Inflation, deflation, gold and currencies

[vincecate]

Silver is up over 5% so far and the market is not even open yet! Options have leverage on that...

http://www.silverseek.com/quotes/24silver.php

Wonder if people are getting worried China will reduce its dollar holdings:

http://news.xinhuanet.com/english2010/c ... 842843.htm

[weak stream]

John's post today regarding inflation/deflation/stag....whatever has become the most tiresome debate since the GFC has begun. He's absolutely right, in my opinion, that we're in a '30s sort of bust (and definitely not the '70s) but there are a few differences between the '30s and today. The primary difference, of course, is the level of lying/cheating/stealing present today would make the financial fleebags of the '30s envious, indeed. The banking cabal started taking their lumps soon after the stock market bust back then but you can see that today's government has encouraged and further enriched the same sociopaths that created the debt bomb in the first place. But, anyways, what to do? Does one simply cover one's ass for the time being and wait to buy up cheap assets (and I mean really really omigod looking cheap) and really take advantage of the situation? Or are we just looking to "trade the day" and not "miss out on the rally". Where can we be? In commodities, money or financial instruments? First, let's also dispense with the notion that we're in a recovery. If the government is borrowing 10% of GDP to juice the economy and we have plus 2 or 3% growth then that means we're in a MINUS 7-8% economy. Kinda pisses me off just a little bit every time the "recovery" is being discussed. Stalin's insight that a lie repeated a thousand times becomes a fact is disturbingly true. So where was I? Yeah, commodities are a-piling up all over creation due to the continuing recession and yet the prices rise. Corporate debt and equity prices keep rising as Wall ST turds with zero interest loans from Helicopter Ben continue buying. Problem is, of course, the continuing recession, which will eventually crush debt and equity values. In the end everything will fall in value, but relative to what? The dollar? Gold? Remember, gold is money and the "liftoff" in gold is really just reflecting the sentiment that the Fed is so high on crack that they will destroy the only thing they make. Dollars. Oh, yeah, and there exists such vast quantities of UST and USD around the world that "tightening" policy won't work in a selling frenzy. Ben is a gambling man with his poker face on, to be sure. John and Generational theory is dead on with this thing and those who "play" in these waters will get zapped in the end.

[vincecate]

In the end everything will fall in value, but relative to what? The dollar? Gold? Remember, gold is money and the "liftoff" in gold is really just reflecting the sentiment that the Fed is so high on crack that they will destroy the only thing they make. Dollars. Oh, yeah, and there exists such vast quantities of UST and USD around the world that "tightening" policy won't work in a selling frenzy. Ben is a gambling man with his poker face on, to be sure. John and Generational theory is dead on with this thing and those who "play" in these waters will get zapped in the end.

You are saying the Fed will destroy the value of the dollar. You might be saying we will measure deflation if we compared/priced the value/cost of things relative to gold coins. There is so much US government debt that if people want out, and start a selling fenzy, the Fed can not save the dollar. Ben is bluffing about tightening. I agree with all this. But then how is John "dead on"? Not sure he agrees with any of this. John thinks the value of the dollar will go up with deflation.

[weak stream]

John and generational theory are dead on about what's going on in that there will be a stronger resemblance between now and the '30s (generational crisis) then the '70s (awakening/unraveling). And, yeah, stay in money and not in commodities and financial instruments.

[weak stream]

One other thought. When the dollar comes crashing, a restructuring of the dollar will occur mighty quick. What they decide to "anchor" the dollar to is the question. Our modern, diversified economy can't operate efficiently lugging around gold bars, oyster shells etc. so they will get some kind of paper currency that people will believe in. The same thing occurred in Poland in the early '90s. Government debt was untenable and the currency was in hyperinflation so they issued a new currency that was backed to a "currency basket" (pound dollar mark). Of course this slams the brakes on government spending but that's another story.

[vincecate]

And, yeah, stay in money and not in commodities and financial instruments. [...] When the dollar comes crashing, a restructuring of the dollar will occur mighty quick.

Looks like there is a contradiction between understanding that the dollar is going to crash and advising people to "stay in money", unless you mean gold and silver. So lets be really clear. Do you advise people to stay in the US Federal Reserve notes known as "dollars" even when you understand the Fed is acting like idiots on coke and destroying the one thing they produce?

The same thing occurred in Poland in the early '90s. Government debt was untenable and the currency was in hyperinflation so they issued a new currency [...]

Yes, when government debts get untenable in a country that can print money they seem to always get hyperinflation. So are you predicting that the US dollar will be destroyed in hyperinflation? Then why put your savings in dollars? I don't get it.

[weak stream]

What I'm saying is that those that stay in *money will fare far better than those in commodities and financial instruments. Which is what happened in the '30s. Many lost 90 or more percent of their wealth in commodities and financial instruments and those that stayed in *money lost less. Those in money who bought up assets at 90 off fire sales did quite well. Again, relative terms here and I do mean super duper scary low asset prices here. Not the "housing is 28% off and is the buy of a lifetime bs you here from Kudlow and the NAR. Of course we'll never know how much better off gold bugs would have made as the govt confiscated gold early on. And then the stuff remained illegal for the next 40 years. The bottom line here is that a) nobody knows exactly what's going to happen and when. b) if hyperinflation blows the dollar to dust a replacement will be found straight away. and c) generational analysis is still the clearest and most plausible direction to go for clues. Beyond that I dunno.

