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.

The crude contagion could cause chaos, crash

On the heels of another massive sell off in crude oil, the US stock market woke up from its slumber.  Instead of the discount in crude oil being priced in as a stimulus, it was seen (perhaps more accurately) as a risk. Crude touched prices that had not been seen since April, 2009.

US equities sold off on higher than average volume, with bonds, gold and silver catching a bid.  The VIX showed fear entering the market and spiked higher, but the rally faded as the day went on.  The US dollar strengthened modestly on the back of a weaker Euro and Yen.

Interest rates on the 10 year bond tested 2.00%, while gold has climbed above $1,200 and stabilized.  Tonight the Nikkei is selling off significantly in Tokyo.

crude oil

Greed may pause to give room for fear to take the reigns.

Markets are decidedly in a risk off mindset.  I suspect that this fear of risk will prevail over the leveraged and crowded long side bullishness that has pushed the US stock market up to record highs with few downdrafts over the last few years.

The fundamental improvements in the US economy have been sluggish, with many corporations buying back their own shares to boost EPS.  There is a dislocation between current perceived valuations and the global economy’s condition.

The crash in crude oil has brought about a serious challenge to many economies of energy producing nations, including the US.  Since 2008 many of the high paying new jobs have been in the energy sector.  Now that oil is down over 50% from its highs, many of these projects are no longer viable and drill rig operations are now at 10 month lows.

us oil and gas rigs jan 5 2015

Energy markets are an indication of economic health.

There is a certain amount of feedback from energy market prices that can be indicative of manufacturing activity, shipping and transportation.  To the extent that supply exceeds demand, prices should diminish until demand returns.  But even with a 50% cut in prices, there still seems to be room for more of a decline.  That is because while demand is diminishing, some oil producers are keeping or increasing supply rather than removing production.  This includes OPEC, Russia and Iraq, who stubbornly churn out more oil as prices lose support.

The perception becomes that a flood of oil is oversupplying the markets, but the reality is that demand has declined to such an extent that softening Chinese manufacturing demand has caused a ripple effect.  Most of the softening demand comes from Europe, China’s largest customer, coming to grips with a wave of economic headwinds.

This new normal, if we are to give it a name, is likely an indication of future global macroecnomic trends.

Global GDP 2015

Deflation strikes Japan and the EU.  Is the US next?

Persistent deflation is becoming a persistent theme.  Bond yields in Germany on 5 year notes hit negative yields.  Japanese bonds have fractional yields.  The US bonds seem to be ebbing lower and lower in interest rates in sympathy of the global deflationary pressures coming home to roost.

Are we going to experience a lost quarter century like Japan?  It seems ever more likely as the similarities are increasingly problematic.  A prescription of debt to solve debt-related problems.  Liquidity injections for structural economic problems show a lack of understanding from central authorities about what is wrong with our economy.

Nikkei stock index

Too much leverage, too many derivatives, too little transparency.

What the world needs now is more clarity about how far stretched the current system has become.  With over 700 trillion dollars of global derivatives, there is such an enormous amount of risk in opaque markets that a significant dislocation could cause another financial collapse.

None of the problems of 2008-2009’s Great Recession have been resolved at home or globally.  Instead the financial players that created the problem have now been given the reigns of the global economy and are leading us down a destructive path towards crisis.

The problems of the world will most likely come home to the US in 2015 and cause a profound impact on our economy and financial markets.  While it may not be apparent yet, I believe that the risks now are much greater than back in 2008-2009 and the ability of monetary authorities to mitigate those risks is impaired by the current and recent aggressive measures.

DerivMkt-BIS-Dec'87-Dec'10

Stay tuned in to the flow of news.  Interesting things may happen sooner than we expect.

Where is the Japanese economy headed?

With deflation continuing despite long-term zero interest rate policy, how does the new Japanese government plan to expand its efforts to revive economic growth and lower unemployment?

Is this our future?

Japan paints a very sobering picture of what the future of the United States may be facing in the future should this loose monetary policy continue unabated. Zombie banks, real estate bubbles, deflation and stock market collapses are all themes very familiar to the Japanese economy in the 1990s.

Unfortunately the circumstances are all too similar here at home. Adding to that Japan also has a large aging population that will soon outnumber its workers, akin to the situation we face in the United States. All of these reasons and more are why it’s important to pay attention to where the Japanese economy is heading.

Severe economic routs have no easy cure

Every time a massive speculative bubble implodes it leaves behind a tremendous amount of credit destruction, which in turn absorbs liquidity and pressures equities, corporate bonds and derivatives like credit default swaps. All of these circumstances potentially create deflationary forces that can shrink the capital base of a country and even create a banking panic. After all, debt is money in many modern economies. As that monetary base shrinks each unit becomes more valuable.

Mitigating the risk of severe economic contraction requires an innovative and careful approach to the underlying cause with attention to stimulating the next catalyst. Green energy is one of many appropriate catalysts for a non-speculative sustainable global economic evolution. Others include technology, infrastructure, education and health system improvements.

Japan must lead or become obsolete

For many years Japan has enjoyed the status of second biggest economy in the world, but that status is quickly fading as Japan’s export-based economy contracts in the face of a global recession and slumping industrial production.

The new government in Japan has an opportunity to reverse policy mistakes of the previous ruling party and create a sustainable economic model that is more focused on durable growth rather than speculation. This would prove to be a model for the rest of Asia if Japan can take the lead.

If Japan’s economy can not evolve and take the next step forward, China and other neighbors will gobble up the industrial production for exports that was once taken for granted.