Deflationary
Forces Dominate Despite Fed's Loose Monetary Policy
By The Curmudgeon
In our October 23rd Curmudgeon Corner commentary we stated that massive hedge fund deleveraging and repatriation of borrowed US dollars invested overseas had produced a huge (and unexpected) US $ rally, which has had major investment implications.
We now believe that the steep sell off in Gold, Crude Oil, and other commodities (all are anti-US $ bets) indicate we are entering into a deflationary cycle- at least for the next 6 to 12 months. This is quite hard to believe from a monetary perspective. The U.S. has deeply negative real interest rates on Treasuries and the unprecedented Fed expansion of the monetary aggregates would normally point to much higher inflation ahead. It is hard to believe the straight line up moves in adjusted bank reserves and the adjusted monetary base since early September. M2 and the Currency Component of M1 are also going through the roof. Check out these eye popping charts at:
http://research.stlouisfed.org/publications/usfd/20081031/usfd.pdf
So how could we have deflation with such a loose monetary policy? Answer: it seems that credit is being destroyed as fast as the new money is created. Banks and corporations continue to write off bad loans and other investment losses. Instead of lending, banks are largely hoarding the high- powered money created by the Fed, in order to bolster their balance sheets or maintain their dividend payments to shareholders. Because the economy is contracting, there is muted loan demand from corporations to expand their operations or to finance increased capital spending. All this puts a damper on inflationary psychology, despite the negative real interest rates that usually results in excessive borrowing and higher inflation. It will be very difficult for companies to raise prices in such an environment.
We think this new deflationary cycle will have very negative implications for commodities, despite their record October plunge. This is a complete reversal of our previous forecast.
Our short to intermediate term outlook for commodities is bearish for several reasons:
1. Fundamentals have drastically changed due to the credit crisis and global financial meltdown. Aggregate demand will be off sharply due to the global recession and slowdown in China and other emerging markets. Infrastructure spending from developing nations will be way down as will be the demand for industrial commodities.
2. The US dollar has been in a sharp up trend since July for all currencies except the Yen. Buying of commodities as an anti-US $ play is over. Crude oil is a great example of this. Even when OPEC cut production more than expected last week, the oil price went down.
Contrary to our previous view, the US dollar will likely remain strong. This is partially due to more $ repatriation, e.g. deleveraging and investors redeeming from hedge funds and equity mutual funds that invested abroad. It’s also perceived that the ECB and UK Central banks will be drastically cutting rates, thereby narrowing interest rate differentials with the U.S. Even if only a bear market rally, the $ is likely to remain firm for several months at least.
3. There are a lot of deflationary forces at work that are countering massive Fed stimulus: loans are still not being made by banks, falling energy/home/stock prices, increased unemployment, big write offs by financial firms, stronger $ makes imports less expensive and slashes cost of competing products, etc. The result will be that inflation will likely moderate for another 6 months. Hence, investors will not perceive the need for commodities as an inflation hedge.
A timely NY Times article (11/1/08) echoes this point:
4. Various derivatives, e.g. structured commodity notes, specialized options, leveraged ETFs, etc, that pushed commodity prices higher are now defunct and will not be revived.
5. There will be a lot of risk aversion and much less use of leverage by surviving hedge and futures funds. Those factors will likely short- circuit any meaningful rise in commodity prices.
For those who are interested in following the actual demand for commodities, we suggest tracking the CRB Raw Industrial Cash Index:
http://www.crbtrader.com/data.asp?page=chart&sym=BVY0
Various CRB indices can be found at:
http://www.crbtrader.com/crbindex/data.asp
In summary, the financial crisis has turned the global economy upside down and on its head. Investment psychology, fundamentals and technical price trends have reversed sharply and we do not want to cling to our old views and get trampled by the new dynamics now at work.
The Curmudgeon
Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.