Hedging On VIX Futures Indicates Of Growing Imbalances?

The anomaly du jour appears to be rising tensions from policies applied versus the natural state of the markets.

The important thing one needs to know is that, has there been pressures from such tensions building underneath?

This from Bloomberg

(bold emphasis mine)

``Investors are guarding against renewed volatility in U.S. stocks even though a so-called fear gauge shows they have overcome the panic resulting from last year’s credit crunch.

``The VIX index, an indicator of expected swings in the Standard & Poor’s 500 Index, closed yesterday at its lowest level since Aug. 29, 2008. The VIX fell 6.9 percent to 20.69, about half a point above its average since the Chicago Board Options Exchange’s calculations began in 1990.



Again from Bloomberg,

``As the CHART OF THE DAY shows, though, the gap between the index and VIX futures is wider than it was almost 14 months ago. The contracts closest to expiration settled yesterday at 23.65, or 2.96 points higher than the index’s value. The differential was just 1.05 points at the end of August 2008.

“Heavy hedging activity” accounts for the wider gap, according to a report yesterday from McMillan Analysis Corp.’s Option Strategist Hotline. The VIX itself has to surpass 24 to signal an increase in stocks’ volatility, which tends to occur when prices fall, the report said.

``The VIX, more formally known as the CBOE Volatility Index, has tumbled 74 percent from last year’s record close. The gauge peaked at 80.86 on Nov. 20, 2008, when the S&P 500 fell to its low for the year."

Additional comments:

Inflationary policies are inherently unsustainable. At the onset inflation has been mainly an asset dynamic.

Nevertheless, policies can lead to the furtherance of inflation (and a diffusion) from which may translate to the extension of today's aberration.

On the other hand, market forces could unravel on the mounting imbalances when inflationary measures can't sustain its levels.

Hedging in the marketplace appears to be looking forward at the latter scenario for 2010.

Anyway, a valued reminder from John Maynard Keynes on mainstream expectations of "desperately seeking normal", ``The market can stay irrational longer than you can stay solvent."

Gold: An Unreliable Inflation Hedge?

``Gold has two interesting properties. It is cherished and it is indestructible. It is never cast away and it never diminishes, except by outright loss. It can be melted down, but it never changes its chemistry or weight in the process. Its price has been remarkably similar for centuries at a time. Its purchasing power in the middle of the twentieth century was very nearly the same as in the midst of the seventeenth century." James Grant quotes Roy Jastram

Since Gold has recently racked up a new historical high in nominal terms, I’d like to dwell on some objections made by several experts.

Gold’s fantastic 4.6% surge over the week to close at a record $1,049.4 seems quite distant yet from its real (inflation adjusted) highs of $2,264 using BLS.gov data, when considering its 1980 high at around $850. In other words, the high of $2,264 reflects on the 1980 purchasing power of the US dollar.

To add, if we consider today’s price levels compared to that when the former US President Nixon shut the quasi Bretton Wood gold window standard in August 1971, current gold prices would only translate to $196.84 in 1971 terms. Extrapolating the previous record high of $850 in 1980 applied to 1971 price levels, we would arrive at $4,529.85.

In short, based on the US Bureau of Labor Statistic’s inflation calculator, current prices of gold would still be very much heavily discounted against current rate of US inflation (in monetary terms).

Importantly, this has yet to factor in the prospects from current policy actions which will eventually lead to more inflation over time.

This would also suggest that there could be immense room for growth in gold prices, if only to reflect on current and future inflation rates.

Predictable Trend: Paper Money Eventually Returns To Zero

The mainstream have been obsessed with their highly presumptive models-capacity utilization, unemployment, wages etc…, all of whom views money as neutral [or where they see money as constant with marginal additions of money as having no effect on prices] and sees inflation as merely expressed in rising prices of goods or services more than a political phenomenon of monetary expansion. Hence, they have all vastly underestimated the impact of inflationary policies.

And this dogmatic fanaticism, which serves as justification for more inflationary policy measures, will risks tilting of inflation towards the extremes.

Moreover, the reality is that the market is far larger than government’s repeated tomfoolery over their constituents, where over the long term, Gold has always maintained its purchasing power against the Fiat currencies which has been imposed on modern society as legal tender (see figure 1).

Figure 1: American Institute For Economic Research: Gold vis-à-vis Currencies of Developed Economies

According to the AIER, ``Apparently many people today believe that all of that is behind us now, that inflating has been curtailed, and that any “embezzlement” of savings currently taking place is something that America’s “forgotten citizens” can live with.

``Anyone inclined to believe this view could benefit from a short course in human history: it is an inescapable fact that throughout known history, there has never, we repeat never, been a fiat currency that over an extended period of time has retained its purchasing power. All irredeemable currencies have in time become worthless, and (except for collectors’ items or rarities) all paper currencies are today worth less than when they were first issued.” (bold emphasis mine)

In the chart above, paper money from developed countries calculated or plotted in terms of US purchasing power has been, over the long run, in a steep decline. François Marie Arouet (1694-1778) prominently known in his pen name as “Voltaire” rightly observed that ``Paper money eventually returns to its intrinsic value -- zero."

This erosion of purchasing power would even have a far worse track record for developing economies. For instance, Brazil already had 7 defunct currencies which makes today’s real the 8^th over its history. This holds true for Argentina whose Peso is the 6^th currency.

So if there is any market or economic trend that is “predictable” or “stable”, it is that paper currencies are all headed for zero, if not extinction. And like most of the modern currencies before today’s extant currencies, demonetized currencies had been mainly due to hyperinflation or war.

