices in financial assets will likely be the undeclared policy thrust.

Nevertheless in a bull market hiatus, which is likely a function of profit taking than policy reversals, declines are less likely to move in tidal fashion, as some stocks may generate speculative attention because the marketplace would continually seek for yields in response to the loose monetary environment.

And applied to the Philippine Phisix, foreign buying, which has largely been absent for most of the first semester of the year, appears to have returned. For three successive weeks, we have seen a net buying from foreign funds in both nominal terms and in the broader market.

So the recent approach towards the 2,900 level could be interpreted as the bidding up of Philippine stocks compounded by foreign buying as we had been expecting. In Philippine Phisix at 2,500: Monetary Forces Sows Seeds Of Bubble, we said, ``So renewed interests from foreign investors on emerging markets are likely to even propel stock prices to higher levels! We should see the same dynamics reinforced locally. This time it will probably be foreigners chasing stock prices.”

Nonetheless, foreigners entering the local market appear to have been responding to the decline of the US dollar index.

If the US dollar is expected to fall further especially against Asian currencies then such dynamics are likely to be sustained. This would function as an important support to key components of the Phisix which also means a cushion from any major correction.

Figure 5: PSE: Share of Foreign Trade

Yet, despite this foreign trade improvement, the shape of today’s rally has departed from the 2003-2007 paradigm, where this time, local investors have powered the market as shown in Figure 6. Foreign trade from the start of the year have seen only occasional bouts where it gone beyond the 50% level which characterized the previous run.

At the end of the day, domestic policymakers will also want to see such trend persist going into the local national election season, as this would boost the odds of reducing the negative rating of the incumbent President PGMA thereby improve the chances for her appointee during the national election derby.

Expect A Different Inflationary Environment

``For inflation does not come without cause. It is the result of policy. It is the result of something that is always within the control of government—the supply of money and bank credit. An inflation is initiated or continued in the belief that it will benefit debtors at the expense of creditors, or exporters at the expense of importers, or workers at the expense of employers, or farmers at the expense of city dwellers, or the old at the expense of the young, or this generation at the expense of the next. But what is certain is that everybody cannot get rich at the expense of everybody else. There is no magic in paper money.” -Henry Hazlitt, What You Should Know About Inflation p.135

Ever since the US Federal Reserve announced that it would embark on buying $300 billion of long term US treasury bonds and ante up on its acquisitions of mortgage-based securities by $750 billion, this has generated an electrifying response in the global financial markets.

First, it hastened the decline in the US dollar index, see figure 1.

Figure 1: stockcharts.com: Transmission Impact of the US Fed’s QE via the US dollar

Next, it goosed up both the commodity markets (as represented by the CRB-Reuters benchmark lowest pane) and key global equity markets, as seen in the Dow Jones World index (topmost pane) and the Dow Jones Asia ex-Japan (pane below main window). The seemingly congruous movements seem to be in response to US dollar’s activities.

At the end of the week as the US dollar rallied vigorously, where the same assets reacted in the opposite direction. So it is our supposition that correlation here implies causation: a falling US dollar simply means more surplus dollars in the global financial system relative to its major trading partners.

In other words, since the efficiency of the global financial markets have greatly been impeded by collaborative intensive worldwide government interventions, the main vent of the officially instituted policy measures have been through the currency markets.

And since the US dollar is the world’s de facto currency reserve, the actions of the US dollar are thereby being transmitted into global financial assets. As former US Treasury secretary John B. Connolly memorably remarked in 1971, ``The US dollar is our currency, but your problem!”

Bernanke’s Inflation Guidebook

And as we have long predicted, the US Federal Reserve will be using up its policy arsenal tools to the hilt. And if there is anything likeable from Mr. Bernanke is that his prospective policy directives have been explicitly defined in his November 21 2002 speech Deflation: Making Sure It Doesn’t Happen Here which has served as a potent guidebook for any Central Bank watcher.

For instance, the latest move to prop up the long end of the Treasury market was revealed in 2001 where Bernanke noted that ``a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities”, and the shoring up of the mortgage market as ``might next consider attempting to influence directly the yields on privately issued securities”.

