This phenomenon will push price inflation much higher, giving you an opportunity to profit on the “reflation trade” that will play out over the next decade.

“Mr. Market” is starting to show clear signs of split personality disorder.

On the one hand, certain areas of the market – the ones much favored in the big run-up – have started to wilt and fade as the much-lauded “green shoots” turn brown. On the other hand, other areas of the market – which didn’t participate so much in the rally at first – have started showing signs of life.

Take the grain markets for example. Foodstuffs like corn, wheat, soybeans and sugar have been red-hot in recent days.

We can see this in the Powershares DB Agriculture Fund (DBA:NYSE), which Macro Trader has been long for a number of weeks. (We took partial profits earlier this week, and continue to ride the move with the remainder of our position.)

DBA, which is NOT built around “total return swaps” like other inverse/leveraged funds, is essentially a basket of futures contracts – primarily wheat, corn and soybeans, with sugar thrown in for good measure.

Commodity after commodity has roared back to life, thanks to a combination of renewed inflation expectations, a cratering U.S. dollar, and newly bullish fundamentals. Let’s take a closer look at some of DBA’s components to see what I mean.

Prices as High as an Elephant’s Eye

“Corn prices surged to a six-month high,” Bloombergreported earlier this week, “after the U.S. government said domestic demand will exceed production for the third time in four years, slashing reserves by 28 percent.”

Corn inventories are expected to fall even as the various demand sources for corn – food, livestock and fuel – rise an estimated 3.5% next year.

Soybean prices, meanwhile, recently hit seven-month highs on the CBOT (Chicago Board of Trade) after U.S. stockpile forecasts dropped. Beans were also boosted by word that the Brazilian National Agriculture Confederation, a major farm lobbying group in Brazil, would press for limited soybean acreage in the coming planting season to help keep prices firm.

And finally Sugar, not to be outdone, recently hit 34-month highs – their highest level in nearly three years – on “poor crops and robust demand,” according to the Financial Times. A failure of India’s local sugar crop was seen as a big price booster. “Swings in Indian sugar output, which move the country back and forth from exporter to importer, are a critical factor in global prices,” the FT reports.

Wheat is the one area with potential for disappointment, relating to large India stockpiles that could be released onto the market later this summer – hence Macro Trader’s willingness to take some gains off the table and watch closely as further developments unfold.

Reflation and Stagnation

Agriculture is thus one area where the market is doing well. Other foodstuffs not mentioned, like cotton and coffee, have also seen big gains in recent weeks. On top of that, various agriculture-related equities have been performing well and look to have strong potential upside in the coming months.

Along with base metals, ag has been showing signs that the “reflation trade” is on. There is a new and aggressively bullish stance emerging on hard assets and inflation-themed plays, including everything from base metals, to gold and silver, to crude oil and natural gas… and well-run companies related to all the above.

China, too, has had a hand in pumping up the reflation trade with its aggressive stockpiling of base metals. (A few weeks back we wondered aloud in these pages if good Dr. Copper, the “metal with a PhD in economics,” was being goosed by China buying. That hunch was more or less correct, as Beijing doubles down on industrial inflation hedges with a vengeance.)

But all is not rosy and cheery for the recovery-minded bulls, as other, weaker areas of the market can attest. At the same time that inflation-linked themes are hopping, other econ-related data points are dropping.

“U.S. railroad freight traffic is running about a fifth lower than a year ago,” The Wall Street Journal reports, adding that the news “is one of several less-obvious indicators that all isn’t well, despite the financial-market rally since early March.”

The underlying reality, as the dismal freight numbers point out, is that a change from “bad” to “less bad” on the economic data front doesn’t mean things are necessarily getting better. It only means we aren’t free-falling quite as fast as we were.

Think of the skydiver hurtling towards the Earth at an astonishing rate. A few thousand feet above the ground he pulls the ripcord and – hooray! – his rate of descent has been arrested, to the point where he is pleasantly drifting rather than free-falling now. But in which direction is he still headed? And where exactly is he going to land? (Let’s hope it’s not an alligator swamp…)

The budding hope that U.S. consumers would come bouncing back with wallet intact also took a hard knock this week. April retail sales were down for the second month in a row, coming in below expectations and breaking the bulls’ happy winning string of positive upside surprises.

Brian Bethune, chief U.S. economist at IHS Global Insight in Lexington, Mass., believes the “green shoots” talk was premature. “There are some preliminary signs (of improvement) in certain areas of the financial markets,” Bethune tells Reuters, “but in terms of the real economy, we are still a long ways off.”

To which we try (and fail) to resist the temptation to say: “Well, duh.”

A Classic Combo

The environment we are headed into – and the view Mr. Market seems to (perhaps) be acknowledging now – is a classic combo of wearisome economic stagnation and creeping paper-fueled inflation. One acts as a fearsome headwind, blowing in the face of consumer-oriented names reliant on economic recovery to justify their newly bid-up valuations. The other acts as a powerful tailwind, further bidding up the price of inflation hedges and hard assets.

The main worry that has wracked markets these past few months, a relentless deflationary downward spiral leading to Great Depression 2.0, has now more or less been put to bed (at least in the mind of investors at large). Upon coming to the realization that we’re not all going to die, a massive post-apocalypse bear market rally ensued as investors audibly exhaled and the “green shoots” meme excited suggestible minds far and wide.

But now the follow-on reality is slowly sinking in that, while we may not be dead ducks, we’re still far (quite far) from being out of the woods. And that means an unpleasant combo of debt-hobbled economic growth, budget-busting government deficits, and persistent fiat currency erosion as far as the eye can see.

Macro Trader’s special recipe for an environment such as this is two-pronged. We are scanning the landscape for bearish trading opportunities in overhyped and overinflated consumer discretionary-type names, still pumped up from the short-covering aspects of rally and vulnerable to fresh disappointment, while simultaneously ferreting out bullish opportunities to play the “reflation trade” (in everything from ag to energy to metals) on the long side.

Source: Reflation and Stagnation – Welcome to What’s Next

Demand-pull inflation is described as too much money chasing too few goods.

The U.S. government is heavily in debt to the tune of over $11 trillion. How will we pay this back? We will certainly not default on our debt anytime soon. It’s possible that the government could simply inflate its way out of this mess, so essentially the biggest debt ever amassed could be paid back with almost worthless dollars.

