-->Bonds and Deflation
Steve Saville
Overview
Several powerful forces have combined to drive US bond prices higher over the past few years. Chief among these forces has been the large-scale buying of US bonds by the Bank of Japan as part of its attempts to weaken the Yen, but other significant influences include yield-spread trades by banks and speculators, strength in Japanese Government Bonds, 'flight to safety' buying, and fear of deflation. What we want to do today, though, is not spend time analysing WHY the bonds have been so strong because we've covered this topic at length in other commentaries over the past year. Instead, we are going to look at the EFFECTS that this bond strength has had, and continues to have, on other markets.
One of the most important effects of the on-going strength in bonds is psychological because regardless of the fact that much of the strength can be attributed to government intervention (aggressive buying of US bonds by the Japanese central bank and the Fed's implied promise to hold the official short-term rate at a very low level until the employment situation improves), many analysts won't believe that an inflation problem exists until after bond prices move considerably lower. In other words, the consensus view is that if the US really was facing a serious inflation threat then bond prices would be much lower (long-term interest rates would be much higher); and this is despite the mountain of evidence that the on-going bond price strength has nothing to do with inflation/deflation.
Now, the knock-on effect of very few people perceiving an inflation problem is that the problem is able to grow because nobody in power, least of all the governors of the Federal Reserve, is interested in trying to solve a problem that supposedly doesn't exist. That is, persistent strength in bond prices prevents any obstacles from being placed in the way of additional inflation because the bond price strength places a smoke screen in front of the underlying inflation problem. This, in turn, means that the prices of those things that benefit from a burgeoning inflation problem are able to move much higher than would otherwise be possible. So, the longer that bonds can remain firm the higher the prices of gold and commodities will eventually move. By the same token, there won't be any need for us to worry about commodities and gold experiencing anything other than routine bull-market corrections until bond prices move sharply lower.
The problem or the solution?
Over the past few years it has often been necessary to think counter-intuitively in order, firstly, to understand what is happening in the markets and, secondly, to understand the likely future effects of these happenings. For example, during the weeks immediately following the devastating terrorist attacks of 11th September 2001 there was substantial strength in bonds and widespread fear of deflation. Our interpretation, though, was that the policy response to the situation was going to result in an even bigger inflation problem and rally in commodity prices than would otherwise have occurred. But this interpretation seemed so 'off the wall' at the time that several of our readers actually cancelled their subscriptions.
In the last two commentaries we've begun to once again discuss the 'deflation bogey' because there's a reasonable chance that financial-market and economic conditions during the second and third quarters of this year will once again cause deflation to become a hot topic; and we wanted to get in early with our rebuttal. Of course, just because we were right about this issue when deflation fears were rampant during 2001, 2002 and 2003 doesn't mean we will be right this year.
We think it is very likely, though, that the PERCEIVED deflation threat will once again be met by a very aggressive inflationary response on the part of policy-makers. Furthermore, given the Fed's enormous power in the field of money/credit creation there is a high probability that the inflation problem will be made much worse before we have to seriously consider the possibility of genuine deflation. And, if policy-makers are lucky (they will need to be extremely lucky) then their efforts to magnify the existing inflation problem will once again be masked by stability or strength in the bond market.
A point that deserves to be emphasised, though, is that when the Fed and other central banks facilitate the creation of additional money/credit in order to 'address' a perceived deflation threat all they are actually doing is pushing an even bigger problem into the future. This is because deflation isn't the problem; the problem is that way too much new money and new debt has been created over the years. That is, there is an inflation problem and deflation, in fact, is the only viable long-term SOLUTION to the problem.
Further to the above, at the root of the matter is the common misapprehension that deflation is the problem and that inflation might be a solution, or, at least, a 'bandaid' that can be applied in order to make the healing process less painful. In our opinion, though, inflation is the PROBLEM and deflation is the SOLUTION; and the problem will continue to get worse until the political will exists to fix it.
