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Good Afternoon,
Friday's markets and their actions confirmed that which many had already feared: this was the worst month for world stock markets, in decades. It is looking more and more like it is going to be one long, cold economic winter, and the fear is that it could lead to trouble on the social front as the harsh stresses knock people in various countries down like bowling pins. Local currencies from Hungary to Poland, and from Romania to the Ukraine have plunged as eastern Europe bleeds foreign investment money faster than a B-movie gore-fest.
The dark and scary mood also persisted in the commodity markets as metal after grain, and sugar after fuel, all dropped by amounts that start with the superlative "largest" before the metric of the drop is described. To wit: gold finished the month with an 18% loss, heading for its worst monthly drop since 1980, wheat for its largest monthly decline in 22 years, copper and aluminium for their largest drop in over twenty years, sugar for its biggest monthly fall in a decade. Need we go on? Sure we do. Capping the worst achievement category, crude oil. It will record its single largest monthly drop....ever.
The final session of Blacktober finished on the downside again for gold bullion. Spot prices fell $14.00 at last check, to $722 as the week's rally which stalled out in the $770's started to look like the precursor to a more pronounced fall in the upcoming week. The metal is acting like a commodity and unlike the currency it is at least partially supposed to be. Deutsche Bank analysts fear that bullion may drop another $100 if the US dollar surges to 1.20 vis a vis the euro anytime soon. Today's consumer spending data revealed a scary nightmare on Main Street in the making. No surprises there. No treats, either. And, no, this is no trick. It is a real as it gets.
Silver finished 7 cents higher at $9.77, platinum dropped $7 to $819 and palladium fell $3 to $195.00 per ounce. The dollar continued to be scary strong, rising like Dracula from his coffin - all the way to 85.67 on the index. Oil rose late in the day, quoted at 68.15 per barrel. The Dow managed a 158 point gain during the final session of the month. A month to forget, for sure. But, enough of that. Let's see what is at the root of all of these horror-show unfoldings.
We have a lot of graveyard ground to cover, so we better dig into the bloody matter. Bluntly stated, stag-deflation is knocking at the door tonight, and its spectre is glowing with an eerie shade of sickly green. Inflation is now harder to find than a poltergeist in full sunlight. We have found two exposes for you to read over this weekend, and ponder how what they portend will affect you. Because affect you, it will. We start the educational section of today's post with a crystal ball gazing session by Marketwatch's Mark Hulbert:
"Is the gold market sensing deflation?
It's important to ask this question, because something is most definitely bothering the gold market. Between Oct. 8 and Oct. 23 alone, for example, bullion dropped by some $225 per ounce. It dropped $15.50 per ounce on Thursday as well.
No doubt there are lots of factors that are conspiring to bid gold down. One that I mentioned in a column a couple of weeks ago is sentiment among gold timing newsletters. See Oct.16 column
I was prompted to consider deflation as another factor by recent developments in the Treasury market. That market is many orders of magnitude larger than the gold market, and its collective judgment cannot be dismissed lightly.
And right now, the Treasury market considers inflation to be a far lower threat than it was just a couple of months ago.
Consider the yields on regular nominal, Treasuries and those that prevail for the Treasury's Inflation Protected Securities, or TIPS. The primary difference between these two kinds of Treasuries is that TIPS' yields are protected against changes in the inflation rate. Theoretically, at least, this means that the difference in these yields will reflect the bond markets' expectation of future inflation.
As of Thursday night, the yield on 10-year regular Treasuries stood at 3.95%, according to the CBOE's 10-Year Treasury Yield Index. The yield on 10-year TIPS, in contrast, stood at 3.03%. The difference of 0.92 percentage points implies that the bond market is betting that the CPI will average less than 1 percent annually over the next decade.
Inflation over the next decade of less than 1%? That seems incredible.
To be sure, the flight to quality in recent weeks has undoubtedly skewed this number downwards. The market for regular Treasuries has received a disproportionate share of that flight to quality, artificially depressing the yields on 10-year Treasuries.
Economists at the Cleveland Fed have devised an econometric model that estimates the degree to which the spread between nominal Treasuries and TIPS is skewed downward by these liquidity considerations. That model recently calculated this bias to be around 0.5 percentage point, suggesting that the true message of the bond market right now is that inflation would average around 1.4% year over the next decade.
That's still incredibly low, given that the CPI over the past 12 months was up 4.9%. It's unlikely that the CPI can start at nearly 5% and nevertheless average 1.4% over the next decade without it actually turning negative along the way.
