This too shall pass …
We are in the midst of a deflationary squall, with the dollar appreciating against virtually every other asset except oil and gas. Treasuries, US stocks, XS stocks, copper, gold … a whole range of things that have nothing in common except our use of the same pricing unit, have been falling in price. So the pricing unit must be where the action is. This is The Titanic Effect in reverse.
Tempting as it may be to attribute causal potency to recent headline drama, it’s more appropriate to view it as catalytic. The spark that sets the pile of tinder afire would have no effect without the tinder, but the tinder would eventually find another spark.
The tinder is thus true cause. In this case it can be spotted merely by rewinding our minds a few weeks to when the “dollar debasement” trade was all the rage. Traders piled in with leverage, the trend got ahead of itself, and must be at least partially unwound.
This isn’t altogether different than the principle behind our “left behind” trade, that suggested the commodities rally would have to spread from metals to left behind oil, and before that that platinum had some catching up to do … that market dislocations tend to go too far and eventually need to be corrected.
From big deflations like 2008 to little ones like we saw a few weeks ago, the cause is the preceding inflation. Inflation is springy. People become convinced that the only possible direction for dollars is down, they short them (borrow them), and a short squeeze eventually results. Inflation causes deflation.
How long will it last? Let’s talk about that in the comments. This analysis doesn’t tell us, but understanding it will help us recognize the sign posts along the road. Best advance guess is based on Synthetic Systems and our recent comments on the latest run, suggesting at least this particular squall has a life expectancy numbered in days, at most weeks. If not, eventually …
They PRINT……………..
Aye. All the media talk about what the Fed’s gonna do is devils dancing on the head of a pin. Wall Street will demand relief. This morning’s weak employment report doesn’t hurt the easing case either. We are in deflation and even the Fed will recognize that … eventually.
Its conundrum is due to the fact that it already eased when it had no business easing. Had it not lost its nerve and stayed on the inflation case a couple years ago it would have a lot more room to maneuver now.
Short term interest rates need to respond to short term developments and the Fed’s attempts to “stabilize” them are completely, 180° wrong headed and foment instability elsewhere.
Let’s hope that it has learned something from its mistakes of the past though and at least takes its foot off the gas pedal when the deflation is over.
BREAKING: 🇺🇸The U.S. lost 92,000 jobs in February, and unemployment rose to 4.4% – BLS
Investment implications?
Markets are moving rapidly and specific conclusions could be dated by the time you see them. Generally speaking though, we’re seeing oil and gas, and by extension broad commodity indices that include them, rise sharply, and equities sell off whenever this happens. COMT has been an excellent hedge. I use it because it tracks the energy-rich and economically weighted SPGSCI and issues no K-1, but most broad commodity funds will do. Though oil is getting the most headlines, I avoid getting overly targeted on it as other energy commodities are also involved and even non-energy commodities like wheat and aluminum are joining.
Gold had already risen a lot and so hasn’t been benefitting like energy from the “left behind” trade. But less effect doesn’t mean no effect and it’s still very much a core strategic asset.
Treasuries have been benefitting from the classic “flight-to-safety” trade, but this is being offset by of out-of-control deficits, from everything from the impact of tariff refunds and massive social and military spending to interest on accumulated prior debt … and the near certainty it will be paid with inflation. As discussed before, bonds alone are not adequate but low bonds doesn’t mean no bonds and they too remain a strategic asset.
Diversification is relevant as ever. Weekend headlines could easily add or subtract 1000 points from the Dow at Monday’s open. In light of Synthetic Systems I’ve entered this period underweight equities but have been adding a bit on each new plunge.
Cash is no trash in a deflationary environment, where virtually by definition it’s an appreciating asset. King Dollar has been flaunting its crown.
But this too shall pass …
Well we now know whether the Dow chose to add or subtract 1000 points at this morning’s open, and it wasn’t to add. Oil prices surged 30% overnight prompting a sharp selloff. Since then oil prices have eased and so has the depth of the selloff.
Is it done? I don’t know. The tinder is still there … overvaluation for stocks and undervaluation for commodities, though the noise level is high and making it difficult to suss out the signal. The credit issues that have been developing may have been eclipsed in the headlines but haven’t gone away. I would like to see deeper discounts before getting aggressive on stocks, and though the dollar has been preternaturally strong in recent days and could have more in store near term, in the longer run the direction is clear. Short term deflationary defense, long term inflationary defense.