Commodities, Gold and Inflation
Rising commodity prices are a potential EFFECT of inflation, but it is generally possible to explain an increase in commodity prices without naming inflation (money supply growth) as one of the culprits. For example, right now an argument could be made that commodity prices are not strong as a result of inflation but are, instead, strong as a result of China's economic boom, weather-related problems, geopolitical issues and OPEC production cuts.
The ability to blame price rises on anything other than inflation is one of the main reasons that price indices such as the CPI have been aggressively promoted by governments over the decades as measures of inflation; the idea being that as long as most people believe that rising prices and inflation are one and the same then it will be possible to blame"inflation" on things over which the government has no control, such as the weather. So, how would we ever know that inflation was one of the main forces behind a rise in commodity prices?
The answer is: the performance of the gold price. Specifically, when gold leads a large and lengthy rally in commodity prices we can be very confident that one of the major forces behind the rally is inflation. This is because the investment demand for gold only rises when confidence in fiat currency falls.
And gold leadership is exactly what we've seen over the past three years. Note, in particular, that the gold price reached a major bottom (in real terms) in February of 2001 and had been rallying for 8 months by the time the CRB Index hit a major bottom of its own. We can therefore be very confident that inflation has played an important part in the rally in commodity prices that began in October-2001
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25 March 2004
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-->3/22 Alex Wallenwein - Inflation or Deflation? How About Just 'Flation'?
Inflation or Deflation?
How about just 'Flation'?
The debate about inflation vs deflation has been raging on these precious metals fora for a long time now. Who is right? Who's wrong? Is anybody right?
Or are all of them right?
"How can that be?!!" your mind screams at me. Who ever heard of inflation and deflation occurring together? What nonsense! At the most, they will cancel each other out, leaving an economy untouched by either. A pristine, Eden-like economy that neither inflates nor deflates to any large degree at all. One of the wonders of the"new economy."
Maybe.
But then again, maybe not.
Until last year, nobody has ever heard of the stock market and gold market running up together, side by side, like old friends, either. But that's exactly what happened. Neither one of those phenomena put a damper on the other. So, why should it be so impossible to happen with inflation and deflation?
Greenspan was heard last year complaining there is"too little inflation." Although that may seem puzzling to the uninitiated (didn't he just get done battling the"inflation dragon" in 1999 when he started raising interest rates out of fear it might, some day, return?), old-timer gold buffs know that no self-respecting central banker can live without inflation.
Gold buffs know that the institutions those critters built were designed to create - and thrive under - a certain"tolerable" amount of inflation (tolerable to whom, I ask?).
The Case for Inflation:
As to the argument that"there is no inflation" one has but to look at the following chart showing the buying power of the US dollar since 1900:
The confusion comes from the sloppy use of terms. Nobody in their right mind would maintain that"there is no inflation" in the face of such a stark and graphic reality. What they actually mean is that the rate of inflation has slowed, and that is obviously true, as the decline shown has markedly flattened in the graph above.
"Inflation" here is simply the opposite of the dollar's decline in purchasing power. It is usually depicted like this:
(United States CPI from 1900 til 2003. Source: http://www.miprox.de)
One can say that, from the days of Nixon's abandonment of the dollar's last ties to gold, things have definitely gone pretty much"uphill" all the way - for the CPI, at least.
Bob Prechter is one of the main proponents out there who argue that we are currently in a deflationary depression period - we just don't know it yet. I myself, along with everybody else who has looked into the"euro vs dollar" issue, have often predicted a huge hyper-inflationary wave approaching - as the world's nine trillion reserve and trade-dollars are slowly displaced by the euro, and driven back home into the US economy by lack of world-wide demand.
Who's right?
All of us are.
The Case for Deflation:
Debt levels never before seen in human history are being piled on by US consumers, producers, and the government alike. At the same time, productive capacity and installations are moving offshore due to"free trade" policies (from the US side) and"vacuum trade" policies (from the Chinese/Asian producers' side). By"vacuum trade" I am referring to monetary policies designed to keep export competitiveness high by means of keeping the Asians' currencies artificially low against the otherwise falling dollar, thus sucking productive installations and jobs out of the US into low-cost China and other countries.