But no trend moves in a straight line. And this holds true even for modern fiat paper currencies. Again from the AIER, ``the upswings in some currencies’ U.S. purchasing power between 1985 and 1988 and since 2002 indicate a relative “weakening” of the U.S. dollar against those currencies during that time rather than actual increases in purchasing power in the countries of issue. Moreover, the occasional short-term upturns cannot disguise the longterm erosion of purchasing power of each currency. The historical record is that the world’s major paper currencies, in terms of what they will purchase, today are worth only from about 1/1000th to 1/4th of what they were worth in 1913. By contrast, and despite short-term fluctuations, the purchasing power of gold is above what it was in 1913.” (bold highlight mine)

So gold does track inflation over the long term, but where we depart from the view held by some experts is on the suggestion that gold underperforms other hard assets in an inflationary period because of taxes.

While it is true that volatility from market forces could bring gold to periodical price pendulum swings that may overshoot and or undershoot, due to myriad temporal factors (such as governments’ intervening in the markets), this could serve as windows of opportunity for outperformance.

In other words, if we can “time” gold’s secular bullmarket cycle then we can outperform other benchmarks.

Besides, if today’s prospective economic environment would somewhat shadow the stagflation era of the 70s, then gold and oil would likely be topnotch performers as before.

However from our perspective, in boxing vernacular, the 70s looks likely to be the undercard (prologue) to the main event.

Globalization And The Triffin Dilemma

Some analysts, mostly from the “deflationist” camp, have further downplayed the role of gold as hedge to inflation.

The gist of the argument: During the 80s to the new millennium, as money printing by the US Federal Reserve soared and where the purchasing power of the US dollar has continually eroded, gold hasn’t successfully served its traditional role of “inflation hedge” and has miserably lagged inflation. (see figure 2)

Figure 2: Economagic: Gold As Poor Inflation Hedge?

As you can see gold as signified by the CRB precious metal index (in red), has been in a bear market and has stagnated following its peak in 1980 and has only bottomed out in 1998.

Whereas monetary aggregate US M2 (in green) which has steadily been accelerating upwards, has been reflected in the declining purchasing power of the US dollar (in blue).

Where gold should have reflected on inflation, it hasn’t. Hence, to the deflation camp, the appearance of ‘poor’ correlation has been construed as basis to conclude that inflation and gold have a tenuous link. Although reasons for these haven’t been given.

We have one word answer to refute this claim: globalization.

To understand today’s globalization process we need to begin with the fundamentals of globalization’s fundamental link, the US dollar as the world’s global reserve currency.

The basic function of an international reserve currency is to play the role of providing the medium of exchange not only to the local economy but to the international economy.

This means that the US dollar will have to be issued by the US Federal Reserve in excess of local requirements in order to cater to the needs of international trade or exchange.

Thereby, the basic way to provide liquidity to global economies or to finance international trade is to buy more stuff (import) than sell abroad (export).

Hence, the concept of providing liquidity to fund global trade is the main function of the international currency reserve. Alternatively, this means that the US will have to continually incur deficits with its trading partners by having an overvalued or “strong dollar” policy for as long as the US dollar remains as the principal currency reserve.

And as international trade grows, the US will have to account for larger trade deficits in order to fund or finance these transactions. At the obverse side, trading partners of the US will accumulate US dollar as reserves.

If the imbalances from the said deficits begin to undermine the US dollar exchange value, then the trade deficits will shrink or stabilize to which may jeopardize the role of the international reserve. This is known as the Triffin Dilemma.

Practically all the specifications of the currency reserve conditions as provided for by Yale University Robert Triffin have lived up to his model.

This had been vividly manifested mostly in late 2008, when the US banking system seized up and consequently triggered a collapse in global trade and precipitated the sharp narrowing of the US current account.

The ferocity of the ensuing volatility rippled throughout the global markets- stocks, commodities, bonds, real estate and others virtually crashed. On the other hand, the US dollar spiked as the banking woes triggered a liquidity squeeze while US sovereign bonds rallied hard.

Yet, importantly, the 2008 meltdown likewise manifested a geopolitical response: shrill outcries to replace the US dollar as the reserve currency status by several key emerging market economies!

So as the US dollar liquidity was drained from the near collapse of the US banking system, markets violently responded, and in the aftermath, several political leaders brashly agitated for a new monetary order. This effectively vindicates the Triffin ‘foreign currency reserve dynamics’ Dilemma.

The point is that most of mainstream arguments superficially focus on the current account imbalances, which subsequently pins the blame on currency policies of ex-US trading partners while mostly weasel over the fundamental role of the US dollar as reserve currency and the attendant internal policies that brought upon the crisis.

To wit, one must be reminded that 14 nations have dollarized or have used or adapted the US dollar as their local currency and some 23 countries have been pegged to the US dollar, according to wikipedia.org.

The implication of the US dollar standard is that, in contrast to the fantasies of mainstream, there is no possible rebalancing of the global current account primarily because the current monetary platform does not accommodate for this, as the recent experience have shown.

For as long as foreign transactions are quoted, paid and settled in US dollars, then the nature of these imbalances will have to continue.

And the only way for a rebalancing to occur would be to replace the US dollar standard, not with another fiat money, with no automatic adjustment mechanism from which ultimately will meet the same destiny, such as much ballyhooed IMF’s SDR, but one with a commodity backed currency.

However, replacing the US dollar standard for the purpose of merely mounting a monetary coup d'état against the US won’t likely occur for political and military reasons.

From our perspective the only way for the US dollar to lose its monetary hegemon is via the same path of where most currencies meet their end; a massive inflation, or at worst, hyperinflation.

