Market Analysis – Monday, February 13, 2017

Overview

This market analysis examines the recent performance of global financial markets, the role of liquidity in supporting financial markets, and the prospect of currency wars from the viewpoint of an analyst-trader that utilizes fundamental, technical, quantitative, and big data analyses.

It’s All About Liquidity

20170213-chart1As discussed ad nauseam, governments relied on loose monetary policies in the aftermath of the 2007-2008 Financial Crises to prop up financial markets as exorbitant debt levels curtailed fiscal remedies and fear of political blame prevented necessary structural changes. Like passing the baton in a relay race (or a game of hot potato), monetary bodies took turns implementing different brands of QE. In approximate order: Fed (QE1, QE2, Op Twist, ZIRP, QE3), BoE (asset purchases), BOJ (asset purchases, ZIRP, NIRP), SNB (asset purchases), ECB (asset purchases, ZIRP, NIRP). But, despite the influx of paper money, developed and many developing economies failed to rise from the mat leading to the next phase of the Financial Crises: currency wars.

Currency Wars

Fear of a repeat of the 1989 Tiananmen Square protests, China unilaterally devalued the yuan twice in August (~2.9%) and December (~4.4%) 2015 in an effort to boost exports and jobs, resulting in a significant global sell-off each time (light blue boxes in Charts 1 and 2). Leaders from Washington to Brussels to Tokyo gasped and an undisclosed agreement was made at the Feb 2016 G20 finance ministers and central bankers meeting in Shanghai between the US, China, EU, and Japan (G4) to prevent a future financial market panic. As described by Jim Rickards, China would peg the renminbi to the USD (e.g. CNY6.50-6.30, Nov 2015 to Feb 2016 range) which would weaken, while the yen and euro would strengthen (Charts 2 and 3). But, a funny thing happened on the way to the pagoda. With the US presidential elections approaching and Donald Trump unseemingly holding steady, DXY drifted upwards starting in May 2016 as the markets factored in the remote possibility of a Trump win and a pro-growth platform. Not part of the agreement, China devalued in May-Jul (~3.4%) and again in Oct-Dec (~4.9%), contributing to a minor sell-off in stocks (green boxes in Charts 1 and 2). Now, with Trump in the White House, all bets are off as the greenback reached a 15-year high in Jan (black circle in Chart 2; DXY intraday high 103.82 on Jan 3).

Pushing an “America first agenda,” Pres Trump has threatened to institute import tariffs, declared China a currency manipulator, counteract China’s aggressive posture in the South China Sea, and has pivoted the US away from China and towards Russia. Many of his cabinet appointees support this view. Nevertheless, the Communist Party’s cling to power resides in its ability to provide jobs for the masses and keep the economy growing – no amount of antagonizing is going to change its stance. With problems of its own making, China must battle internal political unrest stemming from Pres Xi’s centralization of power, a massive credit bubble, and capital flight, to name a few. If push comes to shove, China may forego mini-devaluations and opt for a 20-30% maxi-devaluation, which some neocons would surely label as an act of war. The situation could go pear shape in the short future.

Coming Soon

My next post will examine the current state of financial markets in detail, discuss the role of complexity theory in analyzing the global financial markets, drawing reference to the Thai butterfly that caused the 1997 Asian Crisis (see Case Study: 1997 Asian Financial Crises, Parts I and II), and apply complexity theory and Bayesian statistics to today’s markets to determine the key drivers that could trigger a global market sell-off. My subsequent post will discuss the role of gold, SDRs, or eDollars in the event of a financial market meltdown that surpasses those of 1987, 1998, 2000, and 2007-2008 and the importance of China having a seat at the table of the next global financial system reset. Ultimately, I shall post on my results of using big data analysis, predictive analytics, and ensembles modeling techniques to produce leading drivers and their assigned probabilities of inducing a major market correction using the conclusions from my next post. Stay tuned!

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Emerging Markets Analysis – Monday, April 4, 2016

Overview

This emerging markets analysis examines the outlook for capital flows into emerging economies and its impact on emerging equities over the next twelve months and the outlook for the US dollar from the perspective of an analyst/trader that utilizes fundamental, technical, quantitative, and intermarket analyses.

