Quantitative deflation? Central planning gone awry.

In what may be a surprise to many, quantitative easing appears to be helping to engender an atmosphere of commodity deflation.

Can printing money cause prices to drop?

The creation of trillions of dollars of liquidity has created an interesting paradoxical effect on commodities. If a business is able to finance a resource extraction project which is sustaining a loss, and that funding becomes cheaper than shutting it down entirely, then operating at a loss may become the ‘new normal.’

As a result, those very same companies are selling their product for less than it costs them to extract it.  Additionally, and perhaps equally importantly, this adds to supply at artificially low prices creating a distortion in prices downward.

Meanwhile, demand dries up because the same monetary policy transfers wealth (and purchasing power) from consumers to what the financial media calls the investing class.

Beyond a mere thought experiment…

This increase in supply and drop in demand appears to be evident across many elements of the commodity spectrum right now, including perhaps most visibly energy and metals.

Extraction of resources continues, perhaps at a slightly slower pace, but at much higher levels than if financing were more expensive (or the cost of idling operations was lower).  This is especially evident in the North American shale gas industry and in many oil suppliers inside and outside of OPEC.

Additionally, many gold miners continue to operate at a loss rather than throttling production or shuttering mines.

Such a paradox has two major problems:

1: Should such activities of pulling future demand in to today’s artificially low prices continue it will cause significantly higher resource utilization, leading to more pollution, misallocation of resources and poor planning.

2: A lack of future resource availability sets the stage for significant structural economic problems.  The misallocation of resources and resulting poor planning would lead to less demand for renewable energy sources and their development, as an example.  In effect the first problem makes the second worse.

Bears set the stage for bulls

When such a fantastic crash in commodities happens, it cannot be ignored.  We’ve seen commodity index prices across many measures crash to levels not seen since the late 1990s.  Part of this has to do with an ailing China, but the other component, the lack of supply destruction, has to do with the aforementioned financing making continued operations more sensible on paper than throttling or shutting down extraction projects.

As a result, it would appear as though we are in the midst of a vicious commodity bear market that could be setting the stage for an incredible bull market in commodity prices.

As misallocation of resources leads to a lack of availability when demand does return, this will in turn cause a significant price shift higher as prices must destroy demand that cannot be met by supply.

Shifting sentiment can take years

The lead time for companies to re-expand their operations and engage in additional exploration generally takes years.  That is to say, the shifting mindset from one of conservation of capital to one of speculation and euphoria will not happen overnight.

When it does, however, this bear market may be seen as a generational opportunity to have invested in commodities and the companies that produce them at a fraction of their fair market value.

Fedflationary fabrications

These press conferences with Federal Reserve Chairman Dr. Bernanke are becoming more amusing as of late:

“We, the Federal Reserve, have spent 30 years building up credibility for low and stable inflation [..]” – Ben. S Bernanke

Really?  On what basis of calculating inflation can one say with a straight face that over the last 30 years inflation has been tame or for that matter stable?  Let’s take a look at the 30 year chart of the CRB index, which represents a broad view of commodities as priced in US dollars.

30 year CRB index chart showing high inflation and unstable prices

30 year CRB index

Clearly inflation is not under control.  However, if the above chart is not enough to make one skeptical of the Fed’s latest remarks, then here’s a 30 year chart of the US dollar index, the currency in which prices are set for all the items we purchase in the United States (and other countries using or pegged to the US dollar).

30 year US dollar index chart

30 year US dollar index

What one can gather from these charts is that we’re experiencing 30 years of a weakening dollar and extremely volatile commodities prices.  Our central bank has the audacity to tell us that inflation is under control, and that in essence one should ignore gas prices, food prices and the prices of other goods which have surged over the last few decades (because all of the official inflation statistics ignore said prices).

I’ve always been a skeptic of the Fed’s press releases and these conferences, but this statement alone is enough to make one’s head spin when put in to context with the charts above.  I believe instead that the Fed is claiming inflation is under control as a guise to give them the flexibility to perform more easing should the European contagion come home, or if our own sovereign debt issues begin to become more apparent to bond investors.

Without quantitative easing, twisting (and lots of shouting) our markets would likely have higher Treasury yields, lower equity prices — but people would be enjoying lower prices on food and energy.  With the labor market stagnating and the overall economic picture still quite dismal, one has to wonder whether the Fed’s dual mandate of encouraging employment and maintaining stable prices has been abandoned in favor of recklessly supporting the financial system at large, and more specifically US Treasury bond and equity prices.  It certainly seems to be the case when objective data is reviewed from a macroeconomic perspective.

Thoughts on equity, energy and metals markets

At this point there is some distortion between energy and metals which have a direct relationship as energy must be expended to mine the metals. usually the ratio is 10x the price of a barrel of oil for an ounce of gold, but now it’s been in a range of 12.5x-15x.

Either oil is very undervalued (which is unlikely) or gold is overbought at these levels.

Today’s close of the stock markets and oil seems to indicative of a risk repricing that began last week.

960 (around the 50 day moving average) on the S&P 500 and $65 a barrel on light sweet crude are my downside targets short term, but if either breaks we could trade to much lower support levels.

In addition, when examining the huge sell off in natural gas prices, it’s near certain that energy has more negative catalysts than positive because industrial utilization continues to lag despite the green shoots propaganda that we keep hearing.

Finally, there are a growing number of bears calling for a shake out of March’s lows coming this fall because of a new leg down in commercial real estate that will bleed liquidity out of the equity markets and REITs.

Potential risk reversal in global markets

It looks like safe haven assets like bonds, yen and dollars are becoming more attractive vs. risky assets like commodity currencies, commodities, equities and emerging markets in general.

I think we may be entering the next leg down as Mohamed El-Erian and others have expressed the same sentiment I have. The rally is running on fumes.

We probably will retest the lows in the market and bring some fear back in to the trading. VIX is up 6%+ today and we’re seeing a lot more put buying as institutions either bet against or insure profits in stocks.

Consumer sentiment was terrible and there is now some question as to whether the FDIC is solvent after taking over Colonial Bank. All the Maes are probably completely toxic now, too. I hope foreign central banks continue their generosity or the falloff here could become a disaster.

Fed fractionalizes funds rate to market cheer

The stock market cheered the US central bank’s historic interest rate cut today, surging nearly 5% on the S&P 500 back above 900 to 911.82. The rate cut, combined with continued quantitative easing in Treasury bonds was evident in today’s trading, with a flood out of US dollars in to commodities and other currencies as well as bond yields dropping sharply.

The implications are clear. Inflation will begin in some measure of time, whether it is days, weeks or months. We can see traders already preparing by taking long positions in anything that stands to benefit from the dollar’s fall. Near term we could see the US dollar index fall as low as 72, retesting its prior lows and further confirming the head and shoulders pattern. Commodities and currencies remain attractive buys.

US dollar index showing head and shoulders

The US dollar index is forming an all too familiar pattern.  This is certainly a result of wreckless monetary policy turning deflation in to a potential stagflationary situation. At this point we recommend purchasing commodities (DYY is a good ETF because it is 2x leveraged and well diversified) and other currencies while there are reasonably priced opportunities.  We like the Euro and Yen for this trade.

US dollar index

US dollar index shows head and shoulders pattern

The courageous may consider purchasing commodities stocks as they will likely participate, but the future of the equities market is not necessarily certain as the recession is deepening.  Today’s unemployment claims were higher than the expected 525k at 573k.  That is a very bad sign that the worst is far from over in terms of how many layoffs we can expect.