The result,. A phony"recovery" at home, paid for by consumers going deeper into hock, further boosted by a government going even deeper into hock (but that doesn't matter, because the government can always"borrow" and force the Fed to print unlimited amounts of cash which it promises to"repay" by stealing tax money from the population - an activity for which any upstanding citizen would be thrown into a prison cell forever).
Anyway, the"recovery" has been paid for by highly interest-rate sensitive debt (speak"ARMs") that cannot be repaid without sufficient job generation, and that at some point in the not-so-distant future will cause the heroic (stupid?) US consumer to pull in his severely damaged horns and spend no more. The reason: interest rates are bound to rise sooner or later, as was discussed in The Gospel of Higher Gold.
So, when that WTC-like debt-structure finally collapses, deflation will most definitely set in. Borrowers will default on loans, which will be written off by the banks, which will contract the"money" supply (somehow I always feel a compulsion to put that term into quotation marks due to the fact that what goes under the name of"money" these days is not lawful money of the United States at all, but simply"legal tender" - pure legislative scrip).
Yet, at the same time, we will have an ever-increasing tsunami, a"paper-slick" if you will of epic proportions, a flood of no-longer-used international dollars washing up on US shores, further goosing up an already goosed-to-the-max US"money" supply, which will serve to further - and this time catastrophically so - deflate the dollar's purchasing power, driving up prices right here at home to levels never before seen in the US.
Will these effects"cancel each other out"?
No. Sorry.
The Case for 'Flation':
What we will end up with is simply the worst of both worlds.
Any"cancelling out" effect that may appear will appear to a limited degree only in the money supply. Some of the"homecoming" dollars will be soaked up by the dollars destroyed by the deflationary debt collapse here in the US. But for all of it to be"soaked up" so that the result is a wash would require that ninety to 100 percent of the domestic US"money" supply will be destroyed in that coming depression.
Why is that so? Because there are about equal amounts of dollars floating outside the US as there are inside the US. About eight to nine trillion dollars on both sides of the mighty waters.
But the economic effect of rising interest rates and mounting debt-defaults during a time of continuing and mounting overall job (and therefore income) losses will in no way be alleviated by this flood of money. There will be more"money" than there would otherwise have been somewhere in the economy as a result of this returning dollar flood, but it won't be in the pockets of the strung-out consumers who can't find a job out there in this oh so productive"new economy" of ours.
This dollar-flood, however, WILL serve to drive up the prices of virtually everything around you, making the task of making ends meet even more impossible for our hapless consumer friends (who happen to be you and me).
Of course, these mounting debt defaults will cause uncounted bank and lender"reorganizations" (a nicer term for bankruptcies), and since banks are always bailed out by the government (as they are the ones who own the government), and because the government's own tax revenues will drop like a leaden duck in an empty well shaft since so many"consumers" have no income and no longer deserve that name, the government will have to"borrow" even more"money" from the Fed which will further drive up the deficit and thereby interest rates, spiraling the whole mess even deeper into the ground.
No, I'm sorry. Nobody is going to"win" this deflation vs. inflation debate. We will all suffer. There will be wide-spread"flation" all over the place, and nobody will care whether this"flation" is of the"in" or the"de" flavor.
When it finally all"flates", what will happen will be much closer to the audible effect of what we commonly call"flatulence": a rapid succession of opening and closing of a certain human orifice that makes a most ridiculous sound - except that this time, nobody will be laughing.
There will be only one way to survive this with your wealth position more or less intact: having a good amount of real money stocked up somewhere within reach - and trying whatever you can to get your family, friends and neighbors to do the same. (Good luck on that one!)
Got gold?
Alex Wallenwein
Editor, Publisher
The EURO vs DOLLAR CURRENCY WAR MONITOR
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