A Lull in Fed Activity

20160404 Chart 1

After a false start in Dec (perhaps, planned), the Fed all but rescinds its hawkish interest-rate normalizing strategy as conveyed via recent dovish FOMC meeting decisions, released FOMC meeting minutes, and speeches. Not only would the Fed not be implementing its original three hikes this year (300 bps over the next several years was the original plan) but, perhaps, none at all, depending on the “data” (Chart 1). With the US economy teetering on recession, energy companies facing bankruptcy, at-risk banks and financial institutions confronting massive write-downs, and US presidential elections just seven months away, the Fed will likely hold-off until early 2017, after the energy sector completes its current round of capital raisings, lenders off-load much of their exposed risk, and the new president swears in before making any major decisions. As discussed in the Market Analysis Reports for March 11 and March 29, this author believes NIRP (plus, possibly, QE4) constitutes the next weighty move by the Fed. Thus, this lull in Fed activity presents opportunities for emerging market equity investors.

Emerging Countries’ Capital Flows

20160404 Table 1

As noted by many analysts, in the wake of the 2007-2008 Global Financial Crisis, capital flow between advanced and emerging economies has become sensitive to monetary policies and its effect on interest rates and central bank balance sheets of developed economies. When considering heightened geopolitical and terrorist tension, lackluster economies, and the uncertainty of monetary policies, capital flows, understandably, have grown volatile. The current abatement in Fed action entices global investors to venture abroad in search of yield.

Some emerging economies will attract a relatively larger share of short-term (and even long-term) capital flows over the next twelve months. Countries with a high dependence on foreign capital that experienced large foreign capital withdrawals over the last eighteen to twenty-four months could expect an influx. During the 2013 Taper Tantrum, the so-called “Fragile Five” (Brazil, India, Indonesia, South Africa, and Turkey) experienced heavy portfolio outflows only to see much return in months. Some countries to watch include Turkey, South Africa, Colombia, Brazil, Peru, and Indonesia – all with high current account deficits that rely copiously on external debt and portfolio equity flow (positive net debt and portfolio equity flows) for financing. To a lesser extent, Poland and Chile could also see strong capital inflows. Interestingly, Argentina, under new President Mauricio Macri, recently settled its dispute with hold-out foreign bond investors and has taken aggressive steps to tackle the country’s problems and seeks to raise up to $15bn in international debt markets in April to settle the bill with holdouts – upon success, more capital raisings would follow to fund government expenditures and to boost depleted foreign currency reserves (Table 1). Also, India could see healthy capital inflows as it weathers the global economic storm better than most, expecting its economy to grow by 7.5% this year– a tad optimistic, perhaps, but significantly better than other economies. And, of course, Mexico, with its close proximity and integrated economy (to the US) could expect a rush of incoming capital. Furthermore, smaller developing economies sporting higher current account surpluses could see a bump up in allocation that would launch local equities: Vietnam, Philippines, and Thailand. Malaysia could be included in this last group, however some money managers still hold concerns over the 1MDB scandal. Another faction that could benefit are emerging commodity-producing countries.

Relief for Commodity-Producers

Since the start of the 2007-2008 Global Financial Crisis, commodities get hammered. But, the widely-broadcasted ending of QE3 creates a massive “risk-off” environment, commencing the summer of 2014, that sends USD parabolic and commodities on its next downleg (Chart 2). The recent dovish stance of the Fed enables commodities to finally form a bottom (Chart 3). Will it stick? Commodity fundamentals remain horrid, but as the adage goes: “Don’t fight the Fed.” And, the corollary: “Especially during a presidential election year.”

