Inflation, Deflation, Real Estate, The Dollar and Their Effect On Equities
We’re at a historically important crossroad right now for the U.S. Dollar. That crossroad is at the top of a jagged mountain, and we stand atop a precipice with a perilous plunge on all sides except for one narrow, treacherous path leading to safer ground (the path of solid, steady economic growth which seems so unlikely right now). And I’m about out of metaphors.
I’ve written sporadically about currencies and how important it is that we keep an eye on them. They’re not the tail that wags the equity dog. They’re the bank that finances the debt that built the home where the little equity dog lives out back. (Ok, so maybe I’m not out of metaphors). Point is, currencies are just that big a deal. As I’ve mentioned before, the currency market dwarfs both the bond market and the stock market by a considerable margin. The weakening or strengthening of the dollar, combined with the reasons for that weakening or strengthening (economic growth or lack thereof, Fed policies) influence global economic activity and account for the growth or failure of the companies whose stock we trade, and just as importantly, the companies who employ many of us.
Here’s a chart of the Dollar vs. Euro from last weekend:
The dollar “climbing” on this chart is actually the dollar weakening (more dollars to buy one Euro). If you’re not used to thinking “up” and “weakening” at the same time, here’s the same chart flipped, which makes the weakening even more obvious:
This chart, which goes all the way back to 2002, shows how the dollar weakened through the beginning of 2005, then drew a Head and Shoulders pattern through mid-2006. The pattern then failed as the dollar broke upwards (weaker) from the right shoulder.
We now sit between the critical levels of 1.3666 dollars/euro as the last line in the sand before a dollar plunge, and the 1.295 area as a support level which, if broken, would portend further strengthening of the dollar.
The main question is which one do we wish for? For me, the answer is that we wish for a stronger dollar to help offset the likely-approaching events which will serve to further weaken it, namely, lackluster economic growth, Fed easing and the continued strengthening of the Yen and Renminbi (yuan).
If the U.S. economy caught a little gust of wind in its sails and actually began picking up steam (which it most definitely has not, considering the unprecedented liquidity poured into it the last few years), the dollar would strengthen, we’d get a tad of inflation, life would be good. It may even allow enough breathing room for China to let the yuan strengthen a bit more without cratering the dollar.
However, the economy doesn’t seem to be “catching fire” at all, no matter how many trillions of dollars have been thrown into the tinder box over the last decade or so. That’s bad, bad news.
The late, great, brilliant economist Milton Friedman tied inflation directly to money supply. Flood the market with more dollars than the economy requires for current growth, and the result is inflation. Lots more dollars chasing a little more product. Those excess dollars sloshing around in the economy get spent and re-spent, increasing the velocity at which money flows through the economy. It’s that money velocity which results in upward-spiraling prices and wages, i.e. inflation.
Conversely, if the Fed were to start reducing the money supply, or even increasing it, but at a rate slower than required by current growth, money velocity would slow down, people would hold their dollars longer, those dollars would begin to increase in value… voila, deflation.
Deflation is not good. The ideal balance for economic growth and happy peasants… er, citizens, is what they call “a little inflation.” Maybe 2-3%. Why? That’s an article in itself, but the short version is that prices go up easily, but are “sticky” on the way down… they don’t fall in proportion to the decreased money velocity. Particularly wages. Would you be agreeable to having your pay cut during recessions (i.e. really tied to the “cost of living”)?? Nobody would. So what can happen is the dreaded deflationary death spiral, where people spend less- so money velocity slows- so economic growth slows- so people spend less… There is only one known way to (try to) abort such a spiral:
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The Fed floods the economy with money (by lowering the Funds rate) so that people loosen up and spend more
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The economy grows and people get jobs and buy houses and feel good (the intended effect), and we get some inflation from the excess money supply (a side effect)
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The Fed then steps in and gradually slows money supply growth by raising the Funds rate, ostensibly to fight inflation, its media mandate.
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If all goes well, we settle back in at 2% inflation and everything’s back on track. Right?
Right, in a perfect world. But that’s where we should be right now, after the hundreds and hundreds of billions of dollars added to the economy in recent years, which resulted in trillions of dollars of extra spending:
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We had the LTCM debacle in 1998
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The Y2K recession and stock market meltdown, and
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9/11…
In response to each of these situations the Fed, under Alan Greenspan’s leadership, did exactly what he and Paul Volker had learned to do after studying the mistakes the Fed made which deepened and prolonged the Great Depression… Greenspan’s Fed flooded the eoncomy with money- in the case of 9/11, by cutting rates by a half percent at a time and pouring liquidity into the market as fast as the 1s and 0s could cross the wires.
