"When misguided public opinion honors what is despicable and despises what is honorable, punishes virtue and rewards vice, encourages what is harmful and discourages what is useful, applauds falsehood and smothers truth under indifference or insult, a nation turns its back on progress and can be restored only by the terrible lessons of catastrophe." … Frederic Bastiat

Evil talks about tolerance only when it’s weak. When it gains the upper hand, its vanity always requires the destruction of the good and the innocent, because the example of good and innocent lives is an ongoing witness against it. So it always has been. So it always will be. And America has no special immunity to becoming an enemy of its own founding beliefs about human freedom, human dignity, the limited power of the state, and the sovereignty of God. – Archbishop Chaput


Saturday, June 25, 2011

Random Thoughts on the Passing Scene

In some private emails I have received some of the writers have expressed fears of a 2008 type meltdown in the precious metals whenever they see me use the word, "deflation". Let me try to address this somewhat here on the website so as to avoid having to make an individual response repeatedly.

First of all, when I use the word, "deflation", I am talking more about the symptoms rather than the causes. My understanding of the actual word is a reduction in the money supply evidenced by falling prices. It is the latter part of that sentence I am particularly interested in. For comparison's sake, when I use the word, "inflation", I am also more interested in the symptoms, i.e. rising prices, rather than the causes behind it which is an increase in the money supply not matched by an increase in productivity.

Regardless, the point I am making when talking about the forces of deflation battling it out against the forces of inflation, is one which means a period of falling prices versus a period of rising prices.

As you aware of by now, the Fed has been at war with the forces of deflation ever since the credit crisis erupted with the failure of Lehman Brothers back in the summer of 2008. Lehman was not the cause; it was merely the first victim. The result was a massive unwinding of highly leveraged speculative positions which drove asset prices lower across the board. Whether it was equities or commodities, it did not matter. They were all taken down hard as the Yen carry trade was unwound and money flowed back into the carry currency (the Yen) and into the Dollar as those short positions were lifted.

Enter the Fed into the fray. They began round one of QE which consisted of buying up the Mortgage Backed Securities and other alphabet-named securities which were plummeting in value and threatening to wipe out the balance sheets of the big banks who were greedy enough to buy and sell those things. That combined with the TARP program provided an enormous surge of liquidity into the markets which lifted both equities and commodities across the board. You had a classic example of the Fed ramping up the money supply in order to stave off deflationary forces. The policy was deliberately inflationary and had its intended affect. It also drove the Dollar sharply lower.

When QE1 began winding down, both the commodity markets and the equity markets began fading off their peak levels. With the economy showing that it lacked sufficient traction on its own to be able to grow at a sufficient pace to generate new hiring or one that made policy makers feel comfortable, QE2 was announced and then implemented. That had the immediate effect of unleashing inflationary forces into the economy in the sense that the liquidity it produced through the increase in the money supply shoved equity and commodity prices higher once again. Once again the forces of deflation (falling asset prices) were beaten back and once again the Dollar moved lower.

Now that QE2 is ending and the economy still shows no signs that it is growing at a pace strong enough to turn the labor markets around, prices of assets are dropping once again. Both commodity and equity markets are moving lower. In other words, this is a deflationary environment although it must be pointed out that the move lower in prices is starting from a very high level in the commodity sector as a whole. Gold is near $1500, crude oil is closer to $90, and corn is close to $7.00. None of these price levels can be considered cheap. So please keep this in mind when I use the word, "deflation", that I am not saying corn is headed back to $3.50, crude oil to $35-$40 or gold to $680 - $700. I am merely saying without the Fed created liquidity to goose up the money supply, prices are responding to the decreasing liquidity and are moving lower, albeit from a higher level. Eventually this will show up at the retail or consumer level but there will be at least a 3-4 month lag, if not a bit more. Prices will come down but will still remain high by historical standards.