Globalization Soaked Up US Inflation

The other point pertinent to gold is that the inflationary measures undertaken by the US Federal Reserve during the 1980-2006 came amidst where Deng Xiao Peng declared his celebrated catchphrase “To Get Rich Is Glorious” and thus opened China to the global economy in 1979.

This was followed by the open door policies or economic liberation reforms of India in 1991 and the collapse of the Berlin Wall (1989-1990) which paved way for the deepening of globalization trends.

As global economies opened up, the supply of goods and services, labor and migration flows, financial intermediation and capital flows became more deeply integrated and thereby produced a far larger output (see figure 3) than the monetary policies engaged by the US central bank.

Figure 3: World Trade Organization: World Export and Global Trade

Global Exports sharply accelerated during the 1990s, which underpinned almost the same degree of expansion in Global GDP per capita.

So increased global trade meant more US dollar financing, as manifested by the burgeoning trade deficits, yet the increased output from the world resulted to higher productivity and thus generally growth deflation or “disinflation”. Ergo, lower gold and commodity prices.

According to the World Trade Organization (2008 World Trade Report),

``A key driver of globalization has been economic policy, which resulted in deregulation and the reduction or elimination of restrictions on international trade and financial transactions. Currencies became convertible and balance-of-payments restrictions were relaxed. In effect, for many years after the end of WWII it was currency and payments restrictions rather than tariffs that limited trade the most. The birth of the Eurodollar market was a major step towards increasing the availability of international liquidity and promoting cross-border transactions in western Europe. Beginning in the 1970s, many governments deregulated major service industries such as transport and telecommunications. Deregulation involved a range of actions, from removal, reduction and simplification of government restrictions, to privatization of state-owned enterprises and to liberalization of these industries so as to increase competition.

``In the case of trade, liberalization was pursued multilaterally through successive GATT negotiations. Increasingly, bilateral and regional trade agreements became an important aspect of (preferential) trade liberalization as well. But many countries undertook trade reforms unilaterally. In the case of developing countries, their early commercial policies had an inward-looking focus. Industrialization through import substitution was the favoured route to economic development. The subsequent shift away from import substitution may be owed partly to the success of a number of Asian newly-industrializing countries that adopted an export-led growth strategy, but also partly to the debt crisis in the early 1980s, which exposed the limitations of inward-looking policies.”

In other words, the deepening globalization trends allowed more citizens of the world to increase wealth generation.

As for the Americans, by financing global trade, they were graced with more selection of goods and services at far more affordable prices.

In addition, US dollar accumulations of emerging or developing nations were recycled back to finance US deficits because the US had deeper and more sophisticated markets, aside from domestic policies aimed at anchoring directly or indirectly to the US dollar by several key developing economies for market share purposes.

More proof of globalization’s absorption of the US dollar…

Figure 4: WTO: Financial Flows to Developing Countries

The explosive growth from Foreign Direct Investments (FDI) in developing countries had been manifested in the mid 90s but slowed during the dot.com bust. Nevertheless, FDI’s to developing nations in the early 90s served as a staging point for the spectacular surges.

To add, worker remittances also had a near parabolic ascent over the same period, operating under the globalization dynamics.

Overall, the early phase of globalization, where emerging economies with vast economies of scale integrated with developed economies, resulted to intensive increases in economic efficiencies.

This virtually accommodated the expansionary policies by the US Federal Reserve which resulted to lower gold and commodity prices.

Thus, gold prices had been muted then as “disinflation” from productivity generated growth dominated the global arena. But nevertheless in contrast to the allegation, gold hasn’t been stripped of its role as an inflation hedge.

Are Bond Yields Implying Deflation?

Many analysts from the deflation camp have also been harping on the brewing inconsistencies between the performances of US sovereign markets relative to global stock markets and commodity markets.

They say that since US sovereign instruments have been rallying along with global stocks and commodities, one of the two groups must be wrong.

For them rallying US bonds signified fear or flight to safety from the specter of deflation, whereas rallying stocks and commodities implied the opposite -economic growth, and thus, inflation.

Further they allege that such divergences favor bond investors more than stock market investors because the former is more “reliable” or “credible” or “sophisticated” or “intelligent”.

Because they mostly adhere to the model of Japan’s ‘lost’ decade or the Great Depression as an outcome for the economic environment, they emphasize on the impotency of global central banks or government actions on the predicament of intractable debt which burdens consumers and the banking system of the US and parts of Europe.

We have lengthily argued against these in Investment Is Now A Gamble On Politics. For us both Japan and the Great Depression are unworthy models of comparison.

Today’s landscape is far more globalized than during the early days and that globalization has somewhat coordinated global central bank actions which could lead to the possibility of more traction from largely synchronized policies.

Nonetheless recent actions in the bond markets appear to “validate” rather than contradict our inflation risks outlook.

Figure 5: stockchart.com: US Treasury Yields Spike!

Across the yield curve, US treasuries have dramatically spiked last week!

While almost every market today have been politicized, as the visible hands of government seems ubiquitous, there is no market as deeply and directly involved with US government as the US sovereign and agency bond markets.

The reason for this is that the balance sheets of the US banking system have been stuffed with sundry assets of different quality, most of them are rubbish. Hence government directly intervenes in these markets to avoid major bank failures by buttressing the banking sector, in order to generate systemic liquidity, to help banks recover profitably from trading on spreads, and hopefully to reanimate the largely impaired credit system.

Similarly, policymakers attempt to control real estate prices from seeking its natural levels or from going lower by acquiring mortgage assets.