The Chinese see the writing on the wall and are getting worried. For years we’ve been getting all this cheap stuff and we’ve given them paper IOUs. They will be left holding a mountain of devalued dollars and Americans will keep all the inexpensive goods we have accumulated over the years.

We learned from the Great Depression that deflation is to be avoided by all means necessary. They call Ben Bernanke “Helicopter Ben” because he once referred to a statement made by Milton Friedman about using a “helicopter drop” of money into the economy to fight deflation. We have recently seen some indications of deflation during this recession, but it’s quickly being eliminated by just speeding up the money printing press. In this case, deflation ultimately leads to inflation.

The Fed cut interest rates to almost nothing in an attempt to head off the deflationary effects of falling house prices and weakening consumer demand. This “reflation” shows us that the Fed is no longer focused on fighting inflation; they are now completely focused on avoiding a depression.

Why is inflation bad? Well, inflation hurts people who have saved up a nest egg and those who live on a fixed-income. The same dollars buy less goods and services. Also, wages never go up as fast as inflation, so working people can experience an increase in their cost of living, without the pay raise to go along with it.

The average American household is heavily in debt, so inflation will allow them to repay their debt in devalued dollars. I once heard a story of a woman in post war Europe that paid off her entire mortgage for the same amount of money that was needed to purchase a book of matches. Knowing this, today’s 30-year fixed rate mortgages at 5.10% look really good…

It’s important that you shield yourself from inflation to protect your wealth and buying power. I think the worst case scenario would be inflation rates similar to the 1970’s as we emerge from this recession.

Ultimately, you can protect yourself from inflation by investing in the right hard assets like gold, silver, copper, oil and even real estate.

Another great way to protect yourself from inflation is to purchase Treasury Inflation-Protected Securities (TIPS). They eliminate inflation risk – while providing a real rate of return guaranteed by the United States government.

The Treasury uses the Consumer Price Index (CPI) as a guide to adjust the principal for inflation on a semiannual basis. A fixed interest rate is paid semiannually on the adjusted principal. In that way, both interest payments and the principal are adjusted for inflation.

TIPS can be purchased directly from the government through its TreasuryDirect program and on the secondary market through banks and brokers.

My favorite way to invest in TIPS is to buy the iShares Barclays TIPS Bond-Exchange Traded Fund. It trades under the symbol TIP. This ETF has low fees, it is very liquid, and holds a diversified portfolio of TIPS of varying maturity dates.

Bottom line: Protect yourself from inflation by having some of your portfolio in TIPS, especially when it’s clear that the recession is behind us.

Source: Inflation is Coming – Protect Yourself with Treasury Inflation-Protected Securities (TIPS)

Humor me. Let’s crunch those numbers.

Those gold certificates have a book value of about US$14 billion, if you include special drawing rights and coin holdings ($1.7 billion). Even if you revalued this inventory, it would still total less than $300 billion, or 12% ofthe Fed’s total assets. So far, that’s a weak defense against our allegations. And it only goes downhill from there. Assuming it still got the goods at all, a lot has changed in just three months. In August, this gold had a market value that represented over 30% of the Fed’s assets.

Back then, additionally, U.S. Treasury securities still made up half the Federal Reserve’s asset base.

Today, however, in a very short space of time, the market value of both of these assets together comprises just 30% of the central bank’s total assets. It is fruitless to discuss what makes up the rest of its “portfolio,” because whatever it is, it is of lesser quality — aka higher risk.

His proposal was interesting, however, for other reasons. In case you missed its inference, the idea of a revaluation in gold reserves on the Fed’s balance sheet is to boost confidence. It is but a keyboard stroke away, a technical matter. Most analysts already take gold’s market value into account anyway.

Still, two outcomes of such a revaluation occurred to me over and above the obvious, I think.

The first: It would align the Fed’s interests with gold prices — by increasing gold prices, it would boost the value of its balance sheet, for instance.

Second, it would inflate gold’s perceived importance — an endorsement of sorts, in the eyes of the Fed. The public and the market would have to reassess their fundamental outlook about the importance of gold, too.

On the surface, Gramley’s proposal aims at making the Fed look like some kind of gold standard bank. But in fact, this kind of thing, especially if it were spun out in reaction to a crisis of confidence, might be so bullish for gold that it sinks the Fed.

If Bernanke were smart, he would want that gold to disappear off the balance sheet without notice.

But let’s forget about what would be bullish for gold and point out what in fact is the fear of deflation.

The Great Reinflation Update

In December, the Fed shoveled another couple hundred billion new Washingtons into the banking system, out of its many open windows. B-r-r-r!

Its balance sheet expanded to over $2.3 trillion as of last week’s report, which came out the day after it decided to cut rates to nothing. My guess is that we’ve seen nothing yet. You thought “cheap money” was bad. This is the era of FREE money. This stuff grows on trees. You don’t even need choppers. Already, despite the intensity of the deflation rhetoric, the money supply numbers continue to point the other way — toward the Great Reinflation. Or should we say “because” of the intensity of the deflation rhetoric!

This week’s money supply numbers suggest the alleged credit freeze continues to thaw.

After stagnating with little or no growth, stuck at under $1.4 trillion over the past four years (since the Fed began hiking rates in 2004), even as the Federal Reserve started cutting rates in 2007 again, U.S. M1 has grown by over $130 billion, or 10%, since August alone. That’s when it stopped sterilizing its “liquidity” injections. But this kind of growth in three months is a record. Percentage-wise, too.

Most of that growth, moreover, is occurring in checkable (demand) deposits. U.S. M2 is growing at almost $100 billion per month, and it is approaching a 9% year-over-year growth rate — its strongest growth since early 2002, midway through the Fed’s last reinflation effort (2001-03).

Most of that growth is occurring in money market fund holdings.

The definitions of money supply that I put stock in suggest that the banking system is inflating deposits at roughly5% year over year, but of special significance is that this growth rate is picking up now.

It certainly is not as robust as the narrow measures of money or the Fed’s balance sheet.

But it is not deflation.

I promise to keep looking for it, nevertheless.