Nevertheless even as Mr. Bernanke once said that ``I am today neither forecasting nor recommending any attempt by U.S. policymakers to target the international value of the dollar”, he believes in the ultimate antidote against the threat of deflation could be through the transmission effects of the US dollar’s devaluation, ``it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation” where he has showcased the great depression as an example; he said,`` If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation.”

Of course, this isn’t merely going to be a central bank operation but one combined with coordinated efforts with the executive department or through the US Treasury, again Mr. Bernanke, ``effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities”.

Although Mr. Bernanke’s main prescription has been a tax cut, he combines this with government spending via purchases of assets, he recommended `` the government could increase spending on current goods and services or even acquire existing real or financial assets. If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.”

And the recent fiscal stimulus, guarantees and other bailout programs which have amassed to some nearly $9.9 trillion [see $9.9 Trillion and Counting, Accelerating the Mises Moment] of US taxpayers exposure plus the recent $1 trillion Private Investment Program or PPIP have all accrued in accordance to Mr. Bernanke’s design.

In all, Mr. Bernanke hasn’t been doing differently from Zimbabwe’s Dr. Gideon Gono except that the US Federal Reserve can deliver the same results via different vehicles.

Inflation is what policymakers have been aspiring for and outsized inflation is what we’re gonna get.

Stages of Inflation

There are many skeptics that remain steadfast to the global deflationary outlook based on either the continued worsening outlook of debt deleveraging in the major financial institutions and or from the premise of excessive supplies or surplus capacities in the economic system.

We agree with the debt deflation premise (but not the global deflationary environment) and pointed to the dim prospects of Geither’s PPIP program [see Why Geither's Toxic Asset Program Won't Float] precisely from the angle of deleveraging and economic recessionary pressures. However, this is exactly why central bankers will continue to massively inflate-to reduce the real value of these outstanding obligations. And this episode has been a colossal tug-of-war between government generated inflation and market based deflation.

It is further a curiosity how the academe world or mainstream analysis has been obsessing over the premise of the normalization of “borrowing and lending” in order to spur inflation. It just depicts how detached “classroom” or “ivory tower” based thinking is relative to the “real” functioning world.

We don’t really need to restore the private sector driven credit process to achieve inflation. As manifested in the recent hyperinflation case of Zimbabwe; all that is needed is for a government to simply endlessly print money and to spend it.

The sheer magnitude of money printing combined with market distortive administrative policies sent Zimbabwe’s inflation figures skyrocketing to vertiginous heights (89.7 SEXTILLION percent or a number backed with 21 zeroes!!!) as massive dislocations and shortages in the economy emerged out of such policy failures.

By the way, as we correctly predicted in Dr. Gideon Gono Yields! Zimbabwe Dump Domestic Currency, since the “Dollarization” or “rand-ization or pula-ization” of Zimbabwe’s economy, prices have begun to deflate (down 3% last January and February)! The BBC reported ``The Zimbabwean dollar has disappeared from the streets since it was dumped as official currency.” The evisceration of the Zimbabwean Dollar translates to equally a declension of power by the Mugabe regime which has resorted to a face saving “unity” government between the opposition represented by current Prime Minister Morgan Tsvangirai of the MDC and President Mugabe's Zanu-PF.

And going back to inflation basics, we might add that a dysfunctional deflation plagued private banking system wouldn’t serve as an effective deterrent to government/s staunchly fixated with conflagrating the inflation flames.

For instance, in the bedrock of the ongoing unwinding debt deleveraging distressed environment, the UK has “surprisingly” reported a resurgence of inflation last February brought about by a “rise” in food prices due to the “decline” in UK’s currency the British pound-which has dropped by some 26% against the US dollar during the past year (Bloomberg). While many astonished analysts deem this to be a “hiccup”, we believe that there will be more dumbfounding of the consensus as inflation figures come by. And we see the same “startling” rise in inflation figures reported in Canada and in South Africa.

What we are going to see isn’t “stag-deflation” but at the onset STAGFLATION, an environment which dominated against the conventional expectations during the 70s.