As Assistant Professor Philipp Bagus recently wrote, ``The financial crisis was caused by solvency problems that led to a liquidity constraint. Central banks tried to fight this by increasing the availability of liquidity and buying or loaning against the same bad assets that caused the solvency problems. If central banks sell those assets again or stop accepting them as collateral, the same solvency problems will reemerge, along with the preexisting liquidity issues. Paradoxically, by buying and accepting bad assets, the central banks did not fix the solvency problem: they merely delayed the inevitable. The bad loans did not turn "good" by changing hands or being accepted as collateral by central banks. Hence, the problem remains and exit strategies can only be successful if the quality of these assets changes or their quality is acknowledged and banks are recapitalized accordingly.”

In short, by levitating markets the US Federal Reserve hopes that risk appetite would radically improve for the Fed’s position, so as it would be able to unload or dispense of the bad assets accrued within the system.

Unfortunately, the Fed seems stuck with monetizing government debts in the face of additional pressures in the economy.

As we earlier pointed out, the US Federal Reserve is supposed to end its Quantitative Easing (QE) program on its self imposed quota on purchases of $300 billion worth of US treasuries. However, it also declared to extend a significant part of the program in order to complete its purchases on $1.25 trillion worth US mortgages.

Figure 6: Federal Reserve of Cleveland: Federal Reserve Purchases

But data from the Federal Reserve of Cleveland shows otherwise (figure 6).

The blue arrow pointing to the red ellipse shows that the US Federal Reserve has been buying in excess of the $300 billion quota for third time. This means that these purchases were not accidental but deliberate. The Fed has acquired about $2.631 billion above its goals.

Meanwhile, the black arrow also shows of the purchases of mortgage securities by the Fed under the present QE program which is slated to end in early 2010.

In the Fed balance sheet watch, the Wall Street Journal sees the same developments,

``The Fed expanded its purchases of Treasurys and agency debt, though its holdings of mortgage-backed securities declined for the second straight week. The Fed started a program in March to ramp up such acquisitions in order to keep long-term interest rates low. The central bank announced in August that it will be buying more Treasurys through the end of October, and said last month that it will be buying MBS into 2010.”

Perhaps one of the reasons behind the recent spike across the yield curve in US sovereign securities could be imputed to the market interpretations of the FED as ending its support on US sovereign papers. This eclipses the a strong economic growth revival in its economy.

But a surge in sovereign yields could affect mortgage rates and could put renewed pressure on housing and commercial real estate (CME) prices. And a disorderly surge in treasury yields could also ripple to other markets.

One must be reminded that the inflationary policies acts like a pyramiding mechanism which requires more and more accelerated amount of inflation in order to support specifically targeted prices in an unsustainable system propped by artificial stilts.

As Credit Bubble Bulletin’s Doug Noland rightly observed, ``Our policymakers have much less flexibility in the new financial and economic landscape. Both fiscal and monetary measures have lost potency. Trillions of dollars of deficits, zero interest rates and a $2 Trillion Fed balance sheet today get less system response than hundreds of billions and a few percent would have achieved previously. This hurts the dollar.”

Hence, reading through the bond markets when they are directly manipulated by governments would represent as serious misdiagnosis. That’s because these markets have effectively been politically choked which doesn’t reflect on market prices. Eventually imbalances accruing from these will implode.

Moreover, we should expect the US Federal Reserves to continue with its QE programs, regardless of the self imposed quota, simply because the guiding economic ideology, the recent triumphalism, biases derived from research (e.g. anti-deflation tools: printing press, zero interest rates) and importantly, political pressures from the banking industry and/or the political leadership have all converged to incentivize the chief policymakers to take on the risks of an “inflation” route.

Lastly, fighting the FED looks myopic.

US Fed Chair Ben Bernanke looks dead set at taking on the “nuclear option” of jumpstarting the US economy by sparking inflation via devaluation.

This clearly is in his guidebook. As Mr. Bernanke pointed out in his 2001 ‘Helicopter’ speech, ``Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation.” (emphasis added)

Importantly all of the prescribed weapons from Mr. Bernanke’s diagnosis against a deflationary outcome, patterned after the Great Depression, seem in place:

1) avoiding mass failures of the banking system. This by taking equity stakes in key financial institutions, aside from exercising diverse roles as the lender, market maker, buyer and investor of last resort via different alphabet soup of programs,

2) adopt zero policy rates,

3) apply an extended period for zero policy rates,

4) run large fiscal deficits

5) seek to further consolidate and expand the powers of the Fed and lastly,

6) use the printing press through QE programs

All these seem potent enough to ensure for the US dollar to massively devalue.

However, the problem is that the US dollar in the 1930s had been anchored to gold.

Today, the US dollar has essentially replaced the function of gold as the world’s anchor currency.

And global governments may not tolerate the US to unilaterally devalue at their expense. And as we pointed in King Canute Effect: Lagging Peso A Consequence Of Central Bank Intervention, as Asian Central Banks including the Philippines have tacitly embarked on interventions in the currency markets to stem the rise of the national currencies.

Ultimately, all these collective policies to “reflate” the system risks, not deflation, but hyperinflation.