Emerging commodity-producing country equities bottom and track commodity prices upward in near lockstep, from mid-Jan 2016 (immediately after NY Fed Pres Dudley speech). As expected, high net commodity-to-GDP economies lead the way. The steep rise in UAE equities suggest the market expects bullish oil prices to continue, which Russia and Indonesia certainly cheer. Even problem-riddled Nigeria is forming a trough (Chart 4). For moderately high net commodity-to-GDP economies, Brazil and Colombia stage a remarkable turnaround zooming from group laggards to top of the class in several months (Chart 5). The prospect of Macri winning the presidency helps push the Merval to an all-time high. And, the long-awaited settlement with foreign bold holdouts and a state visit by Pres Obama solidifies Argentina’s planned return to the international debt markets (Chart 6). Argentina’s return is timely as the USD Index nears completion of a one-year topping formation (green circle in Chart 2 and Chart 7) that would lead to USD weakening for the indefinite future (USD Index next probable target: 85, a 10% depreciation), thereby making future repayments in relatively stronger pesos more attractive.

The Weakening US Dollar20160404 Chart 7

Emerging economies benefit from a softer dollar in several ways. China gains as pressure lessens on the PBOC, which removed its peg to the dollar and allowed the renminbi to weaken against the strengthening greenback (Chart 7).  Thus, watch for the PBOC to “re-peg” to the weakening USD, thereby helping exports. But, pressure increases on other emerging exporters, who may further loosen monetary policies and lower interest rates to defend its exports – the currency wars continue.

As already mentioned, commodity-producers enjoy a fillip and capital inflows into emerging economies could pick-up significantly that would boost local equities and bump up local and international bond prices, jump-start FDI and M&A activity, replenish depleted foreign exchange reserves and help finance current account deficits, and should local currencies strengthen vis-a-vis the dollar, imports of raw materials, natural resources, and machinery and equipment become attractive. Also, a weaker dollar brings relief to US dollar international bond holders as underlying names get a credit rating pop due to improving emerging economies and repayment spur, as mentioned for Argentina.

As business activity springs to life, local consumption rallies, particularly for discretionary spending; the lending cycle swings upwards to reinvigorate whole swaths of industries: banking, brokering, insurance, residential and commercial construction, existing  home selling, appliances, home furnishing and fixtures, houseware and accessories, office supplies, packaging and containers, paper and paper products, textiles, auto and trucks, construction equipment, business equipment, electronic equipment, computer equipment and software, communication systems, foods, cement, farm and construction machinery, building materials, industrial electrical equipment, industrial equipment, lumber and wood, machine tools and accessories, tools and accessories, waste management, and all types of consumer and business services. For emerging market investors, all this adds up to finance, cyclical, and technology stocks advancing first, closely followed by industrials.

Nevertheless, emerging exporters require a destination for their goods and services. Is China’s economy large enough and ready to sufficiently supply demand for final goods? What about India? Surely, rich or large commodity economies, like a rejuvenated Canada, Australia, Russia, Indonesia, Brazil, Nigeria, and Mexico would draw-in products. Little help from Continental Europe, which remains weighed down by a horrendous banking situation, a swarm of refugees, terrorist attacks, and a populace that grows more scared by the day. Also, the UK is not in the buying mood as it contemplates Brexit and economic life thereafter (what happens to existing EU trade, banking, and financial agreements), while staring at a current account deficit-to-GDP of 5.2% (2015), total official national debt-to-GDP of 81% (2015), and total external debt-to-GDP of 569% (2014). So, who does that leave?

Final Thoughts

How long this downleg in the USD lasts is anybodies guess. But, as previously examined, a US move to NIRP could cause economic and financial market linkages to eventually unhinge as the dreaded “Doom Loop” (see Market Analysis for Mar 11 2016) becomes reality to create a self-inflicted implosion and strong inflation (and, even possibly, hyperinflation). In the most extreme case, USD Index approaches the zero limit and some form of SDRs takes over (most likely backed by some portion of gold), but not before global economies and financial markets are thrown into disarray. No wonder China tried so hard to get the renminbi added (effective Oct 1 2016) to the IMF SDR basket (and a seat at the next global financial system re-set). That would also help explain China, Russia, and other nations’ obsession with gathering gold.

