Month: November 2013

So many traders think the key to investment riches lies in buying at the bottom or selling at the top: Such a fine but misguided notion. The cold reality is that unless one has (illegal) inside information, you will only transact at these locations by pure happenstance. The best managers can enter a position in a zip code near the bottom or top, but not precisely. This is why the most successful investors recognize that sizing is the critical concept. A position that is too small will not justify the effort involved in discovering a valuable idea. Even worse, a position that is too large may force a “stop out” before a brilliant theme reaches its denouement. This Commentary reveals a way to gain exposure to a popular idea, but in a manner that will allow one to hang on for the long ride it may take for full realization.

…

The lesson here is that being “right” is just not good enough to claim investment victory, one must find a way maintain exposure to the investment premise long enough to earn a profit. So let’s turn our focus to what may surely be the next “big investment theme” that has so far only succeeded in gaining the moniker of “The Widow-Maker”. If you guessed wagering upon when the Helicopter Economy of Japan will finally lose altitude, you would be correct.

 

In a tree saving effort, let me boil my argument down to this: “It is never different this time.”

– Harley Bassman, Credit Suisse      

That Japan’s economy is doomed (as best seen in this chart), as are its government bonds, is unquestionable. There is simply no way the country, faced with an inescapable demographic collapse… 

…can crawl its back to viability without imploding in an eventual deflationary singularity, from which, however, courtesy of the BOJ’s epic printathon, it may eventually inflate away its debt, but not before crucifying its currency, and the living standards of its population. In other words, there is no realistic escape.

This is not news. The problem is that for many – especially the Japanese experts – this has not been news for years and years, yet anyone and everyone who has so far bet on the collapse of the Japanese house of cards, has lost money if not gone bankrupt due to the negative carry or the time decay of any short options. Hence the name: the “widow-maker” trade.

There may, however, be a loophole for all those who, correctly, know that the end of the line for Japan is just a matter of time. The trade in question is described by the “convexity maven” – Credit Suisse’s Harley Bassman:

The Trade

Taking a “short position” in either Japanese interest rates or their currency is a fundamentally sound idea; however it may take three to seven years for the “Macro-profits” to be fully realized. Over that time, a short position will demand a cost, either in the terms of the negative carry of a spot position or the time decay of a short-dated option. Additionally, since it is unlikely you will enter the trade at the extreme, there could be some mark-to-market vibrations that may breach your risk limits.

To the rescue is the strange circumstance of a widening USD vs. JPY Rate differential in conjunction with a flattening Volatility Term Surface. Below is a table of mid-market values for Par Strike USD call // JPY put options with expiries from one-year to ten-years. The critical observation is that a five-year option costs more than a ten-year option; thus the weird dynamic of owning an option with (effectively) positive “theta”: You are paid to own an option !

This is neither financial “magic” nor an “option special”; these are all plain vanilla options than can be priced using Bloomberg’s OVDV screen. Rather, it is merely the interesting mathematical paradox between the Rate process which is Linear and the Time process which is Logarithmic.

In a nutshell, net interest income is linear to time so two years of coupon payments are twice the size as a single year’s value. In contrast, an option’s price increases with the square root of time, so a two-year option is only 1.4 times greater in price than a one-year option.

The easy execution of this idea is just to buy a ten-year call option and put it away for five years:

Strike = 100; Price ~~ Customer pays 7.375%
Strike = 110; Price ~~ Customer pays 5.375%
Strike = 120; Price ~~ Customer pays 4.125%

The more interesting trade might be to execute a five-year vs. ten-year calendar:

Sell five-year vs. Buy ten-year, Strikes = 100; Client receives 0.50%
Sell five-year vs. Buy ten-year, Strikes = 110; Client pays 0.750%
Sell five-year vs. Buy ten-year, Strikes = 120; Client pays 1.375%

Summary

1) The maximum loss for an out-right purchase is limited to the fee paid;
2) The “net” option decay is positive for longer-dated options;
3) Provides the time required to capture the “event risk” of the premise;
4) JPY rates should likely increase at a faster pace than USD rates when Japan finally needs to externally fund itself. Thus one owns a “rates kicker” since the steep negative slope of the forward currency spread will collapse (and may ultimately invert). This would greatly benefit the calendar spread execution.