As J. Kyle Bass of Hayman Advisors LP fittingly wrote,

``Western democracies, communistic capitalists, and Japanese deflationists are concurrently engaging in what may be the largest, global financial experiment in history. Everywhere you turn, governments are running enormous fiscal deficits financed by printing money. The greatest risk of these policies is that the quantitative easing will persist until the value of the currency equals the actual cost of printing the currency (which is just slightly above zero). There have been 28 episodes of hyperinflation of national economies in the 20th century, with 20 occurring after 1980. Peter Bernholz (Professor Emeritus of Economics in the Center for Economics and Business (WWZ) at the University of Basel, Switzerland) has spent his career examining the intertwined worlds of politics and economics with special attention given to money. In his most recent book, Monetary Regimes and Inflation: History, Economic and Political Relationships, Bernholz analyzes the 12 largest episodes of hyperinflations - all of which were caused by financing huge public budget deficits through money creation. His conclusion: the tipping point for hyperinflation occurs when the government's deficit exceed 40% of its expenditures.” (bold highlights mine)

Hence, the thrust to devalue the US dollar enhances the risks of accelerated inflation which may eventually tip the financial and economic scale towards our critical-‘Mises moment’.

And this translates to massively higher gold prices not only on inflation concerns but at the risks of a global currency crisis.

I’ll end this quote with a repeat reminder from Mr. Ludwig von Mises on stoking perpetual booms, ``The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market. But it could not last forever even if inflation and credit expansion were to go on endlessly. It would then encounter the barriers which prevent the boundless expansion of circulation credit. It would lead to the crack-up boom and the breakdown of the whole monetary system”

Investment Is Now A Gamble On Politics

``Central bank will not allow large banks to fail. This means that it will not allow the fractional reserve process to implode through bank failures and the contraction of the money supply.”- Gary North, 'Dr. Deflation' Changes His Mind After 27+ Years

What amounted to one month of rainfall gushed over the Philippine metropolis in just 6 hours! In the wake of typhoon Onyok, a vast part of Metro Manila have been turned into a virtual swamp, enough for the Philippine government to declare the affected areas in a state of calamity. According to news reports, the devastating floods from the typhoon Saturday, had been the worst in nearly 40 years.

From our perspective, this serves essentially as an example of a high impact, hard to predict rare event which classifies as a Black Swan, in terms of weather.

While one may argue that the approaching typhoon was predictable, the intensity of the rainfall, according to the local weather bureau, wasn’t.

In as much as Black Swans happens in nature, it also occurs in the marketplace. And this has been a contingent that we have been striving to prepare for, so as to achieve the entrepreneurial goal of optimizing profits via risk identification and damage control.

Of course Black Swans don’t just apply from the negative point of view but can also be seen from a positive light. Technological innovations are just vivid illustrations of these.

Nevertheless the important point is to identify where the larger distribution of risks lies as possible source of market based Black Swans.

Deflation’s Ipse-Dixitism

The recent weaknesses in many parts of the global financial marketplace have been used by the bear camp, mostly populated by the deflationistas, to extol on their “bear market rally” theme.

Figure 1: Stockcharts.com: Falling Markets

For varied indicators as the falling Baltic Dry Index (BDI), Friday’s slump in oil (WTIC) and gold (GOLD), rallying US treasuries and the struggling enfeebled market leader in China’s Shanghai index seems to have all converged.

The bear camp argues that the rally has ended on the corroding effects of stimulus, recessionary forces regaining an upperhand, prices acting “way too far, too fast”, possible escalation of trade war and the demobilized consumers from exercising their extenuated spending powers.

While we don’t belong to the camp which advocates more inflation since we think inflation is immoral and generally baneful to the society, as a market participant we understand inflation to be a political process- where policymakers make political decisions of picking winners or salvaging select interest groups or industries or companies at the cost of the taxpayers.

As Henry Hazlitt wrote, `` 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.” (bold emphasis mine)

In other words, for as long as the governments attempt to vehemently prevent the required market adjustments from previously misdirected allocation of resources, mostly by promoting credit expansion and spending, and by government directly purchasing assets with “money from thin air”, they are undertaking inflationary programs.

Yet this avowed policy direction by global authorities to inflate and the penchant by several participants to adamantly insist of a deflationary outcome seem quite self contradictory.

Why the deflation risk is a bogeyman?

For one, we have noted that central banks have the capacity to match or even exceed the issuance of money to offset every outstanding liability a political economy has been blighted with, for as long as the banking system remains afloat.

Two, macro analysis looks at problems on oversimplified basis or from one dimensional aspect of product, labor and capital. Moreover, money is often seen as a constant, where marginal supply of additional money into the economy doesn’t impact prices.

In addition, macro analyses have been predisposed to models that apply only to selective and not on general conditions.

In the case where money is construed as a constant, this fitting remark from Professor Gary North, ``Whenever an economic theory of how the world works makes an exception for monetary theory, the proposed monetary theory is incorrect, or the general theory is incorrect, or both are incorrect.” (emphasis added)

Three, inflation is fallaciously anchored as mainly a consumer dynamic.

Fourth, deflationists disregard pricing levels from a relative perspective. For instance, deflationists tend to ignore the impact from technology’s early adopter buyers. More importantly, they gloss over the fundamental law of pricing based demand and supply allocations, where low prices extrapolate to higher demand.

Fifth, deflationists discount the transmission mechanism from monetary policies given today’s US dollar currency standard platform. Remember, 23 countries (wikipedia.org) are pegged to the US dollar which means these countries are fundamentally importing Bernanke’s policies.

And since debt levels and capital structure vary from country to country, the impact of recessionary forces or debt deflation or consumer spending retrenchment from bubble afflicted economies will be different from those countries importing US policies. In addition, a further variance would be the effect from applying the same home based stimulus programs.

As CLSA’s high profile analyst Christopher Wood in a Bloomberg article, ``It’s wholly wrong to view Asia as a correlated train wreck with the U.S. consumer.”

