The Coming Deflation Scare

Below is an extract from a commentary originally posted at www.speculative-investor.com on 21st August, 2008.

Deflation Fear

The big run-ups in the prices of some commodities during the first half of this year created the general impression that the inflation threat was rising. However, as we noted in a number of TSI commentaries the FEAR of inflation was rising at a time when the ACTUAL rate of inflation (the rate of money supply growth) was low. Our interpretation was outlined as follows in the 19th May Weekly Update:

"...the year-over-year (YOY) growth rate of TMS is presently about 3.5%. To put it another way, TMS tells us that the inflation (money-supply growth) rate is presently in the bottom quartile of its 10-year range.

Our statement that the US inflation rate is presently in the bottom quartile of its 10-year range may appear to be absurd given that the prices for various commodities and everyday goods/services are rocketing upward, but today's rising prices are largely due to the massive inflation that occurred years ago; specifically, the massive inflation in the US during 1998-2004 and outside the US during 2003-2006. There is often a multi-year lag between the cause (money-supply growth) and the effect (rising prices), which is one reason why so few people are able to see the link between money-supply changes and purchasing power changes.

During any long-term inflation cycle the major beneficiaries of the inflation will be the sectors of the economy where the supply/demand fundamentals are the most bullish, that is, those sectors where there is relative scarcity. Commodities should continue to be the major beneficiaries during the current inflation cycle -- a cycle that's probably nowhere near an end -- because that's where the relative scarcity now lies, but the downward correction in the money-supply growth rate over the past few years creates an intermediate-term hazard for commodity investors.

We expect that wider recognition of the inflation problem will eventually bring about a major decline in Treasury bond prices (a major rise in bond yields), but the temporarily SLOW rate of US money-supply growth over the past 2-3 years could support US T-Bond prices over the coming 6 months by putting irresistible downward pressure on the prices of industrial commodities."

Of course, anyone who thought that M3 was a good measure of money supply would not have perceived this glaring mismatch between the inflationary evidence being generated by the commodity markets and what was actually happening on the monetary front (since M3 was expanding at a rapid clip at the time). As it has done at a number of important turning points over the decades, M3 recently generated a 'major league' false signal*.

What appears to be underway right now is a process whereby commodity prices move back into line with the monetary backdrop. In addition, there is a self-reinforcing aspect to this process in that most people wrongly think that rising prices are synonymous with inflation and that falling prices are synonymous with deflation, the result being that falling prices lead to lowered inflation expectations, which, in turn, lead to a fall in the speculative demand for commodities and other items that are widely perceived to be inflation hedges. It is quite possible, in fact, that the expectations of market participants will end up doing a 180-degree turn, meaning that at some point over the coming year the financial world may be dominated by the fear of DEFLATION.

It is important to understand that there can be a big difference, from both a theoretical perspective and a practical investment perspective, between a deflation scare and a genuine deflation threat. Deflation scares occur because prices fall, but falling prices are only related to deflation if they are caused by a contraction in the money supply. And as things currently stand, the year-over-year growth rate of "True Money Supply" appears to have bottomed during the final quarter of 2006 and to now be in the early stages of a new upward trend. This means that if the FEAR of deflation rises over the coming year in response to falling prices it will probably be doing so as the stage is being set for the next round of inflation-fueled price INCREASES.

In previous commentaries over the years we've argued that from the perspective of policymakers the occasional deflation scare can be useful because it provides the justification for the next round of government-sponsored inflation. It is a virtual certainty that as the fear of deflation rises there will be loud calls for the government and the central bank to "reflate", and that policymakers will heed these calls. Moreover, the only practical limit on how much new money the government can borrow into existence and how much new money the central bank can create (by monetising assets and debt) is imposed by the bond market, but government bond yields will remain low and policymakers will be free to inflate to their hearts' contents as long as inflation is not widely perceived to be a problem.

*Note: After deceptively signaling very strong money-supply growth over the past couple of years, recent data suggests that M3 is now moving into line with TMS. Money-supply figures can be quite volatile on a month-to-month basis so it is too early to be confident that the recent data is indicative of a new trend, but it would make sense, given the performance of TMS, if the recent M3 data did turn out to be indicative of a new trend. Also, bear in mind that although M3's 3-month rate of change appears to have dropped to almost zero, it still has a double-digit gain on a year-over-year basis. Due to the monthly volatility we generally focus on year-over-year changes.

Implications for bonds and gold

The money-supply growth rate is relatively slow, an equity bear market is in progress, the economic situation looks set to deteriorate further, an intermediate-term decline is underway in the commodity world, the US$ appears to be in the early stages of a multi-month rally, and the fear of deflation is beginning to grow. This is NOT the right time to be short US Treasury Bonds. However, ETFs that invest in high-yield (junk) bonds are reasonable short-sale candidates at this time because the default rates on these bonds should surge over the coming year if, as we expect, the economy continues to slow and credit remains hard to obtain for all bar the most financially-strong corporations.

Although we suspect that Treasury Bonds will maintain an upward bias into at least the final quarter of this year, for valuation reasons we aren't bullish on this market.

With the exception of the money-supply backdrop (as discussed in the latest Weekly Update), the current situation is bullish for gold. We don't think that genuine deflation is a serious threat, and both gold and gold stocks performed well during the deflation scare of 2001-2003. So, after the over-leveraged euro bulls have been washed out of the gold futures market there will be a decent chance of gold commencing its next intermediate-term advance, even while industrial commodities remain in intermediate-term downward trends.

Steve Saville

The Speculative Investor