Why? Because this isn’t simply about demand and supply of goods and services as peddled by the orthodoxy, but about the demand and supply of money relative to the demand and supply of goods and services. Better defined by Professor John Hussman, ``Inflation basically measures the percentage change in the ratio of two “marginal utilities”: the marginal utility of real goods and services divided by the marginal utility (mostly for portfolio and transactions purposes) of government liabilities.”

For instance mainstream analysts tell us that stock prices reflect on economic growth expectations and that during economic recessions, which normally impairs earnings growth, this automatically translates to falling stock prices.

We’ll argue that it depends--on the rate of inflation.

Figure 2: Nowandfutures.com: Weimar Germany: Surging Stock Prices on Massive Recession

This is basically the same argument we’ve made based on Zimbabwe’s experience, in the Weimar hyperinflation of 1921-1923, its massively devaluing currency, which accounted for as the currency’s loss of store of value sent people searching for an alternative safehaven regardless of the economic conditions.

People piled into stocks (right), whose index gained by 9,999,900%, even as unemployment rate soared to nearly 30%! It’s because the German government printed so much money that Germans lost fate in their currency “marks” and sought refuge in stocks. Although, stock market gains were mostly nominal and while the US dollar based was muted (green line).

In other words, money isn’t neutral or that the impact of monetary inflation ranges in many ways to a society, to quote Mr. Ludwig von Mises, ``there is no constant relation between changes in the quantity of money and in prices. Changes in the supply of money affect individual prices and wages in different ways.”

For example, it doesn’t mean just because gold prices hasn’t continually been going up that the inflationary process are being subverted by deflation.

As Henry Hazlitt poignantly lay out the divergent effects of inflation in What You Should Know About Inflation (bold highlight mine) ``Inflation never affects everybody simultaneously and equally. It begins at a specific point, with a specific group. When the government puts more money into circulation, it may do so by paying defense contractors, or by increasing subsidies to farmers or social security benefits to special groups. The incomes of those who receive this money go up first. Those who begin spending the money first buy at the old level of prices. But their additional buying begins to force up prices. Those whose money incomes have not been raised are forced to pay higher prices than before; the purchasing power of their incomes has been reduced. Eventually, through the play of economic forces, their own money-incomes may be increased. But if these incomes are increased either less or later than the average prices of what they buy, they will never fully make up the loss they suffered from the inflation.”

In short, inflation comes in stages.

Let us use the example from the recent boom-bust cycle…

Figure 3: yardeni.com: US Debt as % of GDP

When the US dot.com bust in 2000 prompted the US Federal Reserve to cut interest rates from 6% to 1%, the inflationary pressures had initially been soaked up by its household sector which amassed household debts filliped by a gigantic punt in real estate.

As the speculative momentum fueled by easy money policies accelerated, monetary inflation were ventilated through three ways:

1. An explosion of the moneyness of Wall Street’s credit instruments which directly financed the housing bubble.

Credit Bubble Bulletin’s Doug Noland has the specifics, ``As is so often the case, we can look directly to the Fed’s Z.1 “flow of funds” report for Credit Bubble clarification. Total (non-financial and financial) system Credit expanded $1.735 TN in 2000. As one would expect from aggressive monetary easing, total Credit growth accelerated to $2.016 TN in 2001, then to $2.385 TN in 2002, $2.786 TN in 2003, $3.126 TN in 2004, $3.553 TN in 2005, $4.025 TN in 2006 and finally to $4.395 TN during 2007. Recall that the Greenspan Fed had cut rates to an unprecedented 1.0% by mid-2003 (in the face of double-digit mortgage Credit growth and the rapid expansion of securitizations, hedge funds, and derivatives), where they remained until mid-2004. Fed funds didn’t rise above 2% until December of 2004. Mr. Greenspan refers to Fed “tightening” in 2004, but Credit and financial conditions remained incredibly loose until the 2007 eruption of the Credit crisis.” (bold highlight mine)

2. These deepened the current account deficits, which signified the US debt driven consumption boom.

Again the particulars from Mr. Noland, ``It is worth noting that our Current Account Deficit averaged about $120bn annually during the nineties. By 2003, it had surged more than four-fold to an unprecedented $523bn. Following the path of underlying Credit growth (and attendant home price inflation and consumption!), the Current Account Deficit inflated to $625bn in 2004, $729bn in 2005, $788bn in 2006, and $731bn in 2007.” (bold highlight mine)

3. The subsequent sharp fall in the US dollar reflected on both the transmission of the US inflationary process into the world and the globalization of the credit bubble.