Treasuries are selling off, also putting pressure on stocks, on the story that rising commodity prices (notably oil) will cause higher inflation and therefore there will be less rate cutting from the Fed.
There are two serious problems with this narrative.
One is that the media are telling the Fed it has only two choices with respect to rates; cut less or cut more. If this isn’t Wall Street telling the Fed what to do, it’s hard to imagine what would be.
Another is the tacit assumption that rising prices cause inflation. Anybody … quick … see the problem? They have it 180° backward. Inflation causes rising prices. It’s that old bugaboo of confusing rising consumer prices with inflation. In fact they lie at the end of the inflationary chain.
The inflation has already happened. Now the Fed is in a conundrum of its own making, having to tighten in order to contain prices at the same time as it fears tightening because employment is teetering. It is facing not the stability it presumed to support but an unstable mix of both short term deflationary pressure and long term inflationary pressure.
Inflation shows up first in asset prices. When they are galloping higher, that’s when the Fed needs to be concerned about inflation and act to tighten money.
Recent dollar strength is remarkable. We’re seeing the dollar rise not only against foreign currencies, but stocks, bonds and gold. The notable exception is energy, as oil and gas sharply outperform dollars.
The latter is all the more notable given we’re seeing this strength even in the face of large proposed releases of oil from strategic reserves. Just today the International Energy Agency announced an agreement on behalf of 32 member countries to release a record 400 million barrels of oil from their emergency reserves. Nymex crude is nevertheless up nearly 6% to $88.31 at last check.
The Fed meanwhile is off sides as it cut when inflation was high and now hesitates when it’s going negative. It’s talking as if rising oil prices will cause inflation.
It is confused. Rising prices don’t cause inflation; inflation causes rising prices.
Markets continue to exhibit a strong deflationary undertow. Media and the Fed are grossly in error in confusing higher oil prices with inflation. Inflation is when prices go up due to the currency losing value. These oil prices increases are real, not inflationary. The dollar is actually rising in value, not only versus other currencies, but versus alternative stores of value like stocks. bonds, and commodities … pounds, euros, Treasuries, US stocks, XS stocks, copper, gold, silver, platinum … the USD is appreciating versus them all.
The Fed can do nothing about oil, but it issues the currency. All it need do is focus on that which it controls.
That the Fed is off sides is further underscored by the fact that at this time in 2008, as oil prices were approaching an all time high of $147 a barrel, the Fed was cutting rates. Why it should have then and not now is a mystery, unless it is playing politics, which has no business doing. Though I’ve staunchly opposed every rate cut since 2022, we had an inflation problem then.
We have a deflation problem now.
Why a Wall Street Insider Warns Markets Feel ‘Ominously’ Like They Did in 2008
“Financial conditions, including rising oil prices and mounting pressure in private credit markets, are increasingly resembling the lead-up to the 2008 financial crisis, according to Bank of America strategist Michael Hartnett.”
So it’s not just me that thinks this smells like 2008. To put a finer point in it, it’s reminiscent of March 2008. Markets tanked then on the Bear Stearns collapse. If we were to stick to the 2008 script, oil peaks mid-year, full bore deflation ensues, then this fall comes a Lehman moment.
But that’s a big if … it would be too easy. One thing that’s different now is that the Fed’s inflationary arsenal is well developed. This time in 2008, it hadn’t years of recent experience with QE. And in fact QE is going in right now, though presently limited to TBills. It’s a simple matter to expand both the quantity and maturity of asset purchases.
But the dozy Fed seems asleep at the switch, confused by rising oil prices into thinking inflation is still the bugaboo. It clings to its lagging indicators, oblivious to the fact that inflation – and deflation – start in the asset markets, not the consumer markets that are months and years downstream. It’s also cowed by its insensate doctrine that rates can move only in incremental, unidirectional steps. So the possibility of cutting in March and hiking in April, if need be, is too far out of its cozy little box to comprehend. It can’t do anything unless it is convinced it can commit to keep doing it for months.
So it must wait until the evidence is overwhelming to snap out of its paralytic stupor. If only markets were free to set short term rates! They could rise and fall on a weekly, daily, or even hourly basis. like real markets do. And since they’re short term rates, there are no wild price changes as with long term yields, allowing them to act as shock absorbers for the markets at large.
