Market Analysis – Monday, July 27, 2015

This market analysis examines the current economic environment, the recent performance of U.S. financial markets in relation to the 2007-2008 Financial Crisis, and the scenario for hyperinflation from the perspective of an analyst/trader that utilizes fundamental, technical, quantitative, and intermarket analyses. With U.S. presidential elections less than 16 months away, will the government (The Fed) really raise short-term interest rates before then, the occurrence of which, many market participants agree, would lead to a major, and possible historical, sell-off in the financial markets?

Inflation or Deflation: The Market has Already Spoken
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The market prices in deflation. The battle between inflationary and deflationary forces following the 2007-2008 Financial Crisis, at an initial glance, appears to be nearing a climax. Each time an equity market meltdown seemed imminent, causing investor flight to safety that boosted US bonds relative to stocks, the Fed rolled out, yet, another unconventional monetary program to inject money and credit into the economy, leading to a recovery in stock prices and a fall in the US bond-stock ratio (Chart 1; also, Market Analysis for January 12).

Despite the “official” ending of QE in October 2014, the S&P 500 has risen 6.7% (as of July 20) since the end of January, all while Fed Chairwomen Yellen insists that she would raise rates soon. Worrisomely, US bond yields have recoupled with stock prices, signaling that deflation shall dominate the economy in the foreseeable future (Charts 2 and 3). A re-examination of the relative strength of inflation-sensitive stocks (comprised of mining & metals ETF, oil & gas ETF, oil & gas equipment and services ETF, TIPs ETF) and deflation stocks (comprised of financials ETF, utilities ETF, 1/TIPs ETF) reveals that deflationary effects emphatically took control of the economy starting in September 2014 as a major support line was broken (circle in Chart 4). Again, while many economists will wait until lagging economic data become available to cast judgement, the market has spoken: deflation is back. So, where’s the liquidity that continues to drive US equities higher coming from?

The Yen Carry Trade
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The monetary liquidity baton has passed to the Bank of Japan. As discussed in the previous edition of Market Analysis (January 12 2015), the BOJ has initiated its own version of QE that dwarfs that of the Fed in relative terms. The Yen Carry Trade, running since rumors first surfaced that Shinzo Abe would vie for the prime minister role of Japan back in September 2012, kicked into high gear as the yen depreciated over 20% against US dollar during the last ten months (Chart 5). Since mid-October 2014, the S&P 500 has tracked USDJPY nearly step-for-step (Chart 6).

The ECB and SNB Quantitative Easing
On January 22, ECB President Mario Draghi announced a dramatic boost in ECB asset purchases to Euro 60 billion per month of euro-area bonds from central governments, agencies and European institutions, totaling at least Euro 1.1 trillion by September 2016. Several weeks later, the Riksbank launched its own bond purchase program (roughly $10 billion in total) in hopes of driving Swedish yields and the krona lower. While the krona has depreciated 4.3% against the greenback and remains virtually unchanged against the euro since the beginning of February, Swedish 10-year bond yields have actually risen slightly (up 2 bps to 0.72%), not what officials expected.

Hypothetical Scenario for Hyperinflation
For hyperinflation to occur requires a fiat monetary system and a large and growing budget deficit. In his book The Monetary Dynamics of Hyperinflation (1956), Columbia University economics professor Phillip Cagan defined hyperinflation as a price-level increase of at least 50% per month. A study by John Hopkins University economics professor Steve Hanke and economics researcher Nicholas Krus, World Hyperinflations (2012), discusses 56 episodes of hyperinflation, dating back to France 1795-1796. Some people argue that Hanke and Krus’s strict adherence to Cagan’s definition (e.g. if the price-level falls below 50% after twelve months, only to rise back above the next month would be considered a new episode) overstates the number of cases. Thus, Peter Bernholz, Professor Emeritus of Economics at the University of Basle, puts the number of bouts of hyperinflation over the same time frame at 30 (Monetary Regimes and Inflation (2003)).

So, what causes hyperinflation? Hanke and Krus name war, political mismanagement, and transition from a command to a market-based economy as some reasons. The debasement of currency traces back to antiquity. For example, Roman emperors to pay for their wars and global expansion would reduce the size of coins or lower the amount of silver contained within denarius coins, thereby increasing the supply of money relative to the supply of available goods and services; inflation, but not hyperinflation, soon followed. Today, fiat monetary regimes resort to the virtual printing press to digitally expand the monetary base, while the corresponding governments issue more debt for which it exchanges with the monetary bodies. Thanks to modern financial-banking systems, the money supply expands as the velocity of money multiplies the effect of each economic transaction. For now, the multiplier effect has been muted by a sluggish economy, but should expectations return to normal and the monetary base remain at its historical lofty level ($3.9 trillion as of June 30, 2015, Board of Governors of the Federal Reserve System) inflation would likely take-off in short order. As long as existing holders of government debt and beneficiaries of government obligations (public pensioners, social security, medicare/medicaid, food stamp, and unemployment benefit recipients, etc.) remain confident that they will be paid in full and that others will accept the currency, the system holds. As the level of public debt and future obligations rises relative to collected taxes (not GDP), investors and government obligation recipients start to get nervous.

As of July 24, 2015, total U.S. public debt outstanding stood at $18.1 trillion; federal tax revenue $3.1 trillion; federal spending $3.6 trillion; and federal budget deficit $497 billion (TreasuryDirect and U.S. National Debt Clock). According to Bernholz, all cases of recorded hyperinflation experienced government borrowing as a percent of government spending of over 40% at one time. Even, if an attempted recovery managed to push borrowing back below 40%, hyperinflation eventually overwhelmed the economy. When a government needs to borrow to pay back its interest and principal, it enters a debt spiral from which escape is difficult. Inasmuch as a deficit remains, new debt continues to be added on which interest must be paid. Thus, the U.S. finds itself today.

As deflation takes hold, and, probably, spreads abroad (Case Study: 1997 Asian Financial Crisis: Parts I and II), government officials are likely to aggressively step-up quantitative easing efforts to generate counter-balancing inflation. To be sure, deflation is not necessarily a pernicious phenomenon; during the gold standard, monetary authorities kept prices stable by routinely allowing slight deflation following a burst of inflationary, economic euphoria. Unfortunately, recent history is littered with examples of countries that tried to deliberately inflate their way out of a financial problem. In 2009, the U.S. government borrowed 40.2 cents for every dollar it spent. The total U.S. public debt outstanding listed above excludes unfunded government liabilities; some put the total at over $60 trillion and, possibly, $100 trillion. With all that in mind, notwithstanding the effect on equity markets, would the Fed really hike interest rates before elections?


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