Therefore, deflation in an absolute sense signifies as ipse dixitism or unsupported dogmatic assertion.

Unworthy Paradigms: Great Depression And Japan’s Lost Decade

Sixth, deflation proponents generally make comparisons with that of the Great Depression and the Japan experience even if both circumstances have been totally different from today.

The Great Depression was a byproduct of an amalgam of:

-Massive monetary contraction (30%),

-Regime uncertainty or investors’ reluctance to participate in a perceived hostile atmosphere resulting from a string of adverse policies imposed, which appears to have threatened property rights and prevented the necessary price adjustments, such as wages.

To quote Benjamin Anderson from Robert Higgs’ Regime Uncertainty “The impact of these multitudinous measures—industrial, agricultural, financial, monetary, and other—upon a bewildered industrial and financial community was extraordinarily heavy”, and

-high taxes and protectionism amidst a recession which metamorphosed into a depression [see earlier post Lessons From The Great Depression: Taxes, Protectionism and Inflation].

Japan's stagnation, on the other hand, which has been popularly but erroneously known as suffering from deflation (technically defined as contracting money supply), had likewise been a consequence of a mélange of regulatory mess, particularly high tax regime, policies that propped up the legacy of obsolescent zombie industrial companies [see Asia: Policy Induced Decoupling, Currency Values Aren’t Everything], reluctance to liberalize due to cultural idiosyncrasies (bad management of companies due to interlocking relationships among companies and the ``disdainful of the idea of shareholder value and of traditional profit metrics” notes James Surowiecki) and the conflict of interest issues from Japan’s bureaucracy which embraced state capitalism.

The recently victorious Democratic Party of Japan (DPJ) declared it would reduce the latter’s influence, but the question is always HOW?

Moreover, Japan’s lost decade has been largely insulated from the world as most of its liabilities had been denominated in local currency. The culturally high savings quirk by the Japanese financed most of the failed boondoggles during the nearly 2 decade long of stagnation. However, demographic issues (which has been depleting savings) and current conditions (weaning off from the US consumers and reorienting trade towards China and Asia) imply that the old model is about to make a major transformation.

MAD “Mutually Assured Destruction” Policies

Seventh, deflationists often switch gears from using the monetary aspects to excess capacities or current account balances or non-monetary (usually trade) dimensions in rationalizing deflation on a global scale or data mine facts to fit their arguments.

For instance, the Global Savings Glut theory has been prevalently used as an attempt to shield the US from policy flaws which pins the blame on “currency manipulation” by Asian savers.

Hardly anyone from the mainstream incorporates the role of the US dollar, as the world’s de facto currency reserve, in the discourse of the origins of today’s imbalances.

Professor Robert Triffin rightly predicted more than 40 years ago of the accruing imbalances that a reserve currency would endure. That’s because of the incremental tensions which would amass from conflicts of national monetary policies vis-à-vis global monetary policies (provider of international liquidity). This is known as the Triffin dilemma, where the reserve currency can remain overvalued from which it would continue to accumulate deficits or undergo proportional devaluation in order to stabilize or shrink deficits [see previous discussion in The Nonsense About Current Account Imbalances And Super-Sovereign Reserve Currency].

So while the mainstream goes into a perpetual blaming spree alongside with their sanctimonious omniscient prescriptions, they don’t seem to realize that this has been the operating nature of reserve currencies, especially from a “paper money” standard.

Moreover, the recent trade dispute between US President Obama and China over increased tariffs over tires have breathed “protectionism” as an excuse for deflation.

Figure 2: BCA Research China: Tempest In A Teacup, For Now

While the risk of an escalation of a trade war appears plausible, I am predisposed to the view that these politically motivated actions has been designed to wangle some short term deal with vested interest groups, particularly the labor union-the United Steelworkers or protectionist policymakers.

However we share the optimism with BCA Research when they wrote, ``However, there are good reasons to believe that the recent tensions are likely to be contained. For one, the amount of trade in question is a tiny fraction of total trade flows between the two countries. Chinese sales of tires and steel pipes to the U.S. amount to about US$4 billion a year (compared to $US230 billion of total Chinese exports to the U.S.). Meanwhile, Beijing’s action in taking the trade dispute to the WTO shows China’s willingness to resolve disputes within the legal framework of international trade rather than via direct bilateral confrontation. Overall, the Obama administration’s seemingly toughened stance towards China-related trade issues is mainly a maneuver designed to garner domestic political support rather than an outright intention to wage a trade war. The biggest risk that could significantly heighten trade tensions and economic confrontation is if the U.S. government and lawmakers once again challenge China’s exchange rate policy and tax rebates for its exporters. Bottom line: Chinese authorities will likely continue to focus on the big picture of promoting domestic growth, so long as there is no systematic challenge to the country’s trade and foreign exchange policies to complicate its growth-boosting strategy.” (bold underscore mine)

Put differently, the Tire tariff was perhaps meant as diversionary tactic or as a concession in order to diffuse far larger protectionist tensions held by some quarters in the august halls of the US congress. In short, if we are right, the controversial enactment of the Tire tariff appears to be more symbolic than of a real risk.

In addition, it would also be plain naive to extrapolate for the US to arbitrarily lure China into a trade war when US officials are aware that the Chinese holds the largest share, about $800 billion (as of July), of US treasuries or nearly a quarter share of the foreign owned pie see figure 3.

Figure 3: Wikipedia.org: Foreign Holders of US Treasuries

As the legendary trader Julian Robertson of Tiger Management says in a recent CNBC interview, ``“We’re totally dependent now on the Chinese and Japanese” [as posted in Julian Robertson: We are going to have to Pay the Piper].