This is one the reasons that I believe we will see another round of QE if Bernanke and the Fed feel it is warranted, even though they will face criticism should they do so. You will recall that throughout the rise in commodity prices, the Chairman repeatedly stressed in his testimonies before Congress and in his speeches that the rise in commodity prices was moderate and was temporary. I disagreed then and still do now that the rise was moderate (a move from below 400 in the CCI to near 680 in the CCI is not "moderate") but we all must admit that the index has come down lately and so have the prices of most commodities at the various commodity futures markets.

Having set a benchmark with these extremely high prices, any move lower in commodity prices will be measured against that new benchmark. Should the stock market take out a major downside support level and the economic data turn from bad to worse, Bernanke could rightfully argue that he has "upside room" for another round of QE in terms of commodity prices seeing that they are off recent highs. In other words, the public has now been conditioned with a spike to high prices and any move down from those levels will be seen as relief even if the price stabilizes at a new, permanently higher price level. When corn moves from $3.50 to nearly $8.00, a drop down towards $6.50 will be seen as a bargain even though the price is now $3.00/bushel higher than it was a mere 3 years ago. Same goes for crude oil. A drop from $120 towards $90, or even $80 or $70 will make the stuff look dirt cheap even though it will be trading at twice the price it was back in 2008. The list could go on and on.

What we are seeing then is a sort of three steps forward, two steps back in the commodity markets in terms of prices. The public, whether it realizes it or not, has now been conditioned to accepting the new and permanently higher price levels some of which are tied directly to the loss of purchasing power of the US Dollar. The new NORMAL is higher prices. When another round of QE comes our way, the drive to the former peak will be seen as inflationary but the impact will not be as psychologically devastating as was the first surge to these record highs. The next time it will be met with more of a yawn unless prices surge past these old peaks. Then the cries of inflation will arise once again, the Fed will face another round of criticism and the cycle will be repeated as they back off from stimulus yet again.

In such a fashion will the battle between the forces of deflation and inflation play out with the loser being the middle class and those who do not realize what is happening to their way of life.


  1. I buy into the argument that price of crude falling is an inflationary event, because the resulting lower gasoline prices will make more money available for discretionary spending.

    If it were to happen that 2 million barrels per day was released from the SPR (Strategic Petroleum Reserve) through the summer, it would go a long way to lighten the mood of the general populace. And the best part would be that miners wouldn't be hit so hard with rising fuel costs.

    As of May 31, the SPR inventory was 726.5 million barrels.


  2. Again you hit it out of the park like Jose Bautista, Dan, with this very informative piece. Thank you.

  3. Dan, does what you have described, conditioning the public to price levels, come under what Jim Sinclair refers to as MOPE?

  4. In other words, are you saying ...?

  5. Here's a link to M2: http://research.stlouisfed.org/fred2/series/M2?cid=48

  6. Dan, doesn’t this article say that the new rule will negatively affect the global money supply and therefore increase deflationary forces? Which would in turn increase the likeliness of QE3 to happen sooner rather than later?

    Bankers agree on plan to increase capital buffers
    NEW YORK (AP) -- The banks that are most important to global financial stability will be required to hold extra capital on their balance sheets to protect them -- and the global economy -- from financial crises under new rules proposed Saturday.

    Global central bank heads have proposed rules that would require the world's biggest banks to hold an extra 1 percent to 2.5 percent of capital on their balance sheets, depending on their size. The goal of requiring larger cash buffers is to prevent another shock to the global financial system like the one that occurred in 2008 when Lehman Brothers collapsed…


  7. "Eventually this will show up at the retail or consumer level but there will be at least a 3-4 month lag, if not a bit more."

    Doesn't inflation take much longer than that? The inflation of the 1970's started back in the 1960's with the Kennedy administration.

