Deflation Trade Over; Commodities, Stocks and the Fed Inextricably Intertwined

by Victor Sperandeo with the Curmudgeon


Introduction (by the Curmudgeon):


Oil prices this week rose to their highest level of the year while the benchmark 10-year German Bund yield experienced a bout of exceptional volatility. Having fallen to just 0.05% in mid-April, it spiked as high as 0.78% before easing slightly.  That's led many to believe that Europe’s deflation scare is over and inflation may be coming back.     


 “My feeling is that there has been a shift away from deflation worries — the ‘deflation trade’, which led to the collapse of long-term yields — towards some kind of reflation story,” said Frederik Ducrozet, economist at Crédit Agricole. “So it’s no surprise that at least the fast money has shifted out of Bunds,” he added.


"There are creeping worries that inflation, which was seen as non-existent, will soon be part of landscape," said Mark Luschini, chief investment strategist for Janney Montgomery Scott.


Trevor Greetham, senior manager at Royal London Asset Management, told the Financial Times (online subscription required):  “There is likely to be a global headline inflation shock in the second half of this year — although it will be one of the most predictable shocks ever.”


Gilles Moec, European economist at Bank of America Merrill Lynch, warns: “The market is waking up a bit late to the fact that global deflation is not going to happen.”


Note:  The remainder of this post was written by Victor and edited by the Curmudgeon.



Commodity Market Summary & Analysis:


In aggregate, the commodities market has declined for 4.25 years starting in 2011. At the end of the first quarter of 2015 the Bloomberg Commodity Index (formerly the DJ UBS commodity index) was down (-4.21%) while the S&P GSCI was down (-5.31%).


However, from 3/31/15 to 5/8/15 the Bloomberg Commodity Index was net +2.88% and the GSCI was net + 5.81%. All of the recent moves were correlated to the price of Oil. The low of June Crude Oil futures was March 17th at $45.18 and Friday the June Crude Oil futures settled at $59.42 + 31.52%.  Not surprisingly the dollar index topped on Friday 3/13/15 at 100.69 and declined to an intermediate low of 94.13 on May 6th.


The fundamental reason the dollar was rising rapidly was that most economists, including the Fed and IMF, thought that US GDP would grow at a 3+% annual rate for the both the fiscal and calendar year 2015.  As the economy weakened, the rise in interest rates (25 bps for Fed Funds) that the Fed was hinting at for this June was now going to be postponed. Since the dollar's rise assumed a rate rise, when the economy slowed so did the rate increase expectations. As the dollar dropped, commodities rallied, which is the common correlation associated with inflation.


Paradoxically, the commodity rally was caused by U.S. GDP weakness in the first quarter (reported as 0.2%), while the Euro zone GDP was upgraded due to Mario Draghi ("I'll do whatever it takes") who preached and effected  the European version of QE.  


 [Point of order: QE is against the law in the European Union via the Maastricht Treaty. So it had to be over-ruled by judges for Eurozone QE to go into effect.]


Eurozone QE along with China's new stimulus program caused many commodities to rally.  Newly created money also caused the Shanghai Composite stock index to increase by approximately 130% in 10 months (to its high before a 6% correction).  Yet the Chinese economy has "slowed" to a multi-year low. [The Chinese economy grew 7% in the first quarter, its weakest quarterly performance since the height of the global financial crisis, and annual growth of 7.4% in 2014 was the slowest in 24 years.]


The New World Keynesian Model and Its Results:

If an economy weakens (due to more taxes and hard regulations via a Socialist agenda) then lower interest rates further, accomplished by central bank manipulation, including adding huge debt via some form of QE.  Apparently, the ultra-easy money doesn't end till the economy grows at or above the long term trend rate.  


Adjusted for inflation, trend rate growth can never be achieved.  But that doesn't matter to the elite politicians as they believe that printing money (i.e. monetizing the debt) has to - at some point in time (?) - stimulate real economic growth. 


How has that worked so far?


  World debt has grown $57 trillion since 2007 according to McKinsey (see Sidebar in companion Curmudgeon post on Stock Buybacks).

  Interest rates are have been zero or even negative for going on seven years with economic growth barely positive almost anywhere in the world you look. 

  Every country has experienced below trend GDP during that same time period.