The lesson from so many of the great Macro Investments Themes is that it sometimes takes the “fullness of time” to realize the largest profits. Unfortunately, the current environment has less patience to tolerate investment costs, as such a “Positive Carry” long option position should be quite interesting.

The Japanese financial situation will normalize at some point; being “paid to wait” for the first five years solves the thorny problem of trying to time that date.

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/aRQK2WumREA/story01.htm Tyler Durden

So many traders think the key to investment riches lies in buying at the bottom or selling at the top: Such a fine but misguided notion. The cold reality is that unless one has (illegal) inside information, you will only transact at these locations by pure happenstance. The best managers can enter a position in a zip code near the bottom or top, but not precisely. This is why the most successful investors recognize that sizing is the critical concept. A position that is too small will not justify the effort involved in discovering a valuable idea. Even worse, a position that is too large may force a “stop out” before a brilliant theme reaches its denouement. This Commentary reveals a way to gain exposure to a popular idea, but in a manner that will allow one to hang on for the long ride it may take for full realization.

…

The lesson here is that being “right” is just not good enough to claim investment victory, one must find a way maintain exposure to the investment premise long enough to earn a profit. So let’s turn our focus to what may surely be the next “big investment theme” that has so far only succeeded in gaining the moniker of “The Widow-Maker”. If you guessed wagering upon when the Helicopter Economy of Japan will finally lose altitude, you would be correct.

 

In a tree saving effort, let me boil my argument down to this: “It is never different this time.”

– Harley Bassman, Credit Suisse      

That Japan’s economy is doomed (as best seen in this chart), as are its government bonds, is unquestionable. There is simply no way the country, faced with an inescapable demographic collapse… 

…can crawl its back to viability without imploding in an eventual deflationary singularity, from which, however, courtesy of the BOJ’s epic printathon, it may eventually inflate away its debt, but not before crucifying its currency, and the living standards of its population. In other words, there is no realistic escape.

This is not news. The problem is that for many – especially the Japanese experts – this has not been news for years and years, yet anyone and everyone who has so far bet on the collapse of the Japanese house of cards, has lost money if not gone bankrupt due to the negative carry or the time decay of any short options. Hence the name: the “widow-maker” trade.

There may, however, be a loophole for all those who, correctly, know that the end of the line for Japan is just a matter of time. The trade in question is described by the “convexity maven” – Credit Suisse’s Harley Bassman:

The Trade

Taking a “short position” in either Japanese interest rates or their currency is a fundamentally sound idea; however it may take three to seven years for the “Macro-profits” to be fully realized. Over that time, a short position will demand a cost, either in the terms of the negative carry of a spot position or the time decay of a short-dated option. Additionally, since it is unlikely you will enter the trade at the extreme, there could be some mark-to-market vibrations that may breach your risk limits.

To the rescue is the strange circumstance of a widening USD vs. JPY Rate differential in conjunction with a flattening Volatility Term Surface. Below is a table of mid-market values for Par Strike USD call // JPY put options with expiries from one-year to ten-years. The critical observation is that a five-year option costs more than a ten-year option; thus the weird dynamic of owning an option with (effectively) positive “theta”: You are paid to own an option !

This is neither financial “magic” nor an “option special”; these are all plain vanilla options than can be priced using Bloomberg’s OVDV screen. Rather, it is merely the interesting mathematical paradox between the Rate process which is Linear and the Time process which is Logarithmic.

In a nutshell, net interest income is linear to time so two years of coupon payments are twice the size as a single year’s value. In contrast, an option’s price increases with the square root of time, so a two-year option is only 1.4 times greater in price than a one-year option.

