The Inflation vs. Deflation Debate - The Greater Depression

Not suprisingly, I guess, a lot of people are pretty down on the US these days and calling for economic malaise -- with prognostications running from "slower growth" (Bush administration) to "Greater Depression" (most of the tin-foil hat economic blogsters).

While, there seems to be an "argument" between the "deflationary" malaise (1930's US, 1990's Japan) and "inflationary" (1970's US, Gernam Weimar Republic 1920's) camps, I have been careful to try to walk in both worlds.

(technically, inflation is creation of new money (or credit) -- deflation is removal of said money or credit. In this case I'm talking about "price inflation" which is a symptom of the former)

My feeling was that:

asset prices (stocks, non govt bonds, real estate) would deflate, while the price of things that you need to live your "everyday life" would inflate.

The idea was that the availability of money for assets would disappear -- and drive down the ability of people to speculate in them. Meanwhile, the Federal Reserve, in trying to maintain the status quo of high asset prices would create additional liquidity. However, that liquidity would find a home chasing "things that the Chinese and Indians are buying" -- commodities and the raw material inputs for a society growing into "first world" status.

So far, whether that was the real reason that things have played out as predicted or not, that has worked out. However, this week, for some reason, the "wheels" came off that trade.

What happened to my account balance?

With this background in place I want to talk about what I saw in the markets today. Financial stocks were whipsawing wildly. Commodities, and commodity stocks were all under severe pressure most of the entire week.

While it's probably more important (and often smarter) to just follow the markets and not try to understand what is going on in the moment, I'm not geared to do that. And, that's why I'll probably never be a good trader. So, in here I'll attempt to explain what *I* think is driving the market activity of the last few days.

Bear Stearns -- obviously the Bear Stearns collapse was a huge event, for a lot of reasons. The most important was that it scared the bejeebus out of a bunch of people in the FED, the Treasury, the Admin, on Wall Street, Fannie, Freddie, and OFHEO.

Basically EVERYONE went to battle stations and immediately started damage control.

The FED slashed rates .75 points.
The FED cut the discount window rate by .25
The FED now allows non-banks, organizations that it does not directly monitor or control or oversee in any way to give it collateral of dubious value (home loans basically) and in return give out CHEAP loans of treasury paper which can be sold on the open market by these non-banks (think JP Morgain, Goldman Sachs, Lehman, etc.)

Why this is important is that while banks are subject to capital restrictions that cap their use of leverage around 7-1, the investment banks are not....They and their hedge fund clients often use 2 to 4 times as much leverage.

OFHEO relaxed restrictions that Fannie and Freddie were under (for failure to accurately report financials! in the past) and are letting these institutions "gear up" their leverage even further into the face of a declining Real Estate market.

Wall Street investment banks, in a bit of a panic i believe, have begun calling in the leverage being used by their hedge fund clients.

Many of these hedge funds had gone "short" the financials, and long on commodities (fuBarrio's trade for the last couple of years) and this has become a very crowded trade. As the hedge funds are all racing for the door simultaneously it's creating a massive short squeeze in the financials and a quick butchering in the commodity complex.

Meanwhile back in the Bond pits.....

US short term treasuries are now yielding .5% per annum on a 3 month. That's the lowest on record. And, according to Karl Denniger http://market-ticker.denninger.net you could actually execute a "reverse carry trade" on the Japanese the yield is so low.

Denninger explains it as black and white:

1.) either the bond guys (who move many billions of dollars btw) don't know that they are doing, or
2.) we are entering a massive deflationary collapse on the scale of the Great Depression.

I've just started reading Denninger in the last month or so, but he is the best I've found online in trying to explain the gordian knot we've created for ourselves with this debt mess. He does a posting pretty much every trading day.

Good luck, everyone. At this point, I've paired back my exposure to the precious metals to just my "core holding" which is more of an "inflation hedge" than a spec that we are taking off while I'm still looking to go short on runups.....again a very crowded trade, and likely not that profitable until people start relaxin a little more.

If gold can somehow carve out a nice round bottom in the 800's.....retest the 1000....and pullback momentarily, we will be looking at a classic cup and handle after a big up move and i would be recommending to go in very long, perhaps in a leveraged way to catch a big upmove. Now, is not that time yet.

If you are not a trader, and have actually read this far, and wondering what you should do to protect yourself in case things continue to get "nasty" out there....get out of debt, stock up on food and cash, stay in touch with friends and family, (move to south america :) ), and get a gold coin or two and a little silver "just in case".

ciao,
fuBarrio