Source: The Great Reinflation

This from Whiskey & Gunpowder:

Lately I’ve been discussing concept of scarcity in the energy and natural resource sectors. In one recent note, I discussed how the idea of scarcity has transformed from a “geological” basis to an “above ground” basis. In another note I discussed how the financial system of the world has broken down. This breakdown has damaged many a portfolio. But I still believe that an investment focus that is based on future scarcity of energy and mineral resources is basically correct.

In the future there will still be profound restraints on the availability of energy and natural resources. So owning shares in firms that “do energy” or “do resources” is still a good idea over the medium and long term.

We Still Have a Big Problem

We still have a big problem. The credit system is broken (and that’s the nicest thing you can say about it). Many large banks in the world are broken too (ditto). The investment model of the modern era, starting back in the 1860s during the U.S. Civil War, has almost ground to a halt. That is, the idea and method of “floating capital” is not functioning. Indeed, capital no longer seems to float. Actually, it seems like capital has been sinking like a stone.

The lack of capital (at least, in the forms that we’ve come to utilize it for large scale investments) means that it is difficult – impossible in some cases – to go forward with the new energy and resource projects that are designed to mitigate the present depletion’s in older oil fields and other resource provinces.

In the face of this, most governments of the world are trying just to look good for the TV cameras. Central banks and government treasuries across the world have been reduced simply to throwing money at whatever problems catch their collective eye. Squeaky wheels get the grease. So we see the national treasuries “recapitalizing” busted banks. We see the likes of the U.S. Big Three automakers coming hat-in-hand to Congress for a bailout, and Congress in turn acting like it knows how to run a sophisticated manufacturing business. And we hear announcements, from China to the U.S., of massive new public works programs to get the world moving again.

It’s like if we pour enough concrete, and then everything will turn out all right. Somebody ought to ask the Japanese about that. They all but paved the island of Honshu in the 1990s, and still lived through a stagnating era.

Can things really turn out all right? Can we return to some happy past? As Heraclitus once noted, “You cannot step twice into the same river, for other waters are continually flowing on.”

Prosperity Stolen from Fort Knox

Indeed, all rivers flow to the sea. In Asia Times Online, the always insightful Henry C. K. Liu recently wrote that the credit crash has “turned out to be a catastrophic, global, financial perfect storm of unprecedented dimension that will cause serious structural damage to all market economies around the world. It may even spell the end of the cowboy finance capitalism of the past two decades in which risks are socialized and gains privatized, with debt manipulated to act as phantom capital.” Yep.

A fellow Pittsburgher, financial writer Jim Willie, is even more pessimistic. He thinks that in 2008 the U.S. economy and financial structure suffered “mortal wounds.” Jim states – using a very clever turn of phrase (I wish I’d said this) — that a “decade of prosperity was stolen from Fort Knox.” That is, major elements of U.S. monetary policy in recent years involved the gold carry trade enacted by the U.S. Treasury in the 1990s.

What is the gold carry trade? The U.S. Treasury and Federal Reserve treat the details like state secrets. But what has leaked out makes for a sordid story – treasonous, even. It’s enough to make you wish that we still executed people by firing squad in this country. Let me put it this way. Perhaps President-Elect Barack Obama thinks that his biggest surprise will come when he gets “THE briefing” and finally learns what is really out in the tightly guarded hangars near Groom Dry Lake in Nevada (a/k/a “Area 51”), and Dugway Proving Ground in Utah. Well just wait until Pres. Obama asks how much of the original Fort Knox gold still remains the unencumbered property of the U.S. government. Surprise, surprise.

The Wolf is At the Door – Say Hello to the Nice Wolf

In 2008 we all experienced the destruction of a world-wide credit bubble. This was the end of many decades of dollar-abuse and monetary malpractice by the U.S. Federal Reserve and the utterly profligate U.S. government in general. As Gresham’s Law states, “Bad money drives out the good.” And decades of bad money did not just drive out the good stuff. In turn it sowed the seeds of its own destruction.

It was just a question of time before the wolf showed up at the door, and that time has arrived. Say hello to the nice wolf. So now it’s time to face the fact that the U.S. economy is in far worse shape than most people believe. And it will be in bad shape for a long time to come. If everything goes right, it might take a generation to clean out the stables.

But we are already off to a bad start. The 2008 credit meltdown has caused huge collateral damage. And in 2009 we will see an extraordinary attempt to re-inflate that bubble. Will it work? Probably not like people expect.

The traditional financial system is now in the fight of its existence. The system was based on U.S. dollar hegemony and the supremacy of U.S. national power. That, and the way that the U.S. benefited from ingrained habits of foreign monetary authorities kowtowing to Washington based on decades of living with Bretton Woods and its ghosts. It all hit the wall in 2008. But like the creatures in the Aliens movies, these critters won’t stay dead for long. The Wall Street/Treasury Axis will come back to fight hard and play dirty.

Things to Do to Ensure Your Security

I believe that the old system is irretrievably doomed. But you cannot replace something with nothing. There is still no “new” system that has come around to take the place of the old one. Thus the big task for 2009 is to save your personal wealth from going down with the ship. So how do you ensure your security?

In the short term you can protect your financial interests by increasing your cash position as a percentage of your assets. When all else fails, add to cash. Yes, we will probably see inflation in the future, but for now more cash is better.

Also, in anticipation of inflation you should own physical metals like gold and silver. I mean it. I’ve said it before. OWN GOLD! And I mean OWN THE METAL. Take delivery! Maybe I sound like the Mogambo Guru on this, but he’s right. Let me quote Mogambo. “Own freaking gold!”

And get out of any but the very best shares. The first requirement for share ownership is to look for companies with enough cash to fund operations and make it through some very lean times. Then you also want to invest in firms that are going to be important in the world that’s coming down the tracks.

What kinds of firms will be important? Well, energy and resource firms for starters.

Source: Falling Prices and Scarce Energy

This from The Daily Reckoning:

Global financial markets are acting as though the world is about to implode. Over the past four months, the investment community has dumped all assets; regardless of their underlying economic fundamentals. We have seen unbelievable wealth destruction on a global scale and trillions of dollars have evaporated and returned to monetary heaven.

The rate of decline has been astonishing and in the past twelve months, the Dow Jones Industrial Average (Dow) has seen its worst one-year performance – ever! It is interesting to observe that the Dow’s recent plunge has been even worse than the 1929 decline which preceded the Great Depression of the 1930’s (Figure 1). So, are we really witnessing the end of the world as we know it?