The easy execution of this idea is just to buy a ten-year call option and put it away for five years:

Strike = 100; Price ~~ Customer pays 7.375%
Strike = 110; Price ~~ Customer pays 5.375%
Strike = 120; Price ~~ Customer pays 4.125%

The more interesting trade might be to execute a five-year vs. ten-year calendar:

Sell five-year vs. Buy ten-year, Strikes = 100; Client receives 0.50%
Sell five-year vs. Buy ten-year, Strikes = 110; Client pays 0.750%
Sell five-year vs. Buy ten-year, Strikes = 120; Client pays 1.375%

Summary

1) The maximum loss for an out-right purchase is limited to the fee paid;
2) The “net” option decay is positive for longer-dated options;
3) Provides the time required to capture the “event risk” of the premise;
4) JPY rates should likely increase at a faster pace than USD rates when Japan finally needs to externally fund itself. Thus one owns a “rates kicker” since the steep negative slope of the forward currency spread will collapse (and may ultimately invert). This would greatly benefit the calendar spread execution.

The lesson from so many of the great Macro Investments Themes is that it sometimes takes the “fullness of time” to realize the largest profits. Unfortunately, the current environment has less patience to tolerate investment costs, as such a “Positive Carry” long option position should be quite interesting.

The Japanese financial situation will normalize at some point; being “paid to wait” for the first five years solves the thorny problem of trying to time that date.

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/aRQK2WumREA/story01.htm Tyler Durden

Submitted by William L Anderson of The Ludwig von Mises Institute,

After studying and teaching Keynesian economics for 30 years, I conclude that the “sophisticated” Keynes­ians really do believe in magic and fairy dust. Lots of fairy dust. It may seem odd that this Aus­trian economist refers to fairies, but I got the term from Paul Krugman.

According to Krugman, too many people place false hopes in what he calls the “Confidence Fairy,” a creature created as a retort to economist Robert Higgs’s concept of “regime uncertainty.” Higgs coined that expression in a 1997 paper on the Great Depression in which he claimed that uncertainty caused by the policies of Franklin Roosevelt’s New Deal was a major factor in the Great Depression being so very, very long.

Nonsense, writes Krugman. Investors are not waiting for governments to “get their financial houses in order” and protect private property. Instead, he claims, investors are waiting for governments to spend in order to create enough “aggregate demand” in the economy to bring about new investments and, one hopes, full employment.

According to Higgs, the “humor columnist for the New York Times, Paul Krugman, has recently taken to defending his vulgar Keynesianism against its critics by accusing them of making arguments that rely on the existence of a ‘confidence fairy.’ By this mockery,” Higgs says, “Krugman seeks to dismiss the critics as unscientific blockheads, in contrast to his own supreme status as a Nobel Prize-winning economic scientist.”

It seems, however, that Krugman and the Keynesians have manufactured some fairies of their own: the Debt Fairy and the Inflation Fairy. These two creatures may not carry bags of fairy dust, but they might as well, given that their “tools” of using government debt and printing money to “revitalize” the economy have the same scientific credibility.

Let us first examine the Debt Fairy. According to the Keynesians, the U.S. economy (as well as the economies of Europe and Japan) languishes in a “liquidity trap.” This is a condition in which interest rates are near-zero and people hoard money instead of spending it. Lowering interest rates obviously won’t spur more business borrowing, so it is up to the government to take advantage of the low rates and borrow (and borrow).

If governments issue enough debt, argue Debt Fairy True Believers, the econ­omy will gain “traction” as government spending, through the power of pixie dust, fuels a recovery. Governments spend, businesses magically gain confidence, and then they spend and invest. (At this point, we are apparently supposed to just overlook the fact that the Keynesians are saying that we need the Debt Fairy to resurrect the Keynesian version of the Confidence Fairy.)

The Inflation Fairy also plays an important role, according to Keynesians, for if bona fide inflation can take hold in the econ­omy and people watch their money lose value, then they will spend more of their savings. In turn, this destruction of savings will, through the power of Keynesian sorcery, revive the econ­omy. Thus inflation undermines what Keynesians call the “Para­dox of Thrift,” a theory that says if a lot of people withhold some present consumption in order to save for future con­sumption, the economy quickly will implode and ultimately will slip into a Liquidity Trap in which no one will spend anything.