In short, President Obama significantly depends on China, Japan and Asia’s largesse to sponsor his administration’s “borrow and spend” program.

This also means that it would be utter lunacy, if not suicidal, for Pres. Obama to engage in mutually assured destructive (MAD) policies, which should hurt more of the US than China. Further this would accelerate the inflationary process in the US (…unless this serves as an opportunity for the US to seize the moment from a hostile China response to be used as a Casus Belli to declare a default! But the US owes Japan and the rest of the world too.).

Since there will be lesser access to savings globally, the court of last resort will be Chairman’s Bernanke’s printing press.

Here, Mr. Robertson estimates 15-20% annual inflation rates for the US once China and Japan desists from financing the US.

Scared Of One’s Own Shadows

Last and most importantly, deflationists belittle the role of central banking in the economy and the economic ideology underpinning the global political leadership.

In short, deflationists rule out the ramifications from the political aspects of government intervention in the economy.

It is also kindda odd to see some deflationist scared to wits about the prospects of deflation when they have been influenced by the same ideology that espouse on government intervention that paves way for the inflation-deflation boom bust cycles. It’s analogous to being afraid of one’s own shadow.

Deflation basically comes in two forms. One is a consequence of inflationary policies. The other is an outcome of productivity, which means economic output greater than the supply of money. This had been much of the case during the gold standard based, Industrial Revolution.

Nobel prize winner Friedrich A. Hayek in a speech about Choice In Currency, A Way To Stop Inflation eloquently describes the shift from stability into today’s woes,

``The chief root of our present monetary troubles is, of course, the sanction of scientific authority which Lord Keynes and his disciples have given to the age-old superstition that by increasing the aggregate of money expenditure we can lastingly ensure prosperity and full employment. It is a superstition against which economists before Keynes had struggled with some success for at least two centuries. It had governed most of earlier history. This history, indeed, has been largely a history of inflation; significantly, it was only during the rise of the prosperous modern industrial systems and during the rule of the gold standard, that over a period of about two hundred years (in Britain from about 1714 to 1914, and in the United States from about 1749 to 1939) prices were at the end about where they had been at the beginning. During this unique period of monetary stability the gold standard had imposed upon monetary authorities a discipline which prevented them from abusing their powers, as they have done at nearly all other times. Experience in other parts of the world does not seem to have been very different: I have been told that a Chinese law attempted to prohibit paper money for all times (of course, ineffectively), long before the Europeans ever invented it!”

So it is another deeply held erroneous belief that deflation is the greater evil, when 200 years of the gold standard brought about great prosperity. This is in contrast to today’s deepening intermittent boom bust cycles, which only enriches only certain segments of the society and hurts the rest of society when a bust transpires.

Deflation from an inflation bubble simply cleanses the system.

Yet the same camp of deflationists argues for more inflation.

From UK’s Prime Minister Gordon Brown (quoted by Bloomberg), ``The stimulus that we have still got to give the world economy is greater than the stimulus we have already had. What we want to do is safeguard a recovery from a recession we feared would develop into a depression.”

Moreover, the US Federal Reserve recently decided to extend and complete its $1.25 trillion buying program into the mortgage market. According to Bloomberg, ``The central bank has purchased $694 billion of mortgage- backed securities since January and plans to spend $556 billion more by April 2010 to keep interest rates down. The debt-buying is the biggest program in the Fed’s arsenal.”

Isn’t these powerful signal enough, a manifestation of both economic ideology and policy direction? It’s more than just words or propaganda, it reflects action in progress.

And as we argued in Governments Will Opt For The Inflation Route and last week’s A Deeply Embedded Inflation Psyche, for us, it has been a policy tool for the US Federal Reserve to juice up the stock market for the same reasons- economic ideology (to paint the impression of economic recovery by reanimating the irrational “animal spirits”) and policy direction.

As we previously pointed out, the US government today stands as THE mortgage market, why is this so? Aside from trying to “stabilize” the mortgage market, the US banking system holds tonnes of assorted mortgages on their balance sheets.

In short, the US government has been preventing the outright collapse of some important segments of its banking system by providing implicit guarantees on the banking system’s assets.

Moreover, the US government has also acquired ownership representation among the biggest financial institutions. This acts as another form of implicit guarantee.

Aside, the ownership accounts for interventions or interferences aimed at conveying its political objectives into the company’s business operations.

Further by undertaking quantitative easing, the US Federal Reserve reliquefies the marketplace by acting as market maker of the last resort to the illiquid markets.

If the US Federal Reserve hasn’t been the key influence of the stock market, why would issues, which accounted for most of the recent government rescues, have accrued most of the jump in the trading volume at the NYSE? (See figure 4)

Figure 4: William Hester: Without Phoenix Stocks, Volume Continues to Contract

According to William Hester of Hussman Funds (bold highlights mine), ``But almost the entire rise in volume during the last month and half has come from a handful of stocks. Examples include Fannie Mae, Freddie Mac, Citigroup, AIG, and Bank of America. These are just five. There are a couple of other stocks that are interchangeable with these companies and would produce similar results – but the characteristic they all share is that they are financial stocks that only recently were on the brink of collapse. And since the Government's rescue of these and other financial firms, the group has risen up from the ashes. For ease of reference, we'll call these Phoenix stocks.

``The rise in trading volumes in some of these stocks has been considerable. The shares of AIG now often trade with 15 times the volume they traded a year ago. Citigroup has traded at 12 times the amount from a year ago. This helps explain why the trades in these companies' shares are taking up a larger fraction of total share volume.”