Until that event occurs (Japan remains upright after two and half decades of deflation), however, America awash in liquidity, albeit tied up in the financial markets, could overturn its pessimistic posture with a new president at the helm to get businesses to invest, expand, and hire again (fast-food and temporary teaching jobs don’t count) so that consumers feel stable enough to start spending once more to keep the global economic ball rolling. Combine that thought with the prospect of the strengthening (after three years of free-fall) of the world’s third largest economic currency (which, of course, helps its consumers and boost imports; Chart 8) and the posed paradox is solved: US and Japan to the rescue with back-up support from the OECD (many of whose currencies shall appreciate vis-à-vis USD by default, with the Brexit exception of the UK and GBP; Chart 9). Thus, watch for emerging market stocks (and emerging domestic and international bonds) to put in a relatively decent performance over the next twelve months, or so. And, should the Fed decide to buttress its dovish talk with action (ZIRP, NIRP, QE4) before then, back-up the truck.  Or, at least, that seems to be Plan A. Of course, Plan B could always be dusted-off and enacted: War.

Market Analysis – Tuesday, March 29, 2016

Overview

This market analysis examines recent actions by the Federal Reserve and its impact on financial markets, with a focus on emerging equity markets, and the outlook for Fed activity from the perspective of an analyst/trader that utilizes fundamental, technical, quantitative, and intermarket analyses.

All Eyes On The Fed

Fed actions continue to act as the primary driver of developing economies and financial markets. The mere suggestion of liquidity tightening by Fed Chair Bernanke in May 2013 sets off the Taper Tantrum that sucks capital out of risky assets, propelling emerging equity and debt markets downward in weeks (far left, Chart 1). This leads directly to QE3 and a resurgence in risky assets, including emerging equities, which reaches a 3-year high to form the peak in a HS pattern (center, Chart 1). But, stoppage of US liquidity injections (end of QE3), results in emerging markets exit, despite liquidity infusions from BOJ, ECB, BOE, Riksbank, SNB, and DNB (right, Chart 1).

China’s credit-fueled investment expansion grinds to a halt that, combined with a strengthening USD, sends commodity prices plummeting (Chart 2).

In Dec 2015, the Fed finally raises the target Fed funds rate (and indicates a total increase of 300 bps over the next several years), after threatening to do so for two and half years, despite signs of a slowing US economy, shattering US energy companies, lackluster Europe, and imploding China, shoving emerging equity (and debt) markets into freefall (first green down leg, Chart 3). By mid-Feb 2016, the Fed, once again, reverses course to deliver a dovish spin, halting the equity correction in a near perfect “W” bottom reversal. At the widely anticipated Mar 15-16 FOMC meeting, the Fed confirms no raise and then Chair Yellen, at a speech at the Economic Club of New York on Mar 29, implies that not only would the Fed not be implementing its original three hikes this year but, perhaps, none at all, depending on the “data” (Chart 3).  What the heck is happening?

Set-Up for NIRP

The BIS and major CBs coordinate monetary actions since the 2007-2008 Financial Crisis to prevent a meltdown in global financial markets. Eight years later, and after rounds of traditional monetary policy, quantitative easing, qualitative easing, and ZIRP, global financial systems remain on life support. Now, European CBs and BOJ are employing NIRP to support the Fed’s effort to strengthen the greenback and normalize interest rates as official US national debt soars over $19.2 trn, or 102% of GDP. But, with the US economy teetering on recession, energy companies facing bankruptcy, at-risk banks and financial institutions confronting massive write-downs, and US presidential elections just seven months away, the likelihood of a rate hike diminishes by the day. The pretend wealth effect must continue for a little while longer.

By early 2017, once the energy sector has completed its current round of capital raisings, lenders off-loaded much of their exposed risk, and the new president sworn in, the Fed and banks may likely stand aside and let markets re-price. Would this be the ultimate cleansing discussed in earlier reports? Unlikely. More probably, similar to the 2008-2009 equity sell-off, after a 50%, or so, drop, the Fed would enact NIRP and, even, QE4, in a final (hopefully) effort to let the new administration and Congress find a solution to the financial morass.

Obviously, monetary actions have proven ineffective, so political leadership and regulatory, legislative, and structural changes are required to normalize the banking and financial systems and labor markets so that the real economy can grow, once again. If the actual problem of excess debt is not directly addressed, the US faces lost decades of fudged numbers and economic decline, just like Japan. But, under NIRP (see Market Analysis for Mar 11 2016), the unraveling may come much sooner. Throughout, of course, savers suffer and receive the blame for the ineptitude of borrowers.