These fairies can work their magic if (and only if) one condition exists: factors of production are homogeneous, which means that government spending will enable all lines of production simultaneously. The actual record of the boom-and-bust cycle, however, tells a different story. It seems that the Debt and Inflation Fairies enable booms along certain lines of production (such as housing during the past decade), but as everyone knows, the fairy dust lost its magical powers and the booms collapsed into recessions.

Austrians such as Mises and Rothbard have well under­stood what Keynesians do not: the structures of produc­tion within an economy are heterogeneous and can be distorted by government intervention through inflation and massive borrowing. Far from being creatures that can “save” an economy, the Debt Fairy and the Inflation Fairy are the architects of economic disaster.

Despite Keynesian protestations that the U.S. and European governments are engaged in “austerity,” the twin fairies are active on both continents. The fairy dust they are sprinkling on the economy, however, is more akin to sprinkling ricin on humans. In the end, the good fairies turn into witches.

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/iMay7rCnCLQ/story01.htm Tyler Durden

Grant Williams "pulls no punches" in this all-encompassing presentation as the "Things That Make You Go Hmmm" author reflects on what is behind us and looks ahead at the ugly reality that we will face when "the impurities of QE are finally flushed from the system." Central bankers of today have "changed everything" he chides, "in ways that will ultimately end in disaster." Following extraordinarily easy monetary policies across all of the world's central banks, Williams explains why "we are now near the popping point of the 3rd major bubble of the last 15 years," each bigger than the last. The only way Janet Yellen avoids being at the helm when this ship goes down is to blow an even bigger bubble than Bernanke's government bond experiment, "which is highly unlikely." From how QE works, why many don't "feel" wealthy anymore, to the fact that "the geniuses that gave this thing life, don't have the guts to kill it," Williams warns, ominously, "the bills have come due on the blissful latest 30 years."

Starting at around 2:30… Williams introduces the 'extraordinary' differences with today's crop of central bankers

 

5:30 The bubble blowing begins (and ends)

6:45 How QE Works and "why the geniuses that gave this thing life, don't have the guts to kill it."

7:45 Investing Now and Then

9:00 "The bills have come due on the blissful latst 30 years"

9:30 The implications for markets

 

11:00 BoJ specifics…

11:30 Why rotating from bonds to stocks is nuts – even though bonds are in a bubble

13:00 China is flashing red… "if you thikn that doesn't mean anything, then you're wrong"

14:00 Aussie macro and micro economics

18:30 Pension Funds disaster pending – return projections are entirely wrong

22:30 Central Deviousness

23:45 Where Does That Leave Us? – "The Taper is not going to happen in any meaningful way" – The US economy is simply not strong enough.

26:00 So What Do We Do

 

30:00 "Be Brave – Take your money out of the markets and go to cash."

31:00 "Once the impurities of QE are flushed from the system, we can go back to investing in a world that is understandable"

31:30 We've been here before…

 

"Returning to a world with which we are familiar is going to require either some real magic on the parts of Draghi, Kuroda, Carney, and soon to be Yellen; or some kind of tornado that sweeps away everything in its path and allows the world to build again from more solid foundations."

 

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/VpXiSXVZ2C0/story01.htm Tyler Durden

In the aftermath of Ray Dalio’s conversion to an inflationista earlier this year (even if he has since once again been pushing a deflationary agenda when he once again went long Treasurys in late September as Zero Hedge reported previously), which promptly got such permanent deflationists as David Rosenberg to change their multi-year tune, it seemed as if there was nobody left in the deflationary camp. Which, implicitly meant Bernanke was winning as the world’s expectations for a return to inflation were rising (remember: hyperinflation has nothing to do with inflation per se, and everything to do with loss of confidence in a currency, even if formerly a reserve), and also meant the Fed would need to do less to further its reflationary agenda.