Has US government zombie institutions been using their excess reserves or proceeds from the Fed’s QE reliquification program to trade their own shares or trade shares among themselves?

Figure 5: Andy Kessler: Monetary Base versus Dow Jones

Is it just merely a coincidence that monetary base has been growing while stock market has been rising (see figure 5)?

Some would argue, but the other money aggregates have turned south. However, what if banks haven’t been lending but instead speculating on assets?

Besides, there has been no clear agreement as to which of the monetary aggregates should serve as the true representative or as accurate indicator of money conditions in the US or globally. This makes the chart above “correlated but not causal”, as much as those arguing the opposite.

Further, the boom in the bond markets has also revealed that credit has been expanding but has been short circuiting the banking system.

By going direct through the capital markets, credit intermediation hasn’t triggered the banking system’s fractional reserve platform, hence hasn’t been reflected in traditional monetary aggregates.

All told, deflation seems more like a bogeyman widely used to justify more politicization of the marketplace.

Investment Is Now A Gamble On Politics

There are two more very significant developments the deflationists have sorely missed.

The recent weakness in the markets in gold, commodity and China hasn’t triggered a meaningful jump in the US dollar index to confirm the debt destruction and the impotence of central banking, similar to the meltdown of last year.

Moreover, it hasn’t reflected a general tightening of credit conditions out of default fears…yet.

Figure 6: Danske Weekly Credit

As you can see from the Danske Charts above, major credit indicators have all turned lower or has materially improved, all of which hasn't been emitting any trace of “deflation” tremors.

Moreover, there have been reports that the Fed has been exploring ways to tap the funds from the money market to implement its exit strategy. According to the Yahoo Finance ``The Fed would borrow from the funds via reverse repurchase agreements involving some of the huge portfolio of mortgage-backed securities and U.S. Treasuries that it acquired as it fought the financial crisis, the newspaper reported, without citing any sources. This would drain liquidity from the financial system, helping to avoid a burst of inflation as the economy recovered”. (emphasis added)

Yet analyst like Zero Hedge’s Tyler Durden sees this as one of the many subterfuges employed by the FED to “reflate” the system.

This from Mr. Durden (bold highlights mine), ``And the Fed finds a way to screw everyone over yet again. Contrary to expectations that the Fed will use reverse repos to remove excess liquidity (which, by definition, such an action would) it appears that Bernanke's wily scam is to push even more money out of money market funds and into capital markets. Even though banks currently have about $800 billion in excess reserves which the Fed is paying interest on, and which would be a damn good source of liquidity extraction as the Fed considers to shrink its ever expanding balance sheet, the Chairman is rumored to be considering money market funds as a liquidity source…All in all, the Chairman is determined, come hell or high water, to part consumers with their savings: whether it be through zero deposit interest rates, through money market guarantee removals, through talk of inflation or, ultimately, through actions like these. After all, America has gotten to the point where the Fed is beating the drum on the need to keep blowing the capital market bubble bigger and bigger: anything less, and just as Madoff investors discovered, the entire pyramid collapsed overnight, and where people thought there was $50 billion, there was really $0.”

In addition, even while the Fed has declared that it would undertake the completion of its $1.25 trillion QE program by buying $556 billion more on mortgages, there seems to be a problem, it is only left with an estimated $10 billion for US treasuries which is expected to be expire by October.

This implies that should foreign central banks continue to recycle their surpluses on short term Treasury bills, the yield curve should soon steepen as the long end rises (on condition that the Fed holds course by not additionally monetizing US treasuries).

And rising treasury yields places further constraints or pressures to the financing of US government programs.

This from Professor Michael S. Rozeff (all bold underscore mine), ``The government will have problems funding its programs. It will be under pressure to raise taxes and cut back on its programs. Since it will be reluctant to do either, the problems will fall upon the dollar and on the government debt. This will place the government in an untenable position because the higher interest costs of the debt will add to the deficit. A negative feedback cycle will occur in which deficits cause higher interest costs which cause more deficits which cause higher interest costs, and so on. No amount of taxation can solve the government’s fiscal problem that lies ahead. Greater taxes will only make them worse by slowing the economy. That option is foreclosed.”

Ultimately, this brings us to the potential outcome of deflation-inflation debate.

Again Professor Rozeff, ``The two problems – the dollar and debt – are joined. If the FED tries to save the dollar, it affects government debt adversely. The FED can relieve pressure on the dollar by deflating its bloated balance sheet. To do that it needs to sell off the mortgage-backed securities that it has accumulated and not buy the rest that it is now in the process of buying. If it ever does sell off these securities, it will pressure the government debt market. This is very unlikely. Instead I expect it to pay interest on reserves, which will not solve its problems and will only add to the government deficit and start an exponential process of increase in interest paid. If the government tries to save the debt market by having the FED support it as it is now doing, that affects the dollar adversely. The central bank and the government are between a rock and a hard place. One or the other or both of the dollar and the debt are slated to have problems. Enactment of Obama’s health care and energy measures, even in diluted form, will confirm the existing course. Their rejection will be more favorable for the dollar and for government debt. As the political winds shift, so will the fortunes of the dollar and the government debt markets. Investment is now a gamble on politics.”

In short, the US government, not the US consumers, has become the ultimate driver of marketplace. And investing returns would mean reading accurately from political tea leaves.

And once emergent weaknesses in the marketplace becomes increasingly pronounced, governments will be expected, given their Keynesian interventionist ideology, to massively re-inflate the system to the point where the political option would translate to the extreme choice of ‘Mises moment’ endgame: relative deflation possibly via a default or a currency crisis.