And it worked. Sort of. The economy didn’t go into a death spiral, and it even began to grow a little. But not nearly as much as it should be growing. We should have nearly- out- of- control inflation. Fed with Funds rates at 8% trying to calm the flames. Pay skyrocketing due to job demand created by the surging economy.
That is not where we are right now. We have an economy frothing with money, but no growth to speak of (compared to what should be expected).
What we have is an economy that’s trying to stall in spite of all the excess money. What happened to all that money, and where’s the inflation? That money caused a vast inflation in home prices, in case you didn’t notice. Why didn’t that show up in the CPI so that we’d all hear Maria moaning about it on CNBC? Hint: they don’t count it because it would look too bad. We might think our economy wasn’t as “stable” as it so obviously is. Wink. Nod. Consumer prices have been very stable, except for the stuff we don’t want to count.
Including home prices, we would have been showing outrageous inflation over the past 5 years with very very little economic growth. Stagnant, even. Bingo- stagflation.
Now we have the beginning of the collapse of the real estate bubble. Not the end, not the middle. Remember when the “experts” were all chirping about how home prices may “slow in their rate of increase,” but would never go down overall. I remember, because I laughed at them. Not only that, I went on the record and wrote one of my first soapbox articles on Dummyspots about it.
Well, those same “experts” are the ones pronouncing the collapse over, that we have or are near a soft landing, etc. And they’re still just as wrong.
As home prices continue to decline, people will stop spending, not because they’re responsible, but because their ATMs (i.e. cash-out refi’s) have been taken away. Money velocity is decreasing. Economic activity is waning.
If this continues, all the Fed can do is pull the same rabbit out of its hat- the rate decrease. The bond market is already predicting a decrease.
But this decrease won’t be very effective. The Fed doesn’t have the power, with rates at only 5.25%, to drop them far enough to re-liquify to the economy and abort the spiral.
Without some serious economic growth, and seriously quickly, we’re the next Japan of 1988. And the chart of our stock markets may very well look like the chart of the Nikkei in the 90s.
What to do? Watch your charts. Watch your stops. Hope for economic growth. (click) Economic growth.(click) There’s no place like home. Here’s to hoping…
Here are a few of my previous posts along the same tangent, in case you’re not asleep from reading yet:
oonr7 said,
March 16, 2007 @ 3:35 am
wow. What a great, articulate and well informed article. I live overseas and directly feel the impact of the dollars decrease. I wasn’t really keeping my eye on it recently but this article has certainly raised my level of awareness.
Thanks for the info and insight.
QUIKTDR said,
March 16, 2007 @ 11:45 am
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Check this out:
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DinosaurTrader said,
March 16, 2007 @ 1:33 pm
Excellent read! Scary too.
Say if the worst happens, then wouldn’t it even be a bad idea to have cash? Because if the dollar continues to decline, that money is worth less, right? So, what to do? Invest overseas? Buy art? Sell my house now and rent? What? I’m freaked out!
Thanks for increasing my paranoia level on a Friday afternoon.
-dinosaurtrader
Will said,
March 16, 2007 @ 5:36 pm
oonr7 - Thank you! Unlike Senator Obama, I consider being called the “a” word (articulate) to be quite a generous compliment!
DinosaurTrader - Thanks for the visit– Yes, there are some scenarios where dollars (cash or “electronic”) are the last place you’d want to be. The traditional answer is that in such a scenario we should buy gold, but I’m not sure I agree with that. In a true crisis, gold would be terribly hard to trade for anything in the real world, at least where I live. Better off to have a warehouse filled with cigarettes and whiskey!
My particular take is that I’m focusing more on paying off debt, and purchasing assets that are useful no matter what their dollar value. In other words, trying to be responsible and prudent with my money. If I had a lot of excess cash, I’d probably look to hedge my dollars with a basket of other currencies or “hard” assets… but that’s not a problem I have just yet
Born2Code said,
March 16, 2007 @ 10:24 pm
deflation is more natural than inflation. productivity has been rising for the last 300+ years. we grow more per acre, more frequently, i.e. greater yield. we produce more widgets per plant, greater yield. we computer more per second than ever before. we travel faster, communicate quicker… prices of most things should be dropping as it is easier and cheaper to increase supply than ever before…
deflation used to be the norm… up till the Fed arrived on the seen.
