Deflation Delayed is not Deflation
Sep 7, 2004
Sometimes you just have to sit back and watch. Since the correction
that started in April for the precious metal sector, we've had
an onslaught of credible arguments for both hyperinflation and
deflation. There are so many global moving parts that it's really
difficult to account for every factor that may come into play
once one or more of the myriad of economic imbalances attempts
to balance itself. Many analysts have used what appears to be
a US-centric view in a somewhat static, two dimensional environment
to put forth the "synthetic short" dollar thesis. This
argument has merit in that environment, but fails to fully account
for the forces that will come into play in a dynamic, global,
multi-dimensional World. I can't begin to predict how humans
all over the World will vote with their wallets once the dominos
start to fall, but I do know that there's an age-old saying that
"money goes where it's treated best."
My gut feeling is that will not be a force that moves the USDollar
into strength over the long term.
Back at the end of 2003 when I wrote "Where
Did All The Money Go" I asserted that much of the money
supply expansion had found its way into the stock market fueling
a cyclical bull within the secular bear. I still believe this
was true; that's where the money was treated best. I also asserted
that unless the Fed was able to reverse the topping pattern in
the money supply that showed up in the latter half of 2003, we'd
likely see a corresponding outflow from the equity markets. In
fact, the Fed was able to resume the monetary inflation in early
2004 with the help of Japan's unprecedented intervention in the
currency markets along with China's need to find a place to put
their huge trade surpluses. Much of that foreign help has slowed
as those countries seek diversification away from dollar denominated
Once again we find ourselves in much the same situation as we
did last year; the broadest measure of the money supply (M3)
appears to have stopped or at least slowed its expansion.
Here are the raw numbers
For an economy that has experienced
annual monetary inflation in the neighborhood of $6-700 billion
per year over the last several years, a 4 month M3 growth of
only $30 billion certainly qualifies as flat. I believe
we're once again backed into the corner as the Fed is desperately
attempting to keep a monetary deflation from taking place. Unfortunately,
this time it's different from last fall because we have an upward
bias on interest rates with most consumers already tapped out
of their extra "free" money from home equity loans
or cash-out refis.
So, who's left to borrow?
Since a fractional reserve banking system uses debt as its foundation
in the creation of money, we need additional borrowers to avoid
monetary deflation. Also, if the money supply begins to contract
or deflate, then I still think we'll experience capital flight
from the equity markets as many will find their money treated
better by retiring debt, holding cash, or moving into safe havens
like the precious metals. I believe this process has resumed.
In addition, based on the number of foreign investors holding
US equities, I consider it a strong possibility that they'll
simultaneously liquidate their equities and flee from the USDollar
heading back into the currency that treats them best. Also, foreign
central banks may find it necessary at some point to divest a
portion of their US Treasury Bond holdings once the dominos begin
to fall. This foreign movement away from Dollars will counteract
any "synthetic short" strengthening of the USDollar
within the US-centric marketplace. Nevertheless, the short term
ebbs and flows will be extremely hard to predict as volatility
will increase substantially in the FOREX currency markets.
In the end, the USDollar will plummet to all-time lows sending
the anti-Dollar, Gold, to all-time highs.
While I was sitting back watching, waiting, listening, and learning
from others, I continued to search for the missing link that
correlated the recent action in the equity markets to the money
supply. Among the many monetary aggregates available, I started
watching the M1 Money Multiplier with interest. The M1 Multiplier
is a crude gauge of the effects of money growth on the most liquid
end of the money supply. It's basically M1 expansion relative
to the monetary base. M1consists of currency held by the public,
travelers checks, demand deposits, and other checkable deposits
while the monetary base consists of deposits (reserves) held
by depository institutions at Federal Reserve Banks plus Treasury
currency and coins outstanding.
Since all money is loaned into existence, it stands to reason
that a portion of that newly created money will find its way
into demand or checkable deposits. Much of our post-bubble recovery
has relied on consumers tapping into their home equity through
loans or refinances. Those loans were deposited and then used
for everything from big screen televisions to jet skis, but I
also believe a significant portion was used in a "personal
carry trade" where people invested their borrowed home equity
money in the stock market. The potential for this "personal
carry trade" may have a direct relationship with the activity
on the most speculative end of the equity markets, the Nasdaq.
My rationale is that should people have excess cash earning little
or no return, or untapped low interest lines of credit where
they feel their market rate of return will exceed their tax exempt
rate of interest, then they're likely to find a place where they
feel that money is treated better. Conversely, people will draw
down their riskiest investments first to satisfy their short
term needs for cash once they are unable or no longer wish to
borrow, or when their portfolio's value approaches their outstanding
loan balance. Here's a comparison of the M1
Money Multiplier to the Nasdaq (courtesy of StockCharts.com).
Is this a coincidence?
First, just simply look at
these two combined charts from a distance and notice their similarities.
The topping of the Nasdaq occurred simultaneously with the topping
of the M1 Multiplier (1).
The Multiplier reached an intermediate low and reversed upward
prior to descending to a final bottom ahead of the Nasdaq (2 and 3).
The Mulitplier came off the bottom first (3)
and began a steady climb into mid-2003 where it then flattened
while the Nasdaq continued up into its cyclical bull top (4). I believe this flattening signaled deflationary
trouble as well as the impending equity market tops down the
road. Recall that there was also a mid-year bond market plunge
as well as a flattening of the broader M3 money supply in the
second half of the year as evidenced by the first chart. Finally,
the Fed realized there was trouble and began an all out effort
to inflate the money supply in the first several months of 2004.
This is apparent as you can see an initial divergence (5) as the Multiplier climbed to an intermediate
top after the Nasdaq had begun its descent from the early 2004
top. That stimulus has exhausted itself. Finally, notice the
close synchronization of the recent moves between the two with
both apparently hooking downward.
Once again, I believe the trend toward a monetary flat-line will
continue to bode ill for the equity markets unless the Fed can
force another reversal to the upside. Should the monetary trend
move in a negative direction, then I believe we could possibly
see a precipitous market drop as we move directly into the jaws
of deflation. There's a dire need for borrowing; this is the
fatal flaw of fractional reserve banking. The Fed can affect
the monetary base, but they cannot create borrowers that cycle
money through the economy creating economic activity. Unfortunately,
while the Fed is the lender of last resort, the government is
the borrower of first and last resort. In this election
year environment one wouldn't expect too much to happen, but
post-election could bring on a new, full blown round of economic
stimulus regardless of the election's outcome.
So, if the government is the only one left to borrow, then for
what purpose could they possibly find that would have the full
backing and support of our entire nation?
Should there be a perceived or real defensive need to save our
country, we'll willingly sacrifice anything and everything, including
the Constitution and the USDollar, to preserve our republic.
My guess is the war will spread, the borrowing will resume, the
money supply will expand, the dollar will fall, the bankers will
profit, monetary hyperinflation will spillover into consumer
prices, and many more of our nation's youth will be asked to
go into harm's way. The inevitable deflationary outcome will
not be thwarted; it will only be delayed by this hyperinflation
at an ever increasing cost in both economic and human terms.
You see... deflation delayed is not deflation denied!
Sep 5, 2004
Copyright © 2004 David S. Chuhran. All Rights Reserved