Friday, April 22, 2011

The Line In the Sand

The scenario I mentioned below will be accompanied by certain signs if it is to come to pass. The main one will be a breakdown in the dollar below key support.

Everyone is looking at the Nov 2009 intermediate low of 74.205 as key support. Lots of apocalyptic things are supposed to happen if that support is pierced (which it sort of has been, a little bit.)

The real support is 70.698 on the dollar index, which was reached in March 2008. If that support level fails, then we will see a dramatic selloff in the dollar, and I think the jig will be up.

My guess is that the powers that be are not yet ready for that to happen. The price of a currency can be manipulated simply by manipulating the other currencies which the target currency is measured against. The Chinese and Japanese, in particular, have key currencies in the Dollar Index basket, and a vested interest in not seeing the dollar tank just yet. I don't think the Europeans are crazy for the idea of a dollar collapse either. At least not yet. Better to manipulate things to a slower and softer landing if possible. It gives everyone more time to adjust.

Gold and silver are waaaaay overbought, but still don't look ready for a severe correction. I think we will see a modest (10% or so) correction in the next 30 days, and then up to new highs before we get a really nasty pullback that lasts quite a long time.

The bull market is still intact. Don't panic when the plunge comes.

Another key is the price of oil. If we see oil above it's summer 2008 highs, then the oil hyperbull is also confirmed. There will be another sharp correction after that, but I think it's worth buying then.

Wednesday, April 20, 2011

The Battle of the 'Flations

My readers know that I predicted a time of severe hardship in the economy, and counseled them to get out of debt, live simply and frugally, and buy gold and silver.

My expectation has been for a debt-driven deflation. That was my top guess. I admitted that there was a possibility of inflation or hyperinflation, especially after a period of deflation, but I wasn't expecting inflation right now.

But there are some puzzling pieces of data that do not seem to fit either hypothesis.

First, let's get our definitions hammered down. Inflation is an excess supply of money and credit, such that too much money is chasing too few goods and driving the price of the goods upwards. Inflation is characterized by a generalized rise in prices, but a rise in prices is not necessarily inflation. Prices can rise for many reasons. Some shortage, driven by external factors, like a poor harvest, can also cause prices to rise. The key concept for an inflation is that everyone has too much paper money in hand and wants to get rid of it as fast as they can. Wages rise very quickly in a vain attempt to keep pace with inflation. Citizens want to exchange their paper money for something that has tangible economic value. This photo shows that very clearly. The woman is heating her house with nearly worthless Weimar Republic Reichsmarchs. This pile of cash is so worthless that it cannot even buy an equivalent amount of coal for heating. From her perspective, the price of coal would keep going up by leaps and bounds. To her, it's cheaper to burn up the money than to buy coal. In an inflation, the velocity of money (how fast it changes hands) is very high. Paper money is like a hot potato that nobody wants to hold on to for very long. If you get a piece of paper you want to get rid of it as fast as you can. In Weimar Germany, at one point, workers were paid twice a day. The worker's wives showed up with wheelbarrows to collect a half-day's earnings in cash. Then they'd run off to the markets to buys something... anything... with that pile of cash.

Even holding bedpans was preferable to holding Reichsmarks.

A deflation, on the other hand, is a contraction of available money and credit. There are more things for sale than there is money to buy it, so nobody buys much. In a deflation the velocity of money slows dramatically. Prices fall because of a lack of demand. And by some measures that is what has been happening. The following chart illustrates that.

U.S. wages are stagnant. Unemployment is high. Consumer confidence is low. The price of houses is still going down. Retail is sluggish. Borrowing is down and consumer debt is starting to decline as people either pay off their debts or default. All of this points to a deflationary outcome.

But there are also charts showing the supply of money is rising dramatically, like this one from the St. Louis Fed.

The Fed's "Quantitative Easing" is really just a fancy name for money printing, and the Fed is printing lots and lots of money. That should, theoretically, lead to inflation or hyperinflation. And, indeed, we have seen the prices of certain things rise, and that rise for some things seems like it is actually driven by monetary forces. Oil, for instance, is rising steadily, and yet supply exceeds demand, according to some sources, so it should be falling in price, not rising.

I've been puzzling for awhile on what's happening, and I think I've got a tentative answer. There are two variables which make the current world situation different than other situations which have gone before.

1. The U.S. dollar is the world's reserve currency. That means if a company in India wants to buy oil on the world open market, they have to get dollars and then buy oil in dollars. This means that there's a high, ongoing demand for dollars outside of the United States, which tends to protect the value of the dollar vs. other currencies.

2. The U.S. is also the world's consumer of last resort. We buy more stuff than anyone else on the planet, but we manufacture very little of what we consume. We also pay for it in dollars. So our trading partners (China, Japan, etc) have a lot of dollars laying around. Once again, the bulk of this is outside of the borders of the United States.

3. Thanks to the rewriting of laws all over the world in the last 20 years, it is exponentially easier to move goods, and more importantly, money, all around the planet very quickly. Capital flows from country to country very easily nowadays. Easier than it ever has in history.

From this I conclude the following:

1. There is something like a deflation happening in the United States where things that are produced and consumed here are concerned. Houses are the clearest and best example. They are built here and lived in here. Demand for housing is soft. Supply is overabundant. Prices are still declining because of that. Domestic money supply, both in terms of cash and credit, is declining. This is deflationary, but only in the "closed loop" parts of the U.S. economy... things that are produced here by U.S. workers and are mostly sold here. The domestic automotive industry is another example. Dayton, OH is a wasteland of closed GM factories and unemployed auto workers. So is much of Michigan. Those economies are clearly in a depression. Theoretically QE I & II were supposed to address this situation by making lots of easy money available to U.S. businesses and consumers in an attempt to restart demand. But the money has not, by in large, flowed into the U.S. economy. Instead it was taken outside the country.

