My Diary 506 --- Deflation vs. Inflation

Market Thoughts --- Deflation, Inflation, UST and Gold

CAM: I doubt Bernanke gives any thought to velocity. Velocity is a symptom not a cause of anything. The fed obviously wants lending to pick up so it is handing out low cost liquidity but they aren't sitting around thinking about velocity. They are looking at the amount of credit outstanding. Money supply and velocity are just indirect indicators of credit.


HOU: Agreed. I think the Fed and the congress still has the key to the "Weapon of Mass Destruction". That weapon will kill the enemy but also run the risk to break their own system up altogether. It is just the matter whether they want to pay that high cost.

MIK: Let me elaborate more and add some statistics.

Actually, this is the similar debate of inflation vs. deflation in the market and between Friedman/Bernanke and Irvin Fisher. So far, to respond to the severe economic problems, Fed has invented many new vehicles for injecting liquidity into the economy, but few signs suggest a recovery. Total reserves in the latest 12 months increased a record 1,897%. In the latest 3 months, US M2 money stock jumped at an 18.2% yoy, one of the largest quarterly increases on record.

The belief that Friedman and Bernanke hold is that if the money supply is increased sufficiently, velocity will stabilize and Fed will at least be able to keep nominal GDP stable. Irvin Fisher, on the other hand, argues that if a generalized debt deflation takes hold, velocity will decline, just as it did during the Great Depression.

As discussed, I do not think Fed will achieve the desired results of stable V. Velocity is a function of financial innovation, rising during periods of new innovations and falling when these innovations are reversed or unchanging…this is why shadow banking has its new clear power… Fisher also suggested that V rises when leverage increases and falls when leverage abates. So far the evidence at hand suggests that V is thwarting the efforts of the Fed. In 4Q08, V has plummeted, completely offsetting the increase in M2. Thus, nominal GDP declined at a very rapid rate as we have seen (BBG 4Q08 GDP -5.5%)

What Fed has done is creating the environment for a renewed borrowing and lending cycle. This cycle would require that the debt to GDP ratio, which is already at a record level, grow even higher. Would such an outcome really be that desirable when the controlling problem of the US economy is too much improperly financed debt?

I am not able to answer this last question as Dr Ha is probably the right person to answer. As an investor, I simply keep my doubt here.


HOU: The Fed's mentality is to take over the bad assets from the banks and facilitate the lending activity by establishing multi-swap funding facilities. This is not target on the M part but the V part of the equation. The actually currency in circulation did not increase by much so far. To increase the base money by increasing bank reserve wouldn't achieve their goal, they need to print a lot if they really mean to do it.

MIK: I disagree with the point that Fed is using public debts to accelerate the money velocity. This is a simple equation as Nominal GDP= M*V. The only variable that Fed can control is M or high power money, like bank reserve. What Freidman and Bernanke want to achieve is that by increasing the M in a very big chunk that they can hold up the nominal GDP.

Unfortunately, it is V out of their hands. This in turn becomes the concerns of market as if V comes back to its normal level, along with current M, inflation is unavoidable…But as we discussed, the current M is not simply based on monetarization and V has gone as shadow banking + nominal commercial banking are dysfunctional. Thus, I think at this stage of financial/economic crisis, repairing the banking system is on the top agenda of Obama.


HOU: The FED didn't operate their printing machine at full speed for the time being. They want to use public debts to accelerate the money velocity rather than increase the currency in circulation directly. They are too clever by trying to walk on this thin rope between inflation and deflation. I respect their efforts but regret to say from the very beginning that this will be a mission impossible. The real choice left over them is which side they are willing to fall over. With the treasury yields soaring, economic still slumping and trillions of dollar promised to be given out, I see the final day of verdict is approaching. It is the time to pick the poison, no other way out.