And that in effect means the bond market is betting on deflation.
This puts into perspective the federal government's efforts in recent months to pour huge amounts of money into the financial arena. That would otherwise be quite inflationary.
But not if the forces of deflation are as large as the bond market is evidently assuming them to be.
And judging by the recent performance of both the bond and gold markets, it would appear as though deflation still has the upper hand."
In case Mark was not convincing enough, let's consult Nouriel Roubini, weekly Forbes columnist and Professor at NY's Stern Business School. Today's lesson: Stag-Deflation.
Back in January, I argued that four major forces would lead to a risk of deflation-- or "stag-deflation," where a recession would be associated with deflationary forces--rather than the inflation that mainstream analysts have worried about.
They were: (1) a slack in goods markets, (2) a re-coupling of the rest of the world with the U.S. recession, (3) a slack in labor markets, and (4) a sharp fall in commodity prices following such U.S. and global contraction, which would reduce inflationary forces and lead to deflationary forces in the global economy.
How has such argument fared over time? And will the U.S. and global economies soon face sharp deflationary pressures? The answer: Deflation and stag-deflation will, in six months, become the main concern of policy authorities.
First, the U.S. has entered a severe recession that is already leading to deflationary forces in sectors where supply vastly exceeds demand (housing, consumer durables, motor vehicles, etc.). Aggregate demand is falling sharply below aggregate supply. The unemployment rate is up sharply, while employment has been falling for 10 months in a row. And commodity prices are sharply down--about 30% from their July peak--in the last three months, and are likely to fall much more in the next few months as the advanced economies' recession goes global. So both in the U.S. and in other advanced economies we are clearly headed toward a collapse of headline and core inflation.
Is there any doubt about this ongoing inflation capitulation and the beginning of sharp deflationary forces? Take the current views of the economic research group at JPMorgan Chase. This group was, in 2007-08, the leading voice arguing about the risks of rising global inflation and the associated risks of a global growth reflation, and that policy rates would be sharply increased in 2008-09.
This week, however, the JPMorgan research group published its latest global economic outlook, arguing that we are headed toward a global recession, negative global inflation and sharply lower policy rates in the U.S. and advanced economies--a 180-degree turn from its previous position. What a difference a year makes!
Do you have any further doubt that we're headed toward a global deflation or--better--a global stag-deflation? Read on: Aggregate demand is now collapsing in the U.S. and advanced economies, and sharply decelerating in emerging markets. There is a huge excess capacity for the production of manufactured goods in the global economy, as the massive, and excessive, capital expenditure in China and Asia (Chinese real investment is now close to 50% of gross domestic product) has created an excess supply of goods that will remain unsold as global aggregate demand falls.
Commodity prices are in free fall, with oil prices alone down over 50% from their July peak (and the Baltic Freight Index--the best measure of international shipping costs--is 90% down from its peak in May). Finally, labor market slack is sharply rising in the U.S., and rising, as well, in Europe and other advanced economies.
Next question: What are financial markets telling us about the risks of stag-deflation?
First, yields on 10-year Treasury bonds have fallen by about 50 basis points since Oct. 14, getting close to their previous 2008 lows. Also, the two-year Treasury yield has fallen by about 150 basis points in the last month.
Second, gold prices--a typical hedge against rising global inflation--are now sharply falling.
Finally, and more important, yields on Treasury Inflation-Protected Securities (TIPS) due in five years or less have now become higher than yields on conventional Treasuries of similar maturity. The difference between yields on five-year Treasuries and five-year TIPS, known as the break-even rate, fell to minus 0.43 percentage points.
This is a record. Since the difference between the conventional Treasuries and TIPS is a proxy for expected inflation, the TIPS market is now signaling that investors expect inflation to be negative over the next five years, as a severe recession is ahead of us.
So goods, labor, commodity, financial and bond markets are all sending the same message: Stagnation/recession and deflation (or stag-deflation) is ahead of us.
Don't be surprised, then, if six months from now the Fed and other central banks in advanced economies will start to worry--as they did in 2002-03 after the 2001 recession--about deflation rather than inflation. In those years, when the U.S. experienced a deflation scare, Fed Chairman Ben Bernanke wrote several pieces explaining how the U.S. could resort to very unorthodox policy actions to prevent a deflation and a liquidity trap like the one experienced by Japan in the 1990s. Those writings may, very soon, have to be carefully read and studied again.