2. However, there is a huge pool of dollars sloshing around the globe, and the Fed is creating more at a pretty rapid clip. Each new dollar added to the pile devalues the rest of the dollars in the pile. Those who are holding those dollars are in a terrible dilemma. They don't want to hold on to them, because they are declining in value fairly rapidly. Before the Quantitative Easing monkeyshines, they were willing to buy U.S. Treasury Bonds with those dollars for a paltry 3 or 4% interest. But now the Fed and the U.S. government are colluding to keep the interest rates artificially low, so they are losing purchasing power if they invest in any more U.S. Government bonds. We've also been loathe to allow certain dollar holders to buy U.S. companies or assets for political reasons. We didn't want the Chinese buying a certain oil company or Bahrain buying a U.S. Port facility with their dollars.

3. Wherever the holders of those dollars put those dollars, the price of the underlying asset rises dramatically. This is a purely inflationary phenomenon. Too much money is chasing too few goods in this instance. So when the Chinese decide to get rid of their dollars in favor of copper or lithium or soybeans or wheat or oil, the price of those things rises dramatically. That hurts the pocketbook of consumers all over the planet, which in turn reduces their demand for Chinese produced goods, which slows their business and creates more Chinese unemployment and social unrest. The Chinese government fears this more than anything. This also is creating massive social instability in poorer countries, notably in the Middle East. But it will spread to all poor countries as basic foodstuffs become more and more unaffordable to the average families in those nations.

4. There are productive places that the Chinese and others can put their dollars, and they are doing so. They can focus on increasing the available supply of vital food, energy, and clean water. For instance,they are leading the world in the production of Thorium-based nuclear power, which is far superior to Uranium based nuclear power in terms of cost and safety. They can explore and develop new energy sources using those dollars. These will benefit everyone to some extent, but these are few and far between.

5. The one place they can put their dollars that won't really hurt the world economy is gold, and to a lesser extent, silver. And they have been quietly and steadily doing so. The Chinese have dramatically increased their gold holdings in the last five years, for instance, and central banks all over the world have quietly gone from net gold sellers to net gold accumulators. This means that the ultimate bubble is gold, as both Greenspan and George Soros have said.

6. There is a concerted effort by the leadership in the BRIC countries to abandon the dollar as the world reserve currency. They are already implementing a swap-type system amongst themselves which avoids the use of dollars as a medium of exchange. When this happens, the dollar will collapse because much of the built-in demand for dollars has to do with its reserve status. The U.S. government will either default on its debt because interest rates rise too high, or it will attempt to hyperinflate it away.

7. The average U.S. consumer is facing a dire situation. Things which are domestically produced and consumed will continue to fall in price. Unemployment will continue to be high. This is a deflationary scenario. At the same time the goods we do produce here, like oil and agricultural commodities, which are sold on the world market in dollars will be bought out from under us by foreigners waving handfuls of dollar bills, as happens in many third world commodity producing countries. We may well see the U.S. government institute export controls on vital foodstuffs. The things we import and consume (which is most of what we do consume) will increase in price as foreigners demand more and more dollars for their goods. Wages here can and will fall until some sort of equilibrium has been reached. That equilibrium is far below our current standard of living. The average American will learn to live like the average Mexican or Chinese or Indian. This will be very psychologically painful.

8. Eventually the rubber band will get stretched so far that it will either break or bounce back in the other direction. The U.S.-centric world economy cannot sustain this turn of events as it is currently constituted. Everyone in power all over the world knows this, which is why they are purposely trying to lower the U.S. standard of living while at the same time raising the standard of living in other countries, notably China and India, which have the largest populations of potential middle class consumers.

9. The logical telos of this process is the destruction of the dollar and a one world currency. That would "solve" a lot of the problems created by currency imbalances. The Chinese have already proposed some version of the World Bank's "Special Drawing Rights."

10. Under that regime it is highly probable that gold and silver ownership will be prohibited, but until then, they are one of your best bets for storing value.

11. Your other best bets for preserving your wealth are gold and silver, the food and energy sectors, and I would consider finding a way to hold certain foreign currencies. Especially the Yuan, the Canadian Dollar, the Brazilian Reale, and the Ruble.

12. For the U.S., this is about as bad as it can be. We're done as the world's leader and sole economic and military hyperpower. We're going to have to get used to a much less ambitious existence. We're probably talking a decade for all of this to unfold, and the Powers That Be will be laboring to make it a slow, steady, but inexorable change. Adjust now voluntarily or adjust later involuntarily. It's your call.

How would you adjust?
1. Get rid of your debts.
2. Buy gold and silver
3. Get a job in the energy, mining, or agriculture sectors. The rail transport sector will probably grow as well.
4. Get rid of your gas guzzling car. It will soon be too expensive to drive. 40 mpg highway will be the new minimum standard.
5. Learn how to adjust your thinking and get used to being poorer. You can be very happy and have a very rich life without masses of things. I would even say that having less is conducive to that process.
6. Begin thinking entrepreneurally. There will be opportunities to exploit which can and will make you a nice living if you are nimble and smart.