Alas, as the Taper Tantrum and the shock upon its subsequent withdrawal showed, not to mention the recent outright disinflation in Europe, any rumors that the Fed was back in control were wildly exagerated, and here we find ourselves, entering the last month of 2013 with loud speculation that not only will the BOJ increase its own QE but the ECB itself will have no choice but to join the QE party (even as the Fed may or may not taper although it is increasingly looking likely that with an economy this late in the cycle, Yellen will simply forego tapering altogether, and may even navigate Bernanke’s chopper) in order to stoke even more inflation as the current amount was, surprise, insufficient. We ignore all discussion of what such a reckless action would mean for the credibility of fiat, although we remind readers that right now both the US and Japan monetize 70% of their gross bond issuance, and thus deficit.

So with everyone expecting deflation to have been conquered early in 2013, only for events to once again show that neither is it conquered, nor are central banks in charge despite having a collective balance sheet of over $10 trillion, we have once again gotten a demonstration of Bob Farrell’s rule #9: ” When all the experts and forecasts agree – something else is going to happen.” And yet, that is not exactly true: not all “experts” think the Fed has won the fight, and the deflation has been conquered (what the Fed’s response to even more deflation will be is a separate topic altogether, but it is not rocket surgery to assume “more of the same” until one day the Fed breaks the dollar itself). CLSA’s Russell Napier has just written perhaps the most vocal pro-deflation piece we have read in a long time. It is titled, appropriately enough, “An ill wind.“

Selected extracts from CLSA’s Russell Napier:

Inflation has fallen to 1.10/0 in the USA and 0.7% in the Eurozone and we are now perilously close to deflation. Reflation is needed to relieve debt burdens throughout society and in doing so to bolster corporate equity. Investors are cheering the direct impact of QE on their equity valuations, but ignoring its failure to produce sufficient nominal-GDP growth to reduce debt. In a market where such bad news has been seen as good news (as it leads to more QE.), the reality of QE’s failure will become bad news as we head towards deflation.

 

When US inflation fell below 1% in 1998, 2001-02 and 2008-09, equity investors saw major losses. If a similar deflation shock hits us now, those losses will be exacerbated, since the available monetary responses are much more limited than they were in the past.

 

For investors who cannot take the risk of leaving the bull-market party too early, this report focuses on three leading indicators of imminent deflation: copper prices; inflation expectations, as implied by the difference in yield between five-year Treasuries and Treasury inflation-protected securities (TIPS); and the spread on BAA corporate bonds.

 

With US inflation already dangerously low, a significant decline in copper prices would signal a major deflation shock. Investors should sell equities if the five-year TIPS-implied inflation rate falls from the current 1.86% to 1.50% or below, or if the spread on BAA corporate bonds rises from the current 262bps to 300bps or higher.

 

Deflationary winds are strengthening Japanese corporations continue to cut their US-dollar selling prices, forcing Chinese and Korean exporters to follow suit, A further major fall in the yen would ratchet up the pressure. Meanwhile, broad-money growth remains anaemic across the developed world. In the USA, the Fed’s failure to create normal broad-money growth is intensifying as bank credit growth slows rapidly, while in the Eurozone, bank credit to the private sector is now contracting more rapidly than it did in 2009. The failure of monetary policy to defeat deflation is about to become apparent, with dire consequences for equity prices.

 

Conclusion

 

We are on the eve of a deflationary shock which will likely reduce equity valuations from very high to very low levels. This research seeks to provide investors with some lead indicators as to when the current disinflationary forces erupt into a destructive deflation. Each investor must decide for themselves just how close to midnight they want to leave this particular party. The advice of Solid Ground is leave now as it is increasingly likely that one event will be the catalyst to very rapidly change inflationary into deflationary expectations. Indeed, when key prices are already falling across the globe, one should expect one key major credit event to occur.

 

Three times since 1997 inflation has fallen below 1% with very negative impacts for equity investors. On all three occasions an existing low level of inflation was forced lower by dramatic events: the bankruptcy of Russia and collapse of LTCM in 1998; the terrorist attacks of 11 September 2001; and the bankruptcy of Lehman Brothers in September 2008. While nobody would attribute the 11 September atrocity with extant global deflationary forces, the other two episodes can clearly be associated with such forces. So perhaps it is global deflationary forces creating a bankruptcy event, somewhere in the world, that is the catalyst for a sudden change in inflationary expectations in the developed world. It can all happen very quickly; and it is dangerous to stay at an equity party driven by disinflation when it can spill so rapidly into deflation.