[vincecate]

What I'm saying is that those that stay in *money will fare far better than those in commodities and financial instruments. [...] b) if hyperinflation blows the dollar to dust a replacement will be found straight away. and

If there is US dollar hyperinflation and your wealth is in US dollars you will lose. The longer you stay the more you lose. If you wait till the end when they find a replacement for the dollar you will lose everything. If your wealth is in bonds you can lose nearly everything long before the end.

[Higgenbotham]

Are you just saying that when the price of bonds collapses the relative value of federal reserve notes to bonds changes? This is the same thing as the price of bonds collapses, right?

Do you think that bonds dropping in value reduces the money supply and so would make commodities and other prices cheaper? Or would it have no impact on general price levels?

There are a few ways I could discuss this issue. I think the best way is to put out a likely scenario. The 2007 scenario was that ABCP locked up and subprime mortgage values collapsed and from there certain things followed. The next scenario may well start with muni bond values collapsing. Or it may well start with some of the weaker debt that resides outside the US. In all probability it will not start with US government bonds. I'll pick the muni bond scenario. In this scenario, first it should be stated that the investors in these instruments are in most cases relatively wealthy retirees (I have not studied this market extensively). It may be that during any future stress muni bond funds do not allow redemptions. Or it may be that the value of the funds go down and they still trade. I will take the latter as being more likely. In that case, the wealthy retirees will be looking to preserve their wealth and not really understanding the fundamentals to begin with they will sell their muni bond funds. At this point, an important question is why they were in muni bonds to begin with and the overwhelming reason is that the income is tax free. The only other bond investment that has similar tax free advantages is US government bonds, which are free of state income tax. Much of this money will be moved to US government bonds.

While US government bonds appear to be a bad investment from the perspective of looking at them in isolation, if cracks are to appear in weaker bond issues first (anything from junk bonds to credit card receivables to European periphery debt to commericial mortgage debt to muni bonds) and this is highly likely at this point (look at CDS rates for one) the money flows out of the weaker issues are going to hit US government bonds. The way this won't happen is if all appears pretty rosy in the economy and there is no need to be concerned about any of this weaker debt.

Of course, as with anything market related, there are several wildcards in this or any scenario, as I've alluded to previously. One is whether the Fed will back or guarantee the entire worldwide debt market. Another is whether the Fed, even if they will do that, has the ability or the perceived ability or the permission to do so.

As to how that will affect the dollar.

First, let's define the dollar, although as we know there is really no concrete definition. For the purpose of this discussion, I will define the dollar as a Federal Reserve Note, or the liability side of the Fed balance sheet. That would mean the dollar is equivalent to US government bills and bonds and MBS (although we don't know to what extent, what the rating of these things are, and what was paid for them) which is the asset side of the Fed balance sheet. To the extent that the Fed is willing to guarantee other debts defines the extent to which a dollar is indirectly something else. The equivalency does not extend to being able to go to a Federal Reserve Bank and exchange Federal Reserve Notes for any of those insturments but the market readily allows that equivalence and any entity can do it.

When the value of any weaker debt instrument that is further on the scale of equivalence from a dollar declines in value, all things being equal, the effect is to reduce the supply of dollars as well as to bolster the value of the stronger debt instruments that are closer on the scale of equivalence to a dollar. What I hear you saying is that a muni bond or muni bond fund is not the same thing as a dollar. It is and it isn't. It would be like saying that the real estate transactions that occur on the margin are irrelevant because I'm living in my house and not selling. That can be true to a point. But consider also that if you are a retiree and invested in muni bonds, those funds are your cash flow and income stream. In terms of how the funds are spent, it makes no difference to the wealthy retiree whether those funds are under the mattress, in a direct cash equivalent account, or in a muni bond fund. A certain amount will be withdrawn on a regular basis as income. The only difference is that the muni bond fund in a healthy bond market maximizes this lifetime income stream and is thus an optimal income stream to the retiree and the economy. Another thing I would mention is that if a wealthy retiree were to sell his muni bond portfolio and withdraw that as cash (Federal Reserve Notes) out of the financial system and put it under his mattress and treat it as he would a muni bond fund, additional money has been printed but at the same time this action is deflationary in effect because it is reducing the income stream as well as moving the money multiplier into reverse. In this case it also forces the municipalities to operate on a balanced budget and a cash basis provided there is no more Fed intervention.

[Higgenbotham]

Silver is up over 5% so far and the market is not even open yet!

Today I finished selling all of my inflation hedges and have moved 100% to US dollars (t-bills mostly) for the first time. I've been working on this since last Monday. I'd mentioned previously that I went to a deflationary bias for the first time in 2007, having moved from less than 50% US dollars to 75%.

More later. The best asset allocation shifts are typically made during times of maximum emotion and uncertainty and there are never any guarantees.