MIK: Thanks for your insights

Economically, inflation can be classified by three types/reasons -- 1) general inflation, driven by aggregated supply and demand, and measure by CPI or Core CPI; 2) Supply shock, due to the lack of Oil production or blue ear pig disease, which can not be handled by monetary policy. 3) Asset inflation simply means too much money to chase a small group of assets.

I believe we are talking about the first one. But the reality is deflationary and what the Fed and US Treasury doing is also deflationary as the package is paid by more debt. Fed has not opened its printing machine, thus USD getting stronger. In the monetary terms, I also do not see the inflation as the velocity has vanished due to the burst of shadow banking system.

Put it in other ways, the US knows they have to borrow their way out, either domestically or externally. Letting Dollar down means letting US down…Regretting point is China and Middle East have big stake in Dollar Paper assets.

Commodity is always about supply and demand, but for commodity stocks, its about quality, quantity and hedging. Interestingly, measured by the other major currencies, gold prices have hit 1980s height nearly…That was one of the very inflation periods of US in early 1980s…This time, I doubt.

HOU: Very good observation.

The only point that I should add: inflation is not the price going up, on the contrary, price going up is the result of inflation. When we talk about inflation, most people referred to the CPI. But inflation is always a monetary phenominum so that the CPI is just a result of monetary inflation. Therefore, if the FED indeed begins to monetarize the government-debts which they don't so far, the inflation will happen anyway. I wouldn't say the US is another Zimbabuwe but that country is an example how hyperinflation and depression can happen together.

As to commodities, their prices are determined by S&D curves, while most people only see one. The first is the supply and demand of that commodity, the second is the supply and demand of the money denominated. Currently we see the demand for commodities plunging due to the economic downturn. I agree with you that this could last for a long time but the magnitude could be less severe going forward. Meanwhile, the demand of currency is soaring due to the deleveraging process. So these effects determined that the commodity price should be lower. However, in the future, the supply of commodities should be much lowered with the reason you mentioned, while the supply of money will go much higher cause the governments all want to use extra-money supply to defroze the credit market. If they "succeed", we will see higher inflation and commodity price with weak commodity demand for sure. If they don't succeed, it is a depression. So it is an either stagflation or depression scenario I mentioned in 2008. We will have more roller-coaster moves in stock and commodity prices during 2009 and 2010 for sure.

MIK: This is one of the most informative and insightful emails I have seen so far.

Indeed, the real story overnight was not in the stock market, but in US Treasury and Gold, as investors are still debating over deflation or inflation. In general, if the policy responses fail, we get deflation and I believe that gold stocks are going to be a lot more defensive than HK Utility stocks. If policy responses work, it will almost certainly we get inflation due to overdone. Asian equity markets, in particular HK, love an inflationary environment.

That said, I would rather think the deflation threat is real one. Several thoughts here for your interest:

1) Banks --- US eventually moves to the right direction as Asian Financial crisis and Sweden experience have proved this” good vs bad bank” is the only effective way to restore market function…However, it is interesting to see bank stocks fell sharply -- BOA -6.9%, Citi -5%, Wells Fargo -9.5% and JPM-6.72%, saying that it has "plenty of capital".

I think the market is right as there are several critical questions to be answered in order to access the impact on equity investors: 1) what price? This determines the loss between taxpayer and equity holders; 2) who & what are eligible? Banks and loans are likely to be priority as credit availability is key; 3) what terms are attached? TARP preferred, new lending and no bonus for executives and so on. But remember bank stocks historically do not bottom until NPL growth decelerates.

2) Economy --- did we see any signs of stabilization? US new home sales plunged almost 15% mom to 331k in Dec, far below expectations. US initial jobless claims were still at a very elevated 588K in the latest week. However, continuing claims surged an additional 159K in the week ended January 17. The labor market adjustment also is broadening its reach beyond the US. Unemployment rates have started to climb across EU and Japan. That said, firms outside of the US were slow to respond to the downturn in demand and have a lot of job shedding to do in coming Qs.