 

In 1998 falling export prices triggered a Russian default, and in 2008 falling US house prices triggered the Lehman bankruptcy. Going back further, deflation in the oil price in 1982 produced a Mexican default and a credit event which threatened to bring down the US banking system. Deflation in these key prices produced a credit event which rapidly produced a major reassessment of the outlook for the general price level. Across the world today we see falling commodity prices and, primarily due to the weak yen, falling manufactured-goods prices. When there is plenty of leverage in the system and any key price starts to decline then a credit event and a sudden change in inflationary expectations are much more possible than the consensus believes. So watch the TIPS, BAA bond spreads and copper if you must, but this analyst prefers to observe the party from outside.

* * *

We wonder how long before the lack of controlled (that being the key word) inflation will the recent inflationary converts throw in the towel again and once again start pounding the deflationary drum. Actually, in retrospect, we couldn’t care less. The bigger question, as has been the case from Day 1 of QE, is how long until the disproportionate response to even more deflation will the Fed react, as it always does, with even moar stimulus, until it finally does just enough to force consensus to finally begin doubting the viability of the current reserve currency under the mentorship of the Marriner Eccles monetary mandarins. Because as we never tire, no monetary system (or nation, or civilization for that matter) has ever ceased to exist due to hyperdeflation – the cause has always been the response of the ruling class to said deflation.

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/R7OXJDWwpFk/story01.htm Tyler Durden

In the aftermath of Ray Dalio’s conversion to an inflationista earlier this year (even if he has since once again been pushing a deflationary agenda when he once again went long Treasurys in late September as Zero Hedge reported previously), which promptly got such permanent deflationists as David Rosenberg to change their multi-year tune, it seemed as if there was nobody left in the deflationary camp. Which, implicitly meant Bernanke was winning as the world’s expectations for a return to inflation were rising (remember: hyperinflation has nothing to do with inflation per se, and everything to do with loss of confidence in a currency, even if formerly a reserve), and also meant the Fed would need to do less to further its reflationary agenda.

Alas, as the Taper Tantrum and the shock upon its subsequent withdrawal showed, not to mention the recent outright disinflation in Europe, any rumors that the Fed was back in control were wildly exagerated, and here we find ourselves, entering the last month of 2013 with loud speculation that not only will the BOJ increase its own QE but the ECB itself will have no choice but to join the QE party (even as the Fed may or may not taper although it is increasingly looking likely that with an economy this late in the cycle, Yellen will simply forego tapering altogether, and may even navigate Bernanke’s chopper) in order to stoke even more inflation as the current amount was, surprise, insufficient. We ignore all discussion of what such a reckless action would mean for the credibility of fiat, although we remind readers that right now both the US and Japan monetize 70% of their gross bond issuance, and thus deficit.

So with everyone expecting deflation to have been conquered early in 2013, only for events to once again show that neither is it conquered, nor are central banks in charge despite having a collective balance sheet of over $10 trillion, we have once again gotten a demonstration of Bob Farrell’s rule #9: ” When all the experts and forecasts agree – something else is going to happen.” And yet, that is not exactly true: not all “experts” think the Fed has won the fight, and the deflation has been conquered (what the Fed’s response to even more deflation will be is a separate topic altogether, but it is not rocket surgery to assume “more of the same” until one day the Fed breaks the dollar itself). CLSA’s Russell Napier has just written perhaps the most vocal pro-deflation piece we have read in a long time. It is titled, appropriately enough, “An ill wind.“

Selected extracts from CLSA’s Russell Napier:

Inflation has fallen to 1.10/0 in the USA and 0.7% in the Eurozone and we are now perilously close to deflation. Reflation is needed to relieve debt burdens throughout society and in doing so to bolster corporate equity. Investors are cheering the direct impact of QE on their equity valuations, but ignoring its failure to produce sufficient nominal-GDP growth to reduce debt. In a market where such bad news has been seen as good news (as it leads to more QE.), the reality of QE’s failure will become bad news as we head towards deflation.