Market Analysis – Friday, March 11, 2016

Overview

This market analysis examines the current economic environment, global monetary policy, and the outlook for global financial markets from the perspective of an analyst/trader that utilizes fundamental, technical, quantitative, and intermarket analyses.

Aftermath of QE3

Anticipation of the “official” ending of QE3 in Oct 2014, monetary easing at the BOJ, and easing rumors at ECB and Riksbank propels USD higher, starting in July 2014 (circle in Chart 1). Correspondingly, commodities plunge, dragging emerging markets along two months later (dashed vertical line in Chart1 and circle in Chart 2). Meanwhile, US equities, partially thanks to brethren central bank liquidity injections (see Market Analysis for July 27 2015), remain resilient, albeit volatile (first half of Chart 3). But, by mid-2015, Fed Chair Yellen’s talk about a rate hike finally takes hold as US equities breakdown through uptrend support (circle in Chart 3). Chair Yellen promises three rate hikes in 2016 and to raise Fed funds rate 300 bps by 2017. Despite intermittent rallies, equities face a decidedly downward journey…or, do they?

Energy Sector Gets Decimated

If a stronger dollar wasn’t bad enough, a slowing Chinese economy, prospect of new energy supplies from Iran, and highly-levered shale oil companies makes shorting energy a trade of a lifetime as crude oil trades below $30/bbl. With bank loans in dire straits (Citigroup $58bn, BoA $43bn, JPMorgan Chase $42bn, Wells Fargo $42bn exposures), energy companies manage to unload new equity offerings despite collapsing oil and share prices. According to Bloomberg, another $9.2bn share offerings have been announced YTD (as of Mar 1). With this as background, beware of bear market rallies…that knife is still falling! But…

The Fed to the Rescue

Despite the rhetoric out of the Eccles Building and deeply-massaged and contorted official unemployment figures, the facts are that oil prices are under $40/bbl. (not good for Russia nor US banks), US equities are trending down and volatile, and a lot of angry American voters are attending Trump rallies. At a 0.25%-0.50% target rate, the Fed is out of traditional ammunition to fight the next economic downturn, which is imminent. Any delay in a rate rise now means that the eventual hike arrives during a weaker economy, thereby triggering recession. With remaining FOMC meetings slated for Apr, Jun, Jul, Sep, and Nov 1 prior to the Nov 8 elections, perhaps, as NY Fed Pres Dudley’s speech on Jan 15 suggests, it’s too late to raise them at all. Like Pavlov’s dog sensing a free meal, financial markets make a swing-low in early Feb as the S&P 500 bounces from 1864 and WTI Futures Apr 16 from around 29.00. So, what next?

Alice in Wonderland Time

Picking up the QE mantle from the Fed, the BOJ (see Market Analysis for Jan 12 and Jul 27 2015), following the election of Prime Minister Shinzo Abe in 2012, unleases its own version of liquidity infusion, triggering the Yen Carry Trade. ..and, just to be sure, officially enacts NIRP on excess bank reserves last month. The ECB, for its part, announces in early 2015 an “expanded asset purchase program” of Euro 60 bn per month, expected to total at least Euro 1.1 trn. On Mar 10, the ECB increases monthly purchases to Euro 80bn, cuts interest rates (including the deposit rate to -0.40%), re-declares inflation target of 2% (despite ECB projections showing sub-2% inflation for next 5 years), and announces a scheme to pay banks to lend. On the latter, don’t be surprised if European banks use this opportunity (gift seems more like it) to generate some lending and broking fees to help eurozone corporates engage in some good ol’ American-style share buybacks to give European equities a boost. Remarkably, in his speech, Pres Draghi all but rules out further interest rate cuts…er, get it while it’s hot?  With traditional monetary policy, Quantitative Easing, Qualitative Easing, and ZIRP all failures, global CB focus now rests on NIRP to inflate government and bank debt away. And into the rabbit hole we go…

NIRP: What Could Possibly Go Wrong?