In addition, there also was additional confirmation of a deep slide in business spending as US core capital goods orders continued to plummet in Dec, pointing to another big decline in 1Q09. The signs point to a deeper downturn in business spending outside the US as well. Capital goods orders in G3 were down 44% annualized in 3M to Nov. Thus, we are looking for very negative Capex outcomes across the globe in 4Q08 and 1Q09. The collapse in global goods demand has led to a plunge in manufacturing capacity utilization. The prospect of a lengthy period of above-avg unemployment and below-avg manufacturing utilization is going to be an important factor in the inflation outlook in 2009-10. The concerns expressed about deflation risk by the FOMC are likely to be echoed elsewhere in coming months.

3) Commodity --- This one is relatively easy! Take a look of recent accelerating layoffs in the global mining and resources industry, including BHP, Conoco Phillips and Schlumberger. If economy is going to recover in 2H09 and inflation is coming back, why these big miners have different views on the commodities?

HOU: No one actually expects the US will default on its treasury, it will be going too far. However, if the US government has run into problem to issue more debts, they will have to monetarize the treasury and pump the currency in circulation up much faster as a result. This may justify what we saw the near term deflation expectation is quickly dissipating, which turns out to be good for the equity market as it also props up the risk appetite a little bit, for the time being.

I think this is trick played by the US government to balance the market inflation/deflation expectations. I compared it to " 走鋼絲 " in my weekly dated back in 08Q3, but it is still very hard to imagine that the US government can finally get it through without falling down to either side.

The "short long T-bond long gold" trade we recommended last December paid off well recently, but I think we will still have more asset price swings down the road. Flexibility should be one of the most important virtue to outperform in the 2009 market.

Geng: 新浪財經訊 據媒體報道，奧巴馬政府的財長提名人蓋特納指責中國操縱匯率，稱將敦促中國在設定人民幣匯率方麵讓市場機製發揮更大的作用。就在蓋特納此番言論發表後不久，外匯市場就出現了美國國債被大量拋售的局麵。

據路透社報道，在蓋特納說出這些話後，美國國債的價格開始下滑。另據日本共同社報道，也是在蓋特納指責中國操縱匯率之後，外匯市場立刻出現了美國國債被大量拋售的場麵。

針對蓋特納此番言論，英國《泰晤士報》 23 日發表評論說，奧巴馬政府候任財長蓋特納指責中國操作匯率的舉動將被證明是 “ 危險的策略 ” ，並可能使兩國關係受損。《泰晤士報》稱，蓋特納的舉動令市場感到 “ 驚訝 ” ，並將被證明是一個 “ 危險的策略 ” ，因為當前華盛頓的預算赤字仍在擴大，需要外界購買債券來維持開銷。 ( 小雅 )

LIN: If Dr Ha is right, and I believe his judgement is quite realistic, the politically driven trade friction will cause much unpredictable market movement and price volatility, which could frighten and depress investors worldwide, perhaps more so than the financial crisis last October when the world economy was still seemingly OK.

HA: Begger-thy-neighbor will be the policy that every country will pursue in an effort to bail itself out of the crisis, just as the global competitive devaluation witnessed in the aftermath of the Great Depressionan, which was followed by the second world war.

While we hope not to see another military war, unavoidable is an economic war in various forms of B-T-N policies, including competitive currency devaluation, increased trade protection, monetary and fiscal expansions, etc.

We will have to live in a world of low growth and high inflation in future when the current deflationary pressures fade alongside a mild economic recovery and massive mometary expansions.

In the global economic bubbles of not long ago, growth and asset price inflation were crazy due to the imbalances of the economy and the insanity of policymakers. Today, every individual country believes that they are sane in protecting themselves. But as a group they may turn out to be more insane than before.