Finally, while in the short run a global recession will be associated with deflationary forces, some ask whether we should worry about rising inflation in the middle run? This argument--that the financial crisis will eventually lead to inflation--is based on the view that governments will be tempted to monetize the fiscal costs of bailing out the financial system, and that this sharp growth in the monetary base will eventually cause high inflation.
In a variant of the same argument, some posit that--as the U.S. and other economies face debt deflation--it would make sense to reduce the debt burden of borrowers (households and, now, governments taking on their balance sheets the losses of the private sector) by wiping out the real value of such nominal debt with inflation.
So should we worry that this financial crisis and its fiscal costs will eventually lead to higher inflation? The answer to this complex question: likely not.
First, the massive injection of liquidity in the financial system--literally trillions of dollars in the last few months--is not inflationary, as it accommodates the demand for liquidity that the current financial crisis and investors' panic have triggered. Thus, once the panic recedes and this excess demand for liquidity shrinks, central banks can and will mop up all this excess liquidity.
Second, the fiscal costs of bailing out financial institutions would eventually lead to inflation if the increased budget deficits associated with this bailout were to be monetized, as opposed to financed with a larger stock of public debt. As long as such deficits are financed with debt--rather than by the printing presses--such fiscal costs will not be inflationary, as taxes will have to be increased over the next few decades and/or government spending reduced to service this large increase in the stock of public debt.
Third, to the question raised earlier: Wouldn't central banks be tempted to monetize these fiscal costs--rather than allow a mushrooming of public debt--and thus wipe out with inflation these fiscal costs of bailing out lenders/investors and borrowers? Not likely in my view. Even a relatively dovish Bernanke Fed cannot afford to let the inflation-expectations genie out of the bottle via a monetization of the fiscal bailout costs. It cannot afford to do that because a rise in inflation expectations will eventually force a nasty and severely recessionary Volcker-style monetary-policy tightening to get the genie back into its bottle.
Fourth, inflation can reduce the real value of debts as long as it is unexpected, and as long as debt is in the form of long-term nominal fixed-rate liabilities. An attempt to increase inflation would not be unexpected: Investors would write debt contracts to hedge against such a risk if monetization of the fiscal deficits does occur.
Also, in the U.S. economy, a lot of debts--of the government, of the banks, of the households--are not long-term nominal fixed-rate liabilities. They are, rather, shorter-term variable-rate debts. Thus, a rise in inflation in an attempt to wipe out debt liabilities would lead to a rapid repricing of such shorter term, variable-rate debt. And thus expected inflation would not succeed in reducing the part of the debts that are now of the long-term nominal fixed-rate form--i.e., you can fool all of the people some of the time (unexpected inflation) and some of the people all of the time (those with long-term nominal fixed-rate claims), but you cannot fool all of the people all of the time.
In conclusion, a sharp slack in goods, labor and commodity markets will lead to global deflationary trends over the next year. And the fiscal costs of bailing out borrowers and/or lenders/investors will not be inflationary, as central banks will not be willing to incur the costs of very high inflation as a way to reduce the real value of the debt burdens of governments and distressed borrowers. The costs of rising expected inflation will be much higher than the benefits of using the inflation tax to pay for the fiscal costs of cleaning up the mess that this most severe financial crisis has created."
Yes, there will be a quiz on all this. But not that soon. Preoccupation with the US elections will now take over for a few days and markets might like to rest but likely won't be able to. In closing, Bloomberg follows up on the themes discussed above, with a UBS take on gold's [possible] coming year.
" Gold is falling on speculation that the global economy could be heading into a period of deflation, curbing demand for gold as an inflation hedge. ``There's a real concern about deflation; that's one of the reasons gold has moved,'' Martin said. UBS AG cut its 2009 forecast for gold by 15 percent to $700. ``Gold will remain under pressure in 2009 from a combination of slowing demand for jewelry from important emerging markets and disinvestment as inflation slows and the dollar continues to strengthen,'' UBS analyst John Reade wrote in a report today."
Don't know about you, but for now that pile of chocolate candy looks as if it might fit the bill and make some of us feel better. Just make sure you leave some for tonight's begging kids.
We travel to NY on Monday, and will report from the belly of the beast: the NYSE. We're going in in full combat gear. The show is titled: "Inside Commodities" - The niche is headed for its worst month in 52 years. Another superlative for the record books.
Jon Nadler
Senior Analyst
Kitco Bullion Dealers Montreal
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Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a solicitation to make any exchange in precious metal products, commodities, securities or other financial instruments. Kitco Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.
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