Again Mr. Noland for the details, ``And examining the “Rest of World” (ROW) page from the Z.1 report, we see that ROW expanded U.S. financial asset holdings by $1.400 TN in 2004, $1.076 TN in 2005, $1.831 TN in 2006 and $1.686 TN in 2007. It is worth noting that ROW “net acquisition of financial assets” averaged $370bn during the nineties, or less than a quarter the level from the fateful years 2006 and 2007.”

In short, the inflationary process diffused over a specific order of sequence, namely, US real estate, US financial debt markets, US stock markets, global stock markets and real estate, commodities and lastly consumer prices.

Past Reflation Scenarios Won’t Be Revived, A Possible Rush To Commodities

Going into today’s crisis, we can’t expect an exact reprise of the most recent past as the US real estate and the US financial debt markets are likely to be still encumbered by the deleveraging process see figure 4.

Figure 4: SIFMA: Non Agency Mortgage Securities and Asset Backed Securities

Some of the financial instruments such as the Non-Agency Mortgage Backed Securities (left) and Asset Backed Securities (right), which buttressed the real estate bubble have materially shriveled and is unlikely to be resuscitated even by the transfer of liabilities to the government.

Besides, the general economic debt levels remain significantly high relative to the economy’s potential for a payback, especially under the weight of today’s recessionary environment.

Which is to say that today’s inflationary setting will probably evolve to a more short circuited fashion relative to the past.

This leads us to surmise that most of global stock markets (especially EM economies which we expect to rise faster in relative terms) could rise to absorb the collective inflationary actions led by the US Federal Reserve but on a much divergent scale. Currency destruction measures will also possibly support OECD prices but could underperform, as the onus from the tug-of-war will probably remain as a hefty drag in their financial markets.

And this also suggests that commodity prices will also likely rise faster (although not equally in relative terms) than the previous experience which would eventually filter into consumer prices.

In other words, the evolution of the opening up of about 3 billion people into the global markets, a more integrated global economy and the increased sophistication of the financial markets have successfully imbued the inflationary actions by central banks over the past few years. But this isn’t going to be the case this time around-unless economies which have low leverage level (mostly in the EM economies) will manage to sop up much of the slack.

Take for example China. China’s economy has generally a low of leverage which allows it the privilege of taking on more debts.

Figure 5: US Global Investors: China Loans and Fixed Asset Investment Surge

And that’s what it has been doing today in the face of this crisis-China’s national stimulus and monetary easing programs is expected to incur deficits of about 3-7% of its GDP coupled by the QE measures instituted by the US has impelled a recent surge in China’s domestic bank loans and real fixed investments.

Qing Wang of Morgan Stanley thinks that the US monetary policy measures has lowered “the opportunity cost of domestic fixed-asset investment”, which means increasing the attractiveness of Chinese assets.

According to Mr. Wang, ``In practice, lower yields on US government bonds means lower returns on the PBoC’s assets. This should enable the PBoC to lower the cost of its liabilities by: a) lowering the coupon interest rates it pays on the PBoC bills, which is a major liability item on its balance sheet; b) lowering the ratio of required reserves (RRR) on which the PBoC needs to pay interest; or c) lowering the interest rates that the PBoC needs to pay on the deposits of banks’ required reserves and excess reserves, currently at 1.62% and 0.72%, respectively. These potential changes should then lower the opportunity cost of bank lending from the perspective of individual banks.” (bold highlights mine)

In other words, low interest rates in the US can serve as fulcrum to propel a boom in China’s bank lending programs.

This brings us to the next perspective, which assets will likely benefit from such inflationary activities.

