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    - 29 August 2001

Inflation - a political imperative in the US

By allowing debts to be repaid in depreciated currency, inflation favours debtors at the expense of creditors. Also, inflation often has the effect of boosting asset prices, thus increasing the collateral that supports existing debts and providing the basis for new debts. A problem inevitably arises, however, because creditors aren't stupid - they don't like to see their real returns dwindle as a result of loans being repaid with depreciated money. They therefore begin to adjust interest rates higher to account for the currency's anticipated loss of purchasing power over the period of the loan.

The US has experienced a high inflation rate over the past few years. However, as discussed many times in the past, the strong Dollar has suppressed the negative effects of the inflation. By helping to keep producer and consumer prices in check, the rising trend in the Dollar's foreign exchange value has alleviated the need for the high market interest rates that would normally result from high inflation. With the Dollar's foreign exchange value no longer trending skyward, a substantial rise in long-term market interest rates is now on the cards.

American voters are up to their eyeballs in debt, so higher market interest rates and the knock-on effects of higher interest rates (less spending, less investment, lower growth, higher unemployment) would cause big problems to say the least. The potential solutions? Allow the economy to experience a severe multi-year recession to wash away the excesses, thus guaranteeing a loss for the incumbents at the next election, or inflate at an even faster pace to postpone the day of reckoning (hopefully, to some time after the next election). Clearly, the political pressure on the Fed to keep inflating will be enormous.

The big question is, if deflationary forces take hold can the Fed keep the money supply expanding? The answer is no, not if it sticks to its routine of simply setting a target Fed Funds Rate. As the Japanese have shown, even taking interest rates all the way down to zero is of no benefit if lenders stop lending and borrowers stop borrowing. However, the Fed's power is not limited to the setting of a Fed Funds Rate target. In fact, as the following passage from Bob Woodward's book "Maestro" clearly shows (the passage deals with the tactics contemplated by the Fed in the wake of the 1987 stock market crash), the Fed's power to create money out of nothing is effectively unlimited

"They [the Fed] had the legal power to buy up the entire national and private debt, theoretically infusing the system with billions, even trillions, of dollars, more than would ever be necessary to restore liquidity and credit. Of course, the result of that would be Latin American-style inflation. 

In addition, there was an ambiguous provision in Section 13 of the Federal Reserve Act, the lawyers told Greenspan, that could allow the Fed, with the agreement of five out of seven members of its board, to loan to institutions - brokerage houses and the like - other than banks. Greenspan was prepared to go further over the line. The Fed might loan money, but only if those institutions agreed to do what the Fed wanted them to do. He was prepared to make deals. It wasn't legal, but he was willing to do it, if necessary. There was that much at stake. At that moment, his job was to do almost anything to keep the system righted, even the previously inconceivable."

If at some future time the Fed does make full use of the money-creating powers available to it then the power of the Dollar (purchasing power, that is) will plummet. However, a reduction in the Dollar's purchasing power will always be tomorrow's problem until it gets completely out of control, at which point it will become today's problem. Until the depreciating Dollar does become today's problem, that is, until soaring interest rates make it today's problem, there is no reason to expect the US monetary authorities to do anything other than inflate. 

Bubble Comparison

We can learn a lot from history, but a mistake that is often made is to focus on the similarities between the current time and past times while ignoring the differences. The differences can be critical.

There are a lot of similarities between the Japanese credit bubble of the late 1980s and the US credit bubble of the past several years, but one huge difference (a difference that has thrown many analysts) is that the Japanese credit and stock market bubbles ended at roughly the same time whereas the US credit bubble continues to go strong 18 months after the stock market peaked. The resilience of the US credit bubble has resulted in a rather strange set of circumstances - soaring money supply growth, a strong real estate market and moderate increases in consumer spending in parallel with the NASDAQ experiencing one of the worst declines in stock market history.

One characteristic of the Japanese bubble and other previous credit bubbles that we expect to carry through to the current US situation is a decline in the currency of the bubble economy (relative to other major currencies and gold) during the bubble's final stage. 