Regardless of the Armageddon fears prevalent today, I would argue that this slump may turn out to be a fantastic buying opportunity for the patient, long-term investor.

Now, the mainstream media seems to be convinced that our planet is headed into a permanent global depression and investor-sentiment certainly reflects this thought process. The same cheerleaders who, only a few months ago, were gleefully shouting about the emergence of a new global economy are now forecasting eternal disaster. Furthermore, investors are liquidating all assets as images of their children living in shanty towns fill their fearful minds. ‘Demand destruction’ and ‘de-leveraging’ have replaced ‘liquidity’ and ‘global growth’ as the new buzz-words. Stocks are down significantly from the highs, corporate bonds have taken a beating and even commodities (including precious metals) have joined the bear parade. And those who naively bought structured products from private banks have seen total losses. So, where do we go from here?

The best way to begin is by reiterating that global markets are now extremely oversold and undervalued, hence attractive. This may sound counter-intuitive but it is vital to understand that a decline of 40% in US stocks (and even more in some countries) has set the stage for fantastic long-term gains. If my assessment proves to be correct, investors who buy the unimpaired sectors today should make a fortune over the coming decade.

Remember, the best time to buy is when everyone is despondently selling. As John Templeton (founder of Templeton Funds) often said, “bull-markets are born on pessimism, grow on scepticism, mature on optimism and due on euphoria”. And you can be sure that the investment community is feeling extremely pessimistic and fearful today.

At present, a lot of ‘gloom and doom’ and ‘deflation’ chatter is doing the rounds in the mainstream media. The recent selling panic is frequently being described at the worst crisis since the Great Depression. However, this hype does not imply that the economic outlook is similar to the 1930’s. One of the biggest reasons why the Great Depression occurred was due to the failure or inability of the money-supply to expand in line with the need for this money.

Furthermore, the failure of roughly 5,000 banks did not help the situation either as millions of Americans lost their savings! In the current situation, however, various central banks and governments are throwing trillions of dollars into the monetary system and all bank deposits have been guaranteed. And if need be, the authorities will print money until the world runs out of trees. So, in my view, a prolonged deflationary phase or a global depression is not likely to happen.

The recent sharp declines in the markets can be attributed to the fact that two separate negative events caught the public’s attention at roughly the same time – depth of the financial crisis and fears of a US recession. Now, as far as the first issue is concerned, it is my belief that the worst is behind us. For sure, we may hear of sporadic bank busts in the months ahead, but the recent government guarantees prevented a total collapse of the banking system. For the record, I do not agree with the recent bail-outs because they are immoral and are going to cause huge inflation in the future. However, we all have to deal with reality and for now, it seems that the credit markets are starting to function again.

Our research reveals that currently US$3.5 trillion is sitting on the sidelines, waiting to be invested. And when investors deploy this cash into the markets, it will flow towards sectors which have been unharmed in this financial crisis. Now, I do not know about you, but apart from natural resources (where supply and demand imbalances persist) and industrials (which may benefit from massive government-sponsored infrastructure projects), I cannot find any other sector which has strong fundamentals. Housing faces severe over-supply, autos are struggling, banks will suffer due to over-regulation and consumer discretionary stocks will also fare poorly as the over-stretched public in the West tightens its belts.

The one sector of the economy which remains in excellent condition is commodities. Demand is holding firm, supplies of key resources are still tight and the ongoing credit crisis will only delay many projects which were previously meant to come online. This will create additional supply shortages in the future, thereby leading to much higher prices.

As far as precious metals are concerned, it is worth remembering that our world’s financial system has been hijacked by money-printers. Whether it is the Federal Reserve, Bank of England or the European Central Bank – they are all creating money ‘out of thin air’ and inflating the supply of paper currencies.

As this rampant inflation continues, what is astonishing though is that so many investors are being hoodwinked into believing that our world faces a genuine deflationary bust. These days, opinion is divided as to whether we will witness continuing inflation or gut-wrenching deflation. In my view, this discussion is absurd and deflation (or a contraction in the supply of money) is out of the question.

Banks are in the business of lending money and debt creation is essential for their very survival and prosperity. So, you can be sure that the modern-day money lenders will find a new way to further expand the supply of money and debt.

Whilst paper currencies (cash) regained some purchasing power in the past few months due to forced liquidation in the asset markets, there is no chance that they will maintain their value over the medium to long-term. History is littered with numerous paper currencies which became totally worthless and I suspect many of the current ones will also disappear. In fact, a remarkable study confirms that only 23% of paper currencies ever issued have survived the test of time! The vast majority were destroyed due to hyperinflation and are no longer in circulation.

Accordingly, I would urge investors to sit tight with their positions in hard assets (precious metals, energy and agriculture) and add more capital at such depressed levels. Under the best-case scenario, global markets bottomed out over the past two months and even if they did not, at the very least, we should get a multi-month rally in commodities and related stocks.

Source: The End of the World…Or the Right Time to Buy?

This from Sovereign Society:

The time to start building fresh positions in oil, gold, silver and TIPs has arrived. Even distressed real estate should be accumulated if credit can be secured.

Over the next 6-12 months the United States, Europeans, Japanese and Chinese will eventually arrest deflation. And long before that materializes, hard assets will begin a major reversal following months of crippling losses.

Since peaking in July, the entire gamut of inflation assets has collapsed amid a growing threat of deflation or an environment of accelerated price declines. The last deflation in the United States occurred in the 1930s, purging household balance sheets, corporations, states, municipalities and even the government following two New Deals.

Thus far, U.S. CPI or the consumer price index has not turned negative year-over-year. Yet as oil prices continue to lose altitude and other commodities have been crushed, input costs and price pressures continue to decline dramatically since October. The only major component of CPI that continues to post modest year-over-year gains is wages. And with unemployment now rising aggressively this quarter it’s highly likely wage demands will also come to a screeching halt.

Plunging Bond Yields Discount Danger

In the span of just six months, foreign currencies (except the yen), commodities, stocks, non-Treasury debt, real estate and art have all declined sharply in value in the worst panic-related sell-off in decades. More than $10 trillion dollars’ worth of asset value has been lost worldwide in 2008.