  The Atlanta Fed forecasts that U.S. 2nd quarter GDP will be +0.8% (seasonally adjusted annual rate).  Note that they had 1st quarter GDP at 0.1% pegged perfectly. 

  It’s likely that the 1st quarter GDP will be revised down into negative territory according to many forecasters.  That's due to a larger than estimated trade deficit in the quarter


Implications for Fed Policy and Markets:


Where does this all lead for the Fed and the stock/commodity markets?


Rarely does a Fed Chairperson talked negatively about the stock market.  But that's what Fed Chair Janet Yellen did this week.  On May 6th, Bernard Condon wrote   


"A comment from Federal Reserve Chair Janet Yellen suggesting that stocks are generally overvalued added to the selling pressure."   For once, Queen Yellen is correct!  However, why didn't she say the stock market was overvalued last July?  The 12 month change in the S&P 500 was 12.65%, but the 12 month change in earnings was only +2.12% (from $100.20 to $102.32 per share) with earnings decelerating at a rapid rate. Most EPS projections were from $116-$132.


So this begs the question: why would Yellen try to talk the market down if the Fed plans to raise rates this year due to a stronger economy (after the “bad weather” winter season is over)? 


In the past, the Fed only "talked up" markets when they were on the way down due to the Fed raising short term interest rates (but that would only be temporary - right?).  We may have forgotten this pattern as it occurred nine years ago and most "investors" today have very short term memories.


In my view, the Fed is very worried it is not going to be able to raise rates.  That's because fiscal policy is so negative for the U.S. economy that a Fed rate increase might cause a recession before the 2016 election year!


"Investors" hypnotized by zero rates might cause the equity markets to continue to move into more of a (tulip bulb mania) bubble than it has already. So I believe the Fed game plan is to talk the market down, and then not raise rates so it will only rally back to these bubble prices.  We'll see.


Commodities will move up as long as the Fed Fund rate is not going to be raised, and the dollar is thereby moving down. This also assumes China maintains its current stimulus position.


During the last seven years, the Fed has pushed the envelope way beyond what anyone would imagine.  Also the “take-over” of the U.S. economy by this Administration's policies have caused the opposite of what happens in a semi-free Constitutional Republic, Capitalist society. Why no growth and inflation? 


Best answer comes from Antal Fekete who defines deflation as a "Pathological Slowing in the Velocity of Money." To wit: 


“Deflation is clearly not the same as a falling price level. Technological improvements in production cause a gently falling price level under sound money that is no deflation. Defining deflation as a contraction of the stock of money is plainly wrong. We have a vastly expanding money supply, yet a lot of economists (including myself) hold that we are in the midst of deflation. I prefer the definition of deflation as -- a pathological slowing in the velocity of money."  


 I concur largely with this analysis, but it also should be noted that U.S. CORE CPI (which excludes food and energy) has been in a range of 1.65%-to-1.93% from March 2014 year over year on a monthly basis. The Fed used Gross/ Headline CPI (which reflected lower oil prices) to keep rates at zero during this time period as an excuse to not raise short term interest rates.  Of course, that was when oil and commodities were falling.


Now that oil and commodities are rallying, will the Fed use a different headline CPI metric as an excuse that their target of "2% inflation” isn't being achieved?


An “Authoritarian” USA vs Free Markets & Growth:


What is shocking to witness is the power of the U.S. Congress is gone. It all has be GIVEN to the unelected government agency bureaucrats and the President (through Executive Orders and Executive Memoranda's)!  Welcome to the new "Authoritarian" USA.  Ouuuuch!      


What will cause borrowers to obtain even a small portion of the Godzilla amount of bank reserves (est. $ 2.6 trillion) sitting at Fed, and a change in bank policy to relax the current standards of lending? 


In my opinion, it will take a new U.S. President who believes in a free market and growth, as the GOP led Congress has been out to lunch since they won back power (which they never earned, don't or can't use).                                                                                        


Closing Comment:  food for thought of what used to be true:


"Capital is money, capital is commodities. By virtue of it being value, it has acquired the occult ability to add value to itself. It brings forth living offspring, or, at the least, lays golden eggs.”…Karl Marx


The Curmudgeon


Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies.  Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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