 

When US inflation fell below 1% in 1998, 2001-02 and 2008-09, equity investors saw major losses. If a similar deflation shock hits us now, those losses will be exacerbated, since the available monetary responses are much more limited than they were in the past.

 

For investors who cannot take the risk of leaving the bull-market party too early, this report focuses on three leading indicators of imminent deflation: copper prices; inflation expectations, as implied by the difference in yield between five-year Treasuries and Treasury inflation-protected securities (TIPS); and the spread on BAA corporate bonds.

 

With US inflation already dangerously low, a significant decline in copper prices would signal a major deflation shock. Investors should sell equities if the five-year TIPS-implied inflation rate falls from the current 1.86% to 1.50% or below, or if the spread on BAA corporate bonds rises from the current 262bps to 300bps or higher.

 

Deflationary winds are strengthening Japanese corporations continue to cut their US-dollar selling prices, forcing Chinese and Korean exporters to follow suit, A further major fall in the yen would ratchet up the pressure. Meanwhile, broad-money growth remains anaemic across the developed world. In the USA, the Fed’s failure to create normal broad-money growth is intensifying as bank credit growth slows rapidly, while in the Eurozone, bank credit to the private sector is now contracting more rapidly than it did in 2009. The failure of monetary policy to defeat deflation is about to become apparent, with dire consequences for equity prices.

 

Conclusion

 

We are on the eve of a deflationary shock which will likely reduce equity valuations from very high to very low levels. This research seeks to provide investors with some lead indicators as to when the current disinflationary forces erupt into a destructive deflation. Each investor must decide for themselves just how close to midnight they want to leave this particular party. The advice of Solid Ground is leave now as it is increasingly likely that one event will be the catalyst to very rapidly change inflationary into deflationary expectations. Indeed, when key prices are already falling across the globe, one should expect one key major credit event to occur.

 

Three times since 1997 inflation has fallen below 1% with very negative impacts for equity investors. On all three occasions an existing low level of inflation was forced lower by dramatic events: the bankruptcy of Russia and collapse of LTCM in 1998; the terrorist attacks of 11 September 2001; and the bankruptcy of Lehman Brothers in September 2008. While nobody would attribute the 11 September atrocity with extant global deflationary forces, the other two episodes can clearly be associated with such forces. So perhaps it is global deflationary forces creating a bankruptcy event, somewhere in the world, that is the catalyst for a sudden change in inflationary expectations in the developed world. It can all happen very quickly; and it is dangerous to stay at an equity party driven by disinflation when it can spill so rapidly into deflation.

 

In 1998 falling export prices triggered a Russian default, and in 2008 falling US house prices triggered the Lehman bankruptcy. Going back further, deflation in the oil price in 1982 produced a Mexican default and a credit event which threatened to bring down the US banking system. Deflation in these key prices produced a credit event which rapidly produced a major reassessment of the outlook for the general price level. Across the world today we see falling commodity prices and, primarily due to the weak yen, falling manufactured-goods prices. When there is plenty of leverage in the system and any key price starts to decline then a credit event and a sudden change in inflationary expectations are much more possible than the consensus believes. So watch the TIPS, BAA bond spread
s and copper if you must, but this analyst prefers to observe the party from outside.

* * *

We wonder how long before the lack of controlled (that being the key word) inflation will the recent inflationary converts throw in the towel again and once again start pounding the deflationary drum. Actually, in retrospect, we couldn’t care less. The bigger question, as has been the case from Day 1 of QE, is how long until the disproportionate response to even more deflation will the Fed react, as it always does, with even moar stimulus, until it finally does just enough to force consensus to finally begin doubting the viability of the current reserve currency under the mentorship of the Marriner Eccles monetary mandarins. Because as we never tire, no monetary system (or nation, or civilization for that matter) has ever ceased to exist due to hyperdeflation – the cause has always been the response of the ruling class to said deflation.