What’s working since July? U.S. Treasury bonds and the U.S. dollar as investors scramble for safety and liquidity.

On December 5, 30-day and 60-day T-bills yielded just 0.01% – the lowest since the 1930s while the benchmark 10-year T-bond traded below 2.55% – its lowest yield since Eisenhower was president in 1955. Even 30-year bonds have surged as the yield recently dropped below 3% for the first time in more than four decades.

The market is now pricing a severe recession and – possibly – another Great Depression. Despite a series of formidable regular market interventions by central banks since August 2007, the credit crisis is still alive and kicking. The authorities have not won the battle …at least not yet.

Heightened inter-bank lending rates, soaring credit default swaps for sovereign government debt and plunging Treasury yields all confirm that the primary trend is still deflation.

To be sure, credit markets worldwide have improved markedly since the dark days of early October. Investment-grade corporate debt is rallying, commercial-paper is flowing again and companies are starting to issue debt once more – but only the highest and most liquid of companies. For the most part, banks are still hoarding cash and borrowers can’t obtain credit.

The real economy is now feeling the bite as consumption falls off a cliff, foreclosures soar and the unemployment rate surges higher. These primary trends are deflationary as broad consumption is severely curtailed, with consumers preparing for the worst economy since 1981 and rebuilding devastated household balance sheets.

But at some point over the next 12 months, the market might transition from outright deflation or negative consumer prices to some sort of disinflation or at least an environment of stable prices. That’s when inflation assets should start rallying again.

Inflate or Die: The Name of the Game in 2009

The battle now being waged by global central banks, including the Federal Reserve is an outright attack on deflation. Through the massive expansion of credit, the Fed and her overseas colleagues are on course to print money like there’s no tomorrow to finance bulging fiscal spending plans, bailouts, tax cuts and anything else that helps to alleviate economic stress.

Earlier in November, the Fed announced it would target “quantitative easing” and “monetization,” unorthodox monetary policy tools rarely or never used in the post-WW II era.

Without getting too technical, the term “quantitative easing” means the Fed will act as the buyer of last resort to monetize Treasury debt and other government agency paper in an attempt to bring interest rates down. Quantitative easing aims to flood the financial system with liquidity and absorb excess cash through monetization or purchasing of government securities.

Through monetary policy, the Fed controls short-term lending rates but cannot influence long-term rates that are largely set by the markets; the Fed now hopes it can influence long-term rates through quantitative easing. And since its announcement two weeks ago, long-term fixed mortgage rates have declined sharply.

These and other open market operations directed by the Fed and Treasury will eventually arrest the broad-based deflation engulfing asset prices. It will take time. Inflation is the desired goal and is the preferred evil to deflation, a monetary phenomenon that threatens to destroy or seriously compromise the financial system. Policy-makers have studied the Great Depression, including Fed Chairman Bernanke, and the consequences of failed central bank and government intervention in times of severe economic duress are unthinkable.

Ravenous Monetary Expansion

According to Federal Reserve Board data, the Fed is now embarking on a spectacular expansion of credit unseen in the history of modern financial markets.

The total amount of Federal Reserve bank credit has increased from $800 billion dollars to $2.2 trillion dollars (or from 6% to 15% of gross domestic product) as the central bank expands its various liquidity facilities in an attempt to preserve normal functioning of the financial system.

The Fed’s ongoing operations to arrest falling prices are targeted namely at housing – the epicenter of this financial crisis. It is highly unlikely that the United States economy will bottom until housing prices find a floor. Quantitative easing hopes to stabilize this market.

Buy Gold Now

Relative to other assets in 2008, gold prices have declined far less. The ongoing liquidity squeeze has forced investors to dump assets, including gold to raise dollars. I suspect this short-term phenomenon will end in 2009 once the ongoing panic subsides and credit markets become largely functional again.

Gold should be accumulated now ahead of market stabilization. As the financial system gradually comes back to life over the next several months or sooner, the dollar should commence another period of weakness; there will be little incentive to hold dollars with short-term rates at or close to zero percent. The Fed will be in no hurry to raise lending rates.

Still, the Japanese experience in the 1990s warns investors of the travails of long-term deflation.

The Japanese, unlike the United States, only started to seriously attack falling prices in the economy in 1998 through massive fiscal spending. In contrast, the U.S. is already throwing everything at the crisis after just 17 months.

I expect the United States to print its way out of misery and, over time, and conquer deflation. But the cost will be humungous and at the expense of the dollar, U.S. financial hegemony and calls for a new monetary system anchored by gold.

It’s literally “inflate or die” for global central banks. Inflation will win.

Source:  Inflation on “Sale” as Deflation Dominates Global Markets

This from Taipan Daily:

Today I want to talk about the concept of monetary velocity. (I know, I know… monetary what? You’ll see the importance by the time we’re done.)

Let’s start with some background. In Wednesday’s Taipan Daily we noted that short-term interest rates have fallen to multi-year lows. The flip side of falling interest rates is rising bond prices. When bond prices rise, interest rates fall and vice versa.

This means investors and traders have an impact on interest rates through their buying and selling decisions. When investors pile into bonds, for example, they push bond prices up – and interest rates down.

We can see this by looking at a chart of the 2 year treasury note, which went into lift-off mode in mid-2007 (right around the time the credit crisis began).

As you likely know, investors are piling into U.S. treasuries now (particularly short-dated ones) because they are scared out of their wits and don’t know where else to go.

And right now they are scared of deflation.

The Dreaded “D” Word

For the month of October, the Wall Street Journal reports the Consumer Price Index (CPI) saw its largest single-month decline since World War II.

This dramatic drop has the word “Deflation” on everyone’s lips.

It’s quite the switch, actually. As recently as this summer, everyone was worried about Inflation.

Now, according to some estimates, use of the word “inflation” in the popular press has dropped by nearly a third… and use of the D word, deflation, has more than tripled in the past two months.

This is a head scratcher, especially in light of what we’ve been hammering on this past week. How can the markets be worried about deflation when the Fed is printing money like there’s no tomorrow?

Better still, how is it even possible to see the specter of deflation on the horizon when trillions of dollars are being pumped into the system?

To answer those questions, let’s delve into the concept of “monetary velocity.”