Henry Hazlitt gives us again a possible answer ``In answer to those who point out that inflation is primarily caused by an increase in money and credit, it is contended that the increase in commodity prices often occurs before the increase in the money supply. This is true. This is what happened immediately after the outbreak of war in Korea. Strategic raw materials began to go up in price on the fear that they were going to be scarce. Speculators and manufacturers began to buy them to hold for profit or protective inventories. But to do this they had to borrow more money from the banks. The rise in prices was accompanied by an equally marked rise in bank loans and deposits.” (bold highlight mine)

This suggests that expectations for more inflation are likely to trigger rising prices and growing shortages, which will likely be fed by more money printing, and eventually an increase in credit uptake in support these actions.

Some Proof?

China is on a bargain hunting binge for strategic resources, according to the Washington Post March 19^th, ``Chinese companies have been on a shopping spree in the past month, snapping up tens of billions of dollars' worth of key assets in Iran, Brazil, Russia, Venezuela, Australia and France in a global fire sale set off by the financial crisis.

``The deals have allowed China to lock up supplies of oil, minerals, metals and other strategic natural resources it needs to continue to fuel its growth. The sheer scope of the agreements marks a shift in global finance, roiling energy markets and feeding worries about the future availability and prices of those commodities in other countries that compete for them, including the United States.”

China has also engaged in a record buying of copper, according to commodityonline.com March 14^th, ``China has started to buy copper in a big way again. As part of the country’s strategy to make use of the recessionary trends in the global markets, China has hiked its copper buying during the past few months…

``According to recently released data, China’s copper import hit a record high of 329,300 tonnes in February, up 41.5 per cent from the 232,700 tonnes of January.”

Summary and Conclusion

Overall, these are some important points to ruminate on:

-It is clear that the thrust by the US government seems to be to reduce the real value of its outstanding liabilities by devaluing its currency. Since the US dollar is the world’s de facto currency reserve the path of the US government policy actions will be transmitted via its exchange rate value to the global financial markets and the world’s real economy. And this translates to greater volatility of the US dollar. Moreover, except for the ECB (yet), the QE efforts by most of the major central banks could translate to a race to the bottom in terms of devaluing paper money values.

-Collaborative global policy measures to inflate the world appear to be gaining traction in support of asset prices but at the expense of currency values.

-Global central bankers have been trying to revive inflationary expectations that are effectively “reflexive” in nature. By painting the perception of a ‘recovery’ through a rising tide of the asset markets, officials hope that this might induce a torrent of asset buying from a normalization of the credit process.

-The monumental efforts by global central banks to collectively turbocharge the global asset markets could eventually spillover to consumer prices and “surprise” mainstream analysts over their insistence to “tunnel” over the deflation angle. We expect higher consumer prices to come sooner than later especially if EM economies would be unable to fill the role of raising levels of systemic leveraging.

-Money isn’t neutral which means that the impact of inflation won’t be the same for financial assets and the real economy. Some assets or industries will benefit more than the others.

-We can’t expect the same “reflation” impact of the past episode to happen again as the ongoing tug-of-war between market-based debt deflation and government’s fixation to inflate the system has displaced the gains derived from the previous trends of globalization and the sophistication of financial markets. The US real estate markets will have surpluses to work off and the financial markets that financed the US real estate markets will remain broken for sometime and will take substantial number of years to recover.

-The impact of inflation will come in stages and perhaps accelerate in phases.

-The risk is that inflation could rear its ugly head in terms of greater than expected consumer prices earlier than what the consensus or policymakers expect. And if this is the case then it could pose as management dilemma for policymakers as the real economy remains weak and apparently fragile from the excessive dependence on the government and from the intense distortion brought about by government intervention in the marketplace. To quote Morgan Stanley’s Manoj Pradhan, ``Can QE be rolled back quickly? In theory, yes! Both passive and active QE could be reversed very quickly. The desire to hike rates above their currently low levels complicates matters slightly. Why? The effectiveness of passive QE depends on the willingness of banks to seek returns in the economy rather than simply parking excess reserves with the central bank. Hiking interest rates would reduce these incentives.”

Finally as we previously said it is increasingly becoming a cash unfriendly environment.