Below is a chart comparing the Nikkei225 Index, the Dollar-Yen exchange rate (the scale is reversed so that a rising line indicates a rising Yen), and the gold price in terms of the Yen from the beginning of 1988 to the end of 1995. Note that during the final 12-15 months of the Japanese bubble the Yen fell against the Dollar and against gold. This decline in the Yen during 1988-1989 was a trend reversal (the Yen had been very strong from 1985 through to 1988) and signaled that the bubble was in its final stage. 

The Yen bottomed in terms of the Dollar and gold shortly after the bubble burst and then trended higher for the next 5 years. Whether or not the Dollar follows this pattern and begins trending higher after the US bubble bursts will be determined by the response of the Fed.

The US Stock Market

Stocks and Bonds

In the latest Weekly Market Update we said "...if bonds spike up into the 106-107 range (just below the March peak) over the coming 1-2 weeks in parallel with another pullback in the stock market, they would present a spectacularly-good selling opportunity." September bonds closed at 106-6/32 on Wednesday, so they've moved into the selling range. Bonds may see some additional near-term upside if stocks continue to decline, but they are now within shouting distance of the March peak and we do not expect them to exceed this prior peak.

The bond market peaks in January and March coincided, to the day, with bottoms in the equity market and the current pattern is unfolding in exactly the same way. During the 4 weeks following the March-22 peak in bonds that corresponded with the intra-day low in the S&P500, bond futures plunged 6 points (a very large move for this market). We expect something similar to occur this time around and, although a bit more upside is possible over the next few days, we are now short-term bearish on bonds (we have been long-term bearish since early-January).

The approaching peak in bonds is also a sign of an approaching bottom in stocks.

Current Market Situation

From the August-27 WMU: "The ideal pattern for the coming week would be for the market to initially move higher and then drop late in the week to test the lows reached on August-21/22." And "...we would actually be less enthusiastic about the prospects for the coming 2 months if the market does not pullback but instead ramps higher into the Labor Day weekend."

We didn't get any early-week strength, but have got the drop back to the August-21/22 lows (slightly lower for the S&P500 and slightly higher for the NASDAQ100). The ideal situation (from a bullish perspective) would see the market spike lower over the coming one or two trading sessions in parallel with a final surge in bonds. That would give us the perfect set-up for our anticipated September-October rally.

It is always emotionally difficult to move in one direction while the herd is stampeding in the opposite direction, but that is what we are going to do because the market's panic attack is creating an exceptional opportunity. We are mindful of the fact that the trend is down and that an emotional washout is possible, so this is certainly no time to be buying on margin. However, we think that those traders who buy on weakness over the next 1-5 trading sessions will be handsomely rewarded. We purchased one position in QQQ shares last week at around current levels and will add a second position if the market spikes lower today (with a sell-stop set just below the early-April low).

Gold and the Dollar

Current Market Situation

We expect the counter-trend rebound in the Dollar that commenced last week to continue for at least one more week. A reasonable objective for this rebound is a return, by the Dollar Index, to its 200-day moving-average (currently situated at around 115, versus yesterday's close of 113.54). Likewise, it would be normal for the euro to pullback to its own 200-day moving-average at around 0.89.

We expect the pullback/consolidation in the gold price that began last week to continue into next week in parallel with the Dollar's rebound. Gold appears to be setting itself up for a rally and, once ready to go, will probably just need an absence of Dollar strength rather than serious Dollar weakness in order to move higher. Recall that during April and May the gold price rallied as the Dollar traded sideways (see Dollar Index chart below) and reversed lower on the same day (May-22) that the Dollar broke upwards out of its flat consolidation.

During April and May the gold and stock markets rallied while bonds tanked. This occurred because the financial markets came to embrace the belief that the deflation-fighters at the Fed were going to be victorious. We can envisage a similar outcome for the next 2 months.

Changes to the TSI Portfolio

No changes.

 
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