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Run, Rabbit, Run

Everyone knows about the basic concepts of inflation and deflation. They are often described in terms of supply and demand: inflation is “too much money chasing too few goods,” deflation is “not enough cash to go around,” and so on.

But it’s important, too, to recognize that the inflation/deflation equation depends not just on the quantity of money in the system, but also how fast that money is moving through the system. This is where monetary velocity comes in.

It’s a slightly challenging concept to explain – the best analogy I’ve found is a bit goofy, but it works. So here we go…

Imagine you’re standing in front of a large tree trunk. There is a brightly colored marker on the trunk, and there are rabbits running in circles around the tree itself. Every time a rabbit passes the marker on the trunk, you note it down on your clipboard: one X per pass.

Now let’s say you tally up your results and note you made twenty X’s in the space of 60 seconds. Assuming you had your reasons, how could you double the number of X’s in the same amount of time?

There are two ways you could double the number of X’s on your clipboard (to forty per minute in this case). You could increase the number of rabbits running around the tree… or you could go with the same number of rabbits and try to make them run faster.

(Remember, you don’t care if it’s the same rabbit or a different rabbit when you jot down your X. You’re just counting the number of passes.)

As you might have guessed, the rabbits are analogous to money in the system. Money that’s just there is inert… In order to have an affect on the economy, the money has to move.

So when money is “hot” and the rabbits are running at top speed, fewer rabbits are needed to fill up the clipboard with X’s. The rabbits speed around the tree very quickly – analogous to high turnover, or money changing hands very quickly.

When money is “cold,” on the other hand, the rabbits are lethargic, and you need more money (i.e. more rabbits) to get a decent number of X’s on the clipboard. If money stops changing hands entirely – as it seemed to have for a brief span in late September and early October – it’s like the rabbits coming to a dead stop. They aren’t moving at all.

So when the Fed pumps the system full of money, it’s the equivalent of dumping more and more rabbits into the equation. As the Fed gets desperate, maybe they round up dozens or even hundreds of rabbits.

But if all the rabbits are half comatose, the clipboard stays blank (or fills up much too slowly). The Fed’s efforts fail to have the desired effect.

So the upshot is that the Fed can have a direct impact on the quantity of money in the system, but not the velocity of money in the system. It can’t make the rabbits run.

You’re a Rabbit, I’m a Rabbit

The “rabbits” can also be thought of as entities that buy and borrow and lend – banks and businesses and consumers (like you and me). When banks refuse to lend and consumers stop buying and borrowing, monetary velocity goes down – even as the dollars in the system pile up.

Over the years you may have heard comments like, “The Fed has absolute control over the money supply.” That is misinformation. The Fed has zero control in some very important areas. What’s more, they don’t even have the tools to properly measure many of these areas.

When we talk about the velocity of money, for example, we’re not just talking about visible dollars. We’re talking about abstract concepts like people’s willingness to borrow and lend. That kind of thing is impossible to measure on any kind of precise basis.

For example, if five million Americans wake up tomorrow with a sense the world is okay and an urge to go buy something, then that cheery mindset will positively impact the velocity of money in the system – even though you can’t put “optimistic mindset” on a balance sheet.

Conversely, if five million Americans wake up fearful for the future and determined not to borrow another dime if they can help it, that translates into a negative impact. Again, there’s no way to precisely gauge these moods. We can only make rough guesstimates.

So why do we have a grim outlook for deflation right now, even as the printing press money piles up? Because monetary velocity has crashed. Bank balance sheet woes and consumer debt overhang are such that the new attitude towards buying, borrowing and lending – creating turnover, moving cash through the system – is “Thanks, but no thanks.”

Simply put, the rabbits are tuckered out.

So Why Buy Gold?

Okay, some of you may be thinking now, so the dollars are piling up because the velocity of money has crashed. The Fed’s stimulus remains untapped, like an idle oil tanker filled with cash. But if that’s the case – and if deflation worries could worsen – then why buy gold?

It’s a good question. Most of the talking heads don’t bother thinking the answer all the way through. They stop at step one without progressing to steps two or three. “Gold’s no good in a deflationary environment,” they say. “Prices are going down and that’s that. So why would you want gold?”

Well, let’s see.

First recall that deflation is every central banker’s worst nightmare. (Particularly central bankers who spent the bulk of their academic lives studying the Great Depression.) That’s why Fed Chair Ben Bernanke gave a defining 2002 speech titled, “Deflation: Making Sure ‘It’ Doesn’t Happen Here.”

If you’ll indulge this quick recap, here is the key paragraph from Bernanke’s deflation speech:

What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost… We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

The underscore emphasis is mine. What Bernanke believes amounts to this: The printing press is an irresistible force. There is no deflation so immovable that the printing press cannot smash through it.

An irresistible force sounds most impressive. When we think back to the velocity problem, though – recall the lethargic rabbits – the printing press starts looking like the wrong cure for the wrong ailment.

This is because as far as money in the system goes, a velocity problem is different than a quantity problem. The printing press speaks to quantity, but on the question of velocity, it remains mute.

Going back to our tree trunk analogy: Bernanke could round up a thousand rabbits, he could round up ten thousand rabbits, or he could round up fifty thousand rabbits. If the rabbits don’t feel like running around the tree, quantity does nothing. If banks and consumers cannot be goaded into the old patterns of buy, spend, borrow and lend, then it just doesn’t matter how much the Fed pumps in.

Except for one thing: To say it “just doesn’t matter” is not wholly correct. The Fed’s stimulus-pump actions do matter in one particularly awful way. The more money a desperate Fed pumps into a non-responsive US economy, the closer we edge to systemic breakdown for the fiat currency system as a whole.

Breaking Down the Breakdown

My use of “breakdown” in this case refers to the point at which the world loses faith… the point at which investors realize in dawning horror that the world’s reserve currency is doomed.

The trouble lies in the fact that the Federal Reserve has staked its whole crisis-response plan on the power of the printing press. The Fed, in other words, has but one play in the playbook… the play outlined in Bernanke’s deflation speech.

If deflation’s grip is not broken soon, then Bernanke will double down on the printing press strategy… and then double down again. The Fed will pump and pump until the total pool of dollars in the system makes the United States look like a banana republic.