Will said,
March 16, 2007 @ 10:48 pm
B2C- Yep, you hit the nail on the head. One of the purposes the Fed serves is to gradually shift wealth away from all those (we) productive workers and to the beaurocracy by adding money to the system. I was astounded the first time I read that the government could simply “inflate” away as much wealth as they needed from us to finance their spending, with no true “income” tax; it would just be less politically acceptable to do it that way alone.
I know you already understand this, but my statement above may have some folks saying, WTF? … so allow me to wander for another moment- imagine there’s a company with 1000 shares of stock outstanding, and the company is worth $1 million, so the shares are worth $1000 each. Bob works for the company, has worked very hard and bought 100 shares for himself, for $100,000. Now, in this company, the CEO has the power to print more shares of stock anytime he wants.
For whatever reason, the CEO decides he needs to “use” some of the company’s wealth for his own purposes. He simply prints another 1000 shares of stock and issues them to himself. The company is still worth $1 million, but due to the “split”, the stock shares are only worth $500 each, since there are now 2000 shares outstanding. The CEO’s newly-printed shares are worth $500,000… half the wealth of the company has been quietly and surreptitiously CONFISCATED from Bob and his fellow workers, without their knowledge. The only thing they see is that when they go to trade some of their stock shares for a tangible item, say a new car, it now takes more of those shares to buy the same car than it would have last year. To them it appears that the price of the car has gone UP, when what has actually happened is that the value (the wealth represented per unit) of their “stock” has instead gone DOWN due to the dilution from the extra printing.
The government is the CEO, we are Bob and the “shares” are our wonderful dollars, and that, in a nutshell, is how the government, via the Fed, can confiscate our wealth at will through inflation– simply by printing more money.
Sorry to go off of the beaten path like that, but your comment made such a good point, I just couldn’t resist continuing along that same “Fed thread” for a bit.
Will said,
March 16, 2007 @ 11:03 pm
QUIKTDR - thanks for the heads up on the QuoteTracker product; just fished your comment out of moderation among a slew of spam.
Fan said,
March 17, 2007 @ 7:26 pm
Will, you forgot something important. The reason they fear deflation so much is that it usually leads to revolution and a change in government. Inflation is also self-interest on the part of the guvmint.
Will said,
March 18, 2007 @ 8:24 pm
Fan, I agree that deflation is often a notable part of the bigger picture that always seems to coincide with the end of “pure Democracies” and the beginning of Tyranny/ Dictatorship in the historical cycle of civilizations. Our founding fathers were wise enough to TRY to avoid the “pure democracy” situation by setting up our constitutional/representative republic… just as they TRIED to make it impossible for the government to print unlimited fiat currency, but we’re so smart and creative, we’ve found ways around all of their safeguards. I’m afraid we’re probably not more than a generation or two from pure Mob Rule at this point, so I’m thinking they gave it a great try, and this democratic republic lasted longer than any so far (I think?), but we’re headed for the same eventual outcome. And I completely agree with you that those in power (whichever “party” they hail from) know it’s in their interest to keep money supply and inflation gradually spiraling upward, and in doing so keep the public’s “minds empty and their bellies full.”
Matt said,
March 18, 2007 @ 10:15 pm
Great stuff here. Amazing how the blogosphere has plenty of similar thoughts out there on this stuff, yet the mainstream fortunes and forbes couldn’t touch this with a ten foot pole. I guess it all comes down to advertising dollars and this article wouldn’t help mags be sold. Keep up the good work!!
Good to Go Posts . . . « Trading for the Masses said,
March 19, 2007 @ 7:46 am
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Will said,
March 19, 2007 @ 9:33 am
Matt- Thank you. I agree that we Little Guys are able to discuss the ugly stuff with a lot more freedom since we can focus more on “what we see” and less on “what sells” or “what they need to hear to keep them happy”.
livepost said,
March 19, 2007 @ 5:33 pm
Great post. So where is the smart money going? Bonds, Yen, other currencies or bonds, or simply shorting the market? (or maybe all of the above).
Will said,
March 19, 2007 @ 9:38 pm
livepost - I honestly don’t know any of the smart money people well enough to say for sure, but I’d guess some of “all of the above”, with bonds in last place … I can tell you what the “dumb” money is doing right now: sitting tight and hoping, or worse yet, averaging down.