HOU: Another risk going forward is on the Forex market. I see a recent strong move by the BOE and UK government to devalue the pound and the French financial minister has already openly criticized the UK is deliberately depreciating its currency. With the Swiss Franc and Japanese Yen recent upswing, the Swiss and Japanese financial ministers also warned that they will intervene the Forex market if their currencies keep moving stronger.

Everyone wants a relative weak currency to shoulder less burden on this economy fallout, not doubt about it. Therefore while T. Geithner said he would reinforce a so-called "strong-dollar-policy", only a few minutes later, he criticized that China is manipulating its currency and should let the Yuan appreciate.

The recent surge in the gold price, as I think, reflects the fear that major global economies are all likely to devalue their currencies to get out of this debt trap(aka. inflate out of the problem). Without knowing who will "win" this devalue competition in the end, the confidence in global currency system is greatly compromised and therefore we saw more funds flowing into the gold market.

HA: 油價也上了 10 多美元。股票和房價沒漲反跌。我去年 9 － 10 月份說的 " 半年不炒股，兩年不購房，短期投債券，長期買商品 " 在不斷應驗。不過盡管商品價格出現上漲的際象，勞動力市場仍在惡化，消費者信心依然下滑，短期通縮壓力大於通脹。

HOU: The US Treasuries have been sold-off during the last a few days. With the dollar remaining strong, gold reached 900$ per oz and shot to upside if that major barrier was breached. To me, it hints that some money was moving out of the long T-bond market. But those money relocates back to the commodity market, we may see a short term upsurge in commodity price while the economy still being very weak.

Too much money by itself isn't necessarily able to turn the economy around, but it will certainly boost the volatility of asset prices movements down the road.

FANG: 春節快樂 , 牛年大吉 ! 每日國際各主要商品期貨價格走勢 2009/01/24

黃金 ―― 紐約商品期貨交易所 (COMEX) 期金周五收高逾 4%, 一度突破 900 美元水準 , 因匯市走勢振蕩出現避險買盤 , 且投資需求強勁 .2 月期金收高 37.00 美元或 4.3%, 收報每盎司 895.80 美元 . 日內交投區間介於 852.10-903.80 美元 . 匯市走勢振蕩令市場更為緊張 , 提振對黃金的避險買盤 , 管理 3.5 億美元 GAMCO 黃金基金的投資組合經理 Caesar Bryan 說 . 金價上揚 , 盡管美元兌英鎊升至 23 年高位 , 兌歐元升至六周高點 . 金市人氣利多 , 因全球最大的黃金上市交易基金 SPDR Gold Trust GLD 表示 , 截止 1 月 22 日 , 其黃金持有量跳升至創紀錄的 819.11 噸 .

原油 ―― 紐約商業期貨交易所 (NYMEX) 周五收高逾 2 美元 , 3 月原油期貨結算價勁升 2.80 美元或 6.41%, 報每桶 46.47 美元 , 日內交投區間在 41.40-47 美元 . 因美股走穩 , 且原油交易商在權衡石油輸出國組織 (OPEC) 近期減產的影響 . 美股今日在能源股和金融股反彈中得到支撐 . 分析師指 , 因道瓊工業指數一度跌穿 8,000 點水準 , 油價早盤走軟 , 但隨後股市反彈 , 引發周末前出現空頭回補 . 取暖油期貨上揚 , 天氣預報美國東北地區天氣更為寒冷 , 該處為取暖油最大市場 , 分析師指示 , 這亦扶助油價上漲 . 汽油也跟隨整體能源產品價格而大幅上漲 , 符合整體能源市場的走勢 , 分析師說 . 股市上漲 , 道瓊工業指數因能源股和金融股強勢一度升至平盤上方 . 美元兌歐元縮減漲幅 , 因美股扳回其大部分跌幅 , 緩和對避險美元的需求 . 油價大漲也令美元承壓 . 全球商品指標 Reuters-Jefferies CRB 指數 .CRB 跳漲 2%, 觸及近兩周高位 , 因油價和其他商品價格上揚 .