It is this scenario, by the way, that keeps Jerome Whitehead awake at night. Whitehead, now 86 years old, is a former chairman of Goldman Sachs.

“I see nothing but large increases in the deficit, all of which are serving to decrease the credit standing of America,” Whitehead says. “Before I go to sleep at night, I wonder if tomorrow is the day Moody’s and S&P will announce a downgrade of U.S. government bonds… Eventually U.S. government bonds would no longer be the triple-A credit that they’ve always been.”

Mr. Whitehead is right to worry.

Wake Up and Smell the Bullion

Recall too, in case you’ve forgotten, that in times of crisis gold serves a proxy for cash. And in times of deflationary crisis, gold is the only form of cash not subject to the ravages of a printing press. (This might explain why there is a run on gold coins taking place. The U.S. Mint has been forced to ration them out.)

It may take a bit longer for Wall Street (and the world) to wake up and smell the bullion. But as to what happens in the medium to longer term, the distribution of outcomes is pretty cut and dry.

If deflation is vanquished and money starts to move again, interest rates will stay low for a good long stretch of time (so as not to cripple a convalescing economy). In this scenario inflation returns, much to the Fed’s relief, and gold resumes its upward climb.

If, instead, the Fed fails utterly, Bernanke will not go gentle into that good night. He will print his way into spectacular oblivion (as all but promised in his 2002 speech)… and Mr. Whitehead’s bad dream will be realized… and gold will respond accordingly.

Source: Run, Rabbit, Run! The Importance of Monetary Velocity

Many dubious excuses are given – protecting American exports, saving jobs, preventing deflation, for instance – but there is no question that Capitol Hill is actively engineering the dollar’s demise: 18 rate cuts since 2001, three tax cuts, massive deficits, and record money creation bear cold witness to its manipulations.

You don’t spend your way to prosperity; no nation ever has or ever will. But guess what? That very idea is the basis of U.S. and Fed monetary policy. Never in U.S. history have the imbalances in the economy been so pronounced, or so dangerous. “My experience as an emerging markets analyst in the 1990s taught me to be on the lookout for signs of financial vulnerability,” observed analyst Hernando Cortina in a Morgan Stanley research note. [The signs] include ballooning current-account and fiscal deficits, overvalued currencies, dependence on foreign portfolio flows, optimistic stock market valuations coupled with murky earnings, questionable corporate governance, and acrimonious political landscapes. Any one of these signals in an emerging market usually raises a red flag, and a market that combines all of them is almost surely best avoided or at least underweighted. I didn’t imagine back then that one day these indicators would all be flashing red for the world’s biggest and most important market – the U.S. A by-the-numbers analysis of America’s macro accounts in a global context doesn’t paint a flattering picture.”

Yet for growth-starved financial markets, perceptions and hope are often more important than economic reality. According to the macro indicators that the International Monetary Fund (IMF) uses to assess emerging-market economies, the United States fell between Turkey and Brazil.

Hernando Cortina politely concluded: “Investors contemplating the purchase of U.S. dollar-denominated assets would be wise to factor in significant dollar depreciation over the next few years.”

“Households have been on a borrowing spree,” added Northern Trust economist Asha Bangalore. Household borrowing as a percentage of disposable personal income hit a new high of 12.4 percent in the second quarter of 2003. This measure of household borrowing reflects mortgage borrowing, credit card borrowing, borrowing from banks, and the like.

Household borrowing is not only at a record high but a new aspect has emerged – household borrowing advanced during the recession unlike in every other postwar recession when households reduced borrowing. The good news is that consumer demand continues to advance with the support from borrowing.

The bad news is that no economy has ever borrowed its way to prosperity. Despite the conspiracy against it, the dollar has avoided a downright free fall. That’s because dollar investors across the globe are still convinced that, given favorable credit conditions, the U.S. economy will surely reenter the heyday of the late 1990s, taking dollar – denominated assets to new heights. But someday soon, we think, investors will be disabused of their illusions. Sure, the stock market rallied briskly in the recent past, but the U.S. economy continues to struggle. Unemployment persists. And the twin deficits loom larger and larger. If and when America’s creditors – domestic and foreign – decide the country’s massive, record-breaking level of debt is reason enough to get out of their dollar investments, the dollar will have nowhere to go but down, precipitously.

We don’t know when the exact moment of truth will arrive, but we know it cannot be far off. Excessive debt is not the only ominous development in the U.S. economy. Just as foreboding is the American consumers’persistent belief that they are wealthier than they actually are. U.S. financial assets are, once again, in the grip of a large bubble. Take stocks, for instance: It may not be 1999, but investors are sure partying as if it were. If the S & P 500 – an index made up of the country’s largest companies – were to trade at its historical fair value, or at a price-earnings (P/E) ratio of 15, it would have to decline by 50 percent off its high. But bull markets don’t typically start at fair value. If a new bull market were really starting – and stocks were actually undervalued – the S & P would be trading 67 percent lower, at a P/E of 10. But it’s been so long since investors have seen P/E ratios in this range, they seem to believe stocks will never descend from their lofty heights.

The U.S. stock market is once again in the grip of a bubble. The Fed’s frantic reflation campaign, government’s tax cuts, and easy credit have worked their way into stocks, causing the market to burgeon and billow outward in a way completely dissociated from any real measure of value.

In fact, the rally in stocks has been so strong that it has rekindled investors’belief in a new bull market, full economic recovery in the United States, and a return to the glory days of the 1990s. But a funny thing has started to happen. The U.S. stock market is soaring. Normally, that means the dollar would go with it; when a country’s stock market goes up, demand for its financial assets usually goes up, too. But the dollar is being dragged down by debt – government debt, personal debt, and corporate debt. Investors want a bull market, and so they’re making one. But the dollar reflects the real state of the American economy…and it knows better.

Foreign investors are especially burned when stocks and the dollar part company. At first blush, the rallying U.S. stock market seems like a very inviting place for their capital. All denominations are welcome, but not all guests are treated equally well. For example, the S & P 500 soared 26.4 percent in 2004, in U.S. dollar terms. Yet euro – based investors in U.S. stocks would have realized only a 6 percent gain for the year.