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/R7OXJDWwpFk/story01.htm Tyler Durden

Originally posted at Monty Pelerin’s World blog,

Whether the light at the end of the economic tunnel represents sunshine or an on-coming train depends on whom you ask. I am of the opinion that it is a train a comin’. Economic matters cannot get better until we hit bottom and rebuild from the ashes. That need not be except government policies drive us there.

Government, especially the current one, has incented people to not work by providing overly long and generous benefits. Society has an obligation to take care of its less fortunate, but it does not have an obligation to encourage people to join that group and then make it comfortable enough that they have little incentive or ability to leave. The dole should not be a safety net, not a career choice!

One political party in particular has interest in seeing dependency grow. It forms a substantial part of their support and power. The creation of more dependents is the creation of more voters and more electoral success. No society can grow or recover when government deliberately undermines the need to work. That path leads to poverty and destruction.

Printing money is no substitute for effort. It does not create things or wealth. The myth of Keynesian economics is not the answer to a society that declines in labor force participation and has fewer productive people supporting more dependents. Incentives at the individual level must be changed in order to make work more desirable and attractive than welfare.

A society whose workforce is in decline is one that can pretend to live at former levels only by consuming the wealth and capital created by previous generations. This behavior is equivalent to the man who used to make $250,000 per year in a job and now is unemployed. To save face, he continues to live as if he is still earning at his previous rate. He achieves this short-run living style only by consuming the capital that he built up from years of hard work. At some point, he runs out of capital and must live as a pauper (or the modern equivalent of one).

Our economy and government both behave like this formerly rich man. Both are consuming the seed corn in order to maintain the appearance of well-being. Politicians will continue this behavior until the music stops. Hopefully when that happens there is enough left of society and freedom to allow a rejuvenation.

Many believe that government and its partner the Federal Reserve are wise and strong enough to avoid this crash. If printing money and spending money were a solution, there would be no poverty anywhere in the world. Even the poorest country has a government and can afford a printing press.

Thus far there has been no collapse. However, that is equivalent to the man who jumps off the Empire State building and is heard to say as he flashes by the fortieth floor: “So far, so good.” His fate was sealed when he jumped. Similarly, so is our economy’s. Economics has its own gravity. It is as powerful and immutable as that of physics.

“So far so good” is not acceptable for an economy. There has been no economic recovery since one was falsely declared in June of 2009. The distortions and mis-allocations imposed on the economy for the last several decades are cumulative and have finally reached that stage where they can no longer be covered up. The myth of a recovery is getting harder to maintain.

A complete cleansing of the mal-investments, distorted incentives and regulatory burdens must occur before a true recovery can take place.

Can the economy flutter around is some kind of air pocket at the fortieth floor for a year or even several before resuming its destiny with terra firma? Perhaps, but it cannot fly without wings and these have been removed by regulatory interference and economic interventions over the course of decades. They can re-grow, but not before a complete and total cleansing.

A major crash is coming. The dot.com bubble and the housing bubble were not crashes, at least as I imagine a crash. They were the beginnings of corrections that were aborted by government economic intervention. The country survived these two major bubbles, but only at the cost of making the next one bigger. Government did not save us from these two events. They created them and by deferring their correction assured the next one would be bigger and more painful.

The video below shows a train moving down a track. It struck me as a reasonable metaphor for our economy. The train represents market forces, slow but powerful. The train does not appear threatening. But, like markets, it represents a massive force. That the video is in slow motion exaggerates the surprise and the force.

Government may believe it is in control of the economy, but it is not. It may think it is influencing and controlling outcomes. To some degree it is and has. However the forces that have built up over decades of these interventions cannot, at some point, be controlled. The mismatch between Ben Bernanke, Barack Obama, the Federal establishment and all their dollars and regulations is about to be run over by the train that represents decades of suppressed market forces.

No government is a match for hundreds of millions of citizens who are represented by markets. Suppressing markets is suppressing the will of citizens. At some point markets dig in their heals and say enough. Then government is helpless.

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/NanCpgbkqZA/story01.htm Tyler Durden