  8. Thanks Dan,

    You keep a neutral eye on things, which is not always true from some other commodity "addicts".
    I don't know whether it was Turk or Sprott who said again 2 weeks ago that he was seeing silver at 40 $ before end of june, but it doesn't matter.
    What goes up eventually goes down somewhat, and timing is so important now.
    Pleasure to read your updates everyday,
    Hope my english is not too bad ;)

    Wish you a nice weekend,

  9. Thanks for posting the great piece.

  10. It looks as though the 30/31 year commodity cycle has peaked.




    The cycle now suggests 18 years of down to sideways trend. The largest decline of the CCI (into the 400 range) should come as China's over building of factories, ghost cities, malls, airports...finally corrects.

  11. Doesnt matter inflation or deflation - the debt is not going anywhere. It is still around. Inflate it away? not a chance. The US Govt borrows 41c of every dollar it spends. There will come a time when USA will have to live within its means-how the hell will it do that without a 41% decrease in our standard of living? Rock and a hard place!

  12. Dan, weren't you one of the pundits saying that QE3 would come immediately after QE2 with no stop in between? If so, what made you realize that that wasn't the case?

    I'm with you on the deflation tip and I'm quite excited about it. Anyone smart enough to have realized that an end to QE2 was completely deflationary would have sold much of their positions and have cash now.

    I do believe Bernanke will wait until the "last moment" to introduce QE3, when commodities and equities are well and truly beaten down, to ride in like a savior. Why not? He knows he can't fix this sinking ship so he might as well act like he's doing what "needs" to be done instead of something that seems unnecessary at the time of introduction right? He got so much flack for QE2 he probably wants to hear begging before enacting the next round of QE.

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  14. Maradona - not sure what you are referring to. I have made it a point to state that we need a break of the support level of 1250 in the S&P 500 to induce the possibility of another round of monetary accomodation. I do not think I could have been clearer about that. You must not be reading what I am spending my valuable time writing.

    I have also stated that ever since the Fed has signalled the withdrawal of QE2, the CCI has been moving lower with occasional bursts to the upside as global sentiment improves or european sovereign debt issues subside in the minds of traders. Today is a perfect example of this.

    I have also stated that 2012 is an election year and the BErnanke-led FEd will not sit by and do nothing IF the stock indices break a major support level and do not come back. Same goes for commodities in general. This Fed will not let a deflation mindset get a firm footing in the minds of investors. Of that we can be absolutely confident.

    If you are going to post here, please read what I write first before posting and do not put words in my mouth.

  15. Dan, I'm sorry and did not mean to put words into your mouth.

    I honestly thought that you had stated, on more than one occasion, that the Fed would move to instate another form of QE directly after QE2.

    It may have been excerpts like that below which also added to my "strange" belief that you were saying QE3 was imminent:

    "That is why this talk about ending QE2 at the end of June is worth second guessing. If the stock market implodes, and the labor markets fail to respond positively, do you really believe that the Fed is going to be able to resist the calls for more liquidity? That will surely give the doves on the FOMC the added advantage of being able to say, "we told you so"."

    Your commentary is excellent and I don't get a chance to read it every day but appreciate your thoughts.

  16. MARAdona;

    Thanks for the follow up on this. Note that in my comments I had a big qualifier "IF THE STOCK MARKET IMPLODES". That has not happened as of yet. AS a matter of fact the S&P ran further away from the critical support level near 1250. That level will take the index negative on the year and if you get an acceleration to the downside after a break of that support level, you are then going to get a chorus of voices beginning to call for some sort of action from the Fed. That will increase further if the payrolls numbers do not show any signs of stabilizing. The Fed will not do another QE just because the stock market moves lower but they will do something along that line if the stock markets look like they are beginning to experience a rash of liquidation and big down days coming back to back with no signs of willing buyers to step in and stop the bleeding. We are not there yet but I think all of us will know it when it does occur.

    It was the Fed's QE that liked stocks from their lows the first round back in late 2008 and then again when they announced the next round or QE2. All the rally in stocks has come from the Fed's liquidity injections. They are hoping that the markets can hold their own without any additional stimulus but the question is can it?


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