Foreign bondholders are faring no better. Foreign central bank holdings of Treasury and agency securities total over $ 1 trillion. So, roughly speaking, every 10 percent drop in the dollar’s value impoverishes our foreign creditors by about $ 100 billion on their U.S. Treasury holdings alone! That’s real money.

How is it possible that stocks continue their winning ways, even while the dollar continues its losing ways? These two inimical trends are strange bedfellows indeed. What makes the pairing particularly bizarre is the fact that our nation relies so heavily upon the enthusiasm of foreign investors for U.S. assets. What is the Fed doing, and why? One writer has pegged the answer:

“The Federal Reserve Board is working to raise the inflation rate, while the U.S. Treasury is trying to talk down the dollar exchange rate. Not every day does the world’s hegemonic power pursue a policy of currency debasement. Still less frequently does it have the courtesy to tell its creditors what it’s doing to them.”

Indeed. The Fed and Treasury are engaged in a kind of collusion to lower the dollar’s value. And that’s a very dangerous game to play, especially for a country like the United States, which relies so heavily upon foreign capital to finance its economy. It has become fashionable in the corridors of power in Washington to advocate “market-based” exchange rates – code for “weak dollar.” A weak dollar, it is widely believed, will lead to a strong economy. Hmm.

In the olden days, of course, the Fed was supposed to pursue “monetary stability.” But in the enlightened twenty-first century, the Fed has much grander designs. It imagines itself a kind of marionette master to the world’s largest economy, making it dance whenever it wishes, simply by tugging on one little interest rate, or by tugging on the dollar. And so it tugs, and tugs, hoping to revive the economy.

The U.S. Treasury Department is also conspiring with the Fed to weaken the dollar. Hasn’t Treasury Secretary Snow touted the weak dollar as a surefire cure for the struggling U.S. manufacturing sector?

And hasn’t the dollar been tumbling? And yet, isn’t the manufacturing sector struggling just as much as it was when the price of a euro was only 83 cents, instead of $ 1.25? It’s obvious to almost every citizen who does not live in Washington, D.C., that devaluing the dollar to stimulate economic growth is a fool’s mission. A couple of years ago, 255 dollar bills purchased one ounce of gold. Today, an ounce of gold costs more than 850 dollar bills. And on the day that an ounce of gold costs 1,000 dollar bills, our manufacturers will have become so competitive that they will be exporting firecrackers to the Chinese, or so the gang on Capitol Hill believes. But in fact, we will all be poorer for embracing the idiocy of “competitive devaluations.” The problem is, once a devaluation trend begins, it is almost impossible to stop.

The solution comes from repositioning, and the best cues for when, how, and where are found in the gold market – which prospers during times of geopolitical uncertainty and traditionally rises in value when the dollar falls. The gold price has jumped 367 percent from April 2001 to January 2008, from $ 255 to $ 936. The metal’s impressive rise inspired a dramatic rally in gold shares that has vaulted the XAU Index of gold stocks to an all-time high of $197.3 on January 14, 2008.

What does the gold market know? That the Fed’s reflation campaign will succeed too well? A little bit of inflation – like a little wildfire – is a difficult thing to contain. And the gold market seems to have caught a whiff of inflationary smoke.

Or does the gold market know that Iraq will continue to serve as a breeding ground for terrorists and a habitat for anti-American terrorist acts? As the Iraq situation continues, the dollar will suffer…a lot. Or maybe the gold market knows only that U.S. financial assets are very expensive, and worries, therefore, that U.S. stocks selling for 35 times earnings and U.S. bonds yielding 4.5 percent are all too pricey for risk-averse investors to own in large quantities. A vicious cycle is hard to stop. The dollar’s descent is the most worrisome – and influential – trend in the financial markets today. And yet, as long as Cisco is “breaking out to the upside,” few investors seem to care about the dollar’s slide into the dustbin of monetary history. The dollar’ s demise is not inevitable, just highly likely.

When a currency falls, in theory anyway, interest rates usually rise. A government whose currency is falling apart tries to make assets denominated in that currency more attractive by paying higher rates of interest to potential investors. And if the government doesn’t raise rates, the market will do it by selling off bonds and driving yields up. And so, in theory, you would normally expect to see a falling U.S. dollar accompanied by rising U.S. interest rates. The difficulty from the Bush/Greenspan/Bernanke perspective is that rising long-term rates pose an enormous problem: They make it significantly more expensive for debtors – from U.S. consumers to the U.S. government – to service their obligations. And these costs are not negligible.

In fiscal year 2007, for example, the government was obliged to pay out a whopping $ 429 billion in interest expense on the public debt outstanding. At a 1 percent rise in interest rates, that would add $ 43 billion in interest expense. And to meet this added interest expense, the government would, of course, have to float even more bonds, and at the higher interest rate.

This scenario is the government’s nightmare. When the falling dollar eventually pushes interest rates up, the Treasury will have to issue more debt at higher interest rates simply to pay off its existing debt. But if the Asian economic juggernaut were to discontinue recycling its excess dollars into U.S. government bonds and Fannie Mae debt, the dollar would suffer mightily. How much longer until our luck runs out?

In some way, shape, or form foreigners lend our consumption-crazed nation $ 1 trillion every year. We Americans, in turn, use the money they send our way to buy SUVs, plasma TVs, and costly military campaigns in distant lands. However, we do not forget to repay our creditors with ever-cheaper dollars. Someday soon, foreigners must lose interest in subsidizing our consumption habit. That the dollar’s decline comes at the urging of the same nation that prints the things is an irony that is not lost on the world’s largest dollar holders. Reading the tea leaves, many Asian central banks are still exploring ways to lighten up on their U.S. dollar holdings.

“The Chinese aren’t lapping up our Treasury paper for its great investment attributes,” writes Stephanie Pomboy of MacroMavens, “but [rather] because of a mechanical need to maintain the yuan/dollar peg.”

The dollar is a currency fated to tumble. The dollar’s resistance to its debt load, fueled by the machinations of central banks and the misguided faith of dollar investors, undoubtedly qualifies as a trend whose premise is false. Sometime soon this trend will be discredited.

Regards,

Addison Wiggin
The Daily Reckoning

P.S. If you haven’t purchased your updated copy of The Demise of the Dollar you can get this must-read here:

The Demise of the Dollar (And Why It’s Even Better for Your Investments)