By taking the NIRP route, CBs gamble that banks can withstand the hit on their income as lending rates move below deposit rates. For US banks, not as much a problem as not as relient on deposits for funding, but elsewhere it could cause major dislocations. Judging by collapsing European bank share prices, the gamble is not paying off (Chart 6). Making less money, weak banks cut-back on lending, weakening economies and driving CBs to take rates even lower, thereby inducing a self-inflicted death spiral. A WSJ diagram succinctly sums up the situation (Diagram 1).

Deflation-Led Implosion

As discussed in the previous report, economies currently running into strong deflationary headwinds. To be sure, these headwinds stem from underlying problems from the 2007-2008 Financial Crisis and before (see Case Study: US Bear Market of 2007-2009, Case Study: Dot-Com Bubble, and Case Studies: 1997 Asian Financial Crisis, Part I and Part II)*, which never went away: Too much sovereign, corporate, and mortgage-related/asset-backed debt. Keeping debt off-balance sheet, changing accounting rules, or re-classifying debt did not make the debt disappear. Unable to create gentle, steady inflation with the blunt tools at hand, CBs seem determined to pursue NIRP. But, as shown, secondary and tertiary effects can wreck havoc on NIRP.

20160311 Chart 7

Again, as discussed in an earlier report, the markets show early signs of deflation in Sep 2014 (Chart 7), while many pundits and economists focus on lagging indicators that suggest all-is-well. In Jul 2015, markets give another emphatic shout that deflation is now a significant problem. Further incongruous actions of monetary officials and politicians perpetuates extremely loose money policies that will likely push economies past the event horizon and into a deflationary-spiral with a nasty terminus: Hyperinflation. Thus, economies and financial markets find themselves today.

Probability of Hyperinflation?

So, assuming NIRP is enacted on a global scale (BOJ, ECB, Riksbank, DNB, SNB, and, possibly, Fed), the chance that monetary and political authorities can withdraw monies from the banking system before inflation takes-off is exactly nil. Hence, expect double-digit inflation as a result of NIRP. As for hyperinflation (+50% general rise in prices), those economies unable to remove liquidity in rapid order would be staring directly at a Zimbabwe or Weimar Republic hyperinflationary environment. How long do global economies have until the SHTF?

Epilogue

As suspected, this story does not have a happy ending. The CBs, led by the Fed, determine the duration and magnitude of the outcome. Out of traditional bullets, fanciful methods are tried to inject liquidity into economies that simply, like gigantic and tiny Alice, effectively inflate financial market prices temporarily before prices deflate once again, thereby inducing another round of the latest monetary potion – NIRP for now. So, how long does this go on for? Japan has managed to remain whole for two and half decades, while caught in its deflationary spiral. But, as explained, NIRP may change this.

If “The Doom Loop” proves to be moderately accurate, NIRP shall likely be the last kick-of-the-can and weak banks and financial institutions (e.g. insurers and pensions with 6-8% real long-term actuarial investment return assumptions are deluding themselves) will eventually be taken-over by relatively stronger ones, while the weakest, facing bankruptcy, split into “good” and “bad” entities, with “good” ones acquired by the strong and “bad” ones run-off. Of course, major unhinging in economies and financial markets occur, including forceful inflation and, possibly, hyperinflation. But, economists already know the solution: Stop printing money. Hopefully, politicians force the purging of putrid debt, letting several major financial institutions and corporates to go the way of the dodo bird, and, with any luck, setting an example for others, before declaring any moratorium on the painful cleansing.  Once again, that barbarous relic gold (silver as well) will prove its usefulness, as it has done, time after time throughout history, as the ultimate safe haven store of value.

*  Forthcoming Case Study: 1971-1973 End of Bretton Woods System examines, among others, the role that a reserve currency plays in abetting an economy and local borrowing and the massive build-up of debt (sovereign, corporate, mortgage-related/asset-backed, and personal debt) in the US after the US transitioned to a pure fiat monetary system.

Market Analysis – Monday, July 27, 2015

Overview
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
20150727 Chart1 20150727 Chart2
20150727 Chart3 20150727 Chart4
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
20150727 Chart5 20150727 Chart6
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.

Epilogue
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?