This rigid adherence to dogma means that investors have to be prepared for deflation, and at the same time be on the alert for the sudden return of inflation when the Fed’s alarm clock goes off and it’s sleepy eyes flutter open. And then because of the same belief system, to realize the Fed may yet again keep its leaden foot on the gas pedal long after the deflation has passed, setting up the system for yet another bubble and bust cycle.
Market-wise, this leaves us a bit too close for comfort to the 2008 script. Base case is this plunge continues for another week or so, then a rally ensues, taking us past midsummer, after which things turn south in a big way. But as we know, history doesn’t repeat, but merely rhymes, so we will just have to stay alert and chart our course in real time.
Thanks Finster.
Could the FED be worried about long bond sell off/ USD.currency crisis if they are perceived to act “too soon” against deflation?
They are desperate to reopen S of Hormuz. I think it will be instructive to see what happens if they succeed. We may get a relief rally as oil drops.
Financials will be a big “tell” if they rally weakly.
Haha that may not have been my most coherent comment. It was more of a critique of the Fed’s whole paradigm than of its current stance. Short term interest rates should respond to short term developments like other markets. The Fed’s suppression of short term rate volatility essentially forces it into other markets where it’s more damaging.
In what economic canon is it written that short term rates must only move slowly and unidirectionally, while every other market can move by the minute? It’s a completely artificial, made-up dogma.
If short rates could fall today and rise next week, it wouldn’t be a problem for long rates, because they could counter deflation today and inflation next week.
Of course here I mean a rising dollar or a falling one … not adhering to the pretense that inflation and deflation only exist as long term phenomena. That’s just a consequence of using measures that only examine long time frames. It’s mathematically impossible to have inflation or deflation over the course of a month or year without also having it over the course of a day or week.
So I conclude that if the dollar depreciates against virtually every other major store of value for even a day (prices rise), you’ve had a day of inflation, and vice versa … if it appreciates (prices fall), a day of deflation. Yes it’s unconventional, but logical consistency demands it. What conventional economics measures as inflation and deflation far downstream in consumer prices is merely the cumulative effect of all those days upstream in asset prices.
If short rates were more responsive to these short term developments, they wouldn’t have to build up into long term developments.
There is at least one simple solution. Manage the money supply and let short term rates take care of themselves.
You are being completely coherent. What you say makes complete sense and gives you and those who follow this website an edge in investing.
However, (most) people aren’t rational. They act in response to emotions & feelings & belief. I was giving a reason for the Fed’s rationale. 🙂
I suspect the Fed imagines that if it does policy in a gradual, predictable, way, then the markets and economy will respond in kind. All the way back at least as far as Alan Greenspan’s baby steps “at a pace that is likely to be measured”. Of course this didn’t prevent the biggest financial crisis since the Great Depression.
To the contrary, it may have contributed to it. Predictability itself a form of ease. When speculators grow confident in their outlook, they can make bigger and more leveraged bets. To paraphrase Minsky, a sense of stability is destabilizing.
There’s a concept in signal processing engineering known as dither, where random noise is added to an input to reduce the occurrence of large scale patterns in an output. The analogy isn’t perfect, but it illustrates that there are examples in the hard sciences where the absence of small scale disruptions can lead to large ones.
We may be now be near if not at the threshold of the shall passing, at least for the time being. SS had penciled in late Q1, which is where we are now, and allowing for a couple weeks of error would put the end of it in the first half of April at the latest. I wouldn’t go as far as calling an all clear, but base case right now is the next deflationary wave washes ashore some time in latter Q3.
Gold has broken below the trend established before the January spike, and also below the round number $5000, opening the way for further declines. The longer term outlook remains bullish.
The bottom fell out this morning, with gold crashing about 7% into the lower $4500s. We can’t rule out further downside in the coming days, but those who are under allocated could do worse than to start remedying that, bit by bit. To coin a phrase, this too shall pass.
Quite a week for gold … or should I say for the dollar, which it underperformed by 10.25%.
I think it’s safe to say the froth has come out.
Surveying what we know so far about this year, there’s a good chance that deflation may dominate most of it. As Wolf Richter says. nothing goes to heck in a straight line, and that means there will be countertrend phases, one of which I still expect to develop soon. We’re also expecting a second deflationary wave later this year, as mentioned above. The period in between though won’t necessarily be smooth sailing … 2026 could resemble 2022. We’re getting a bit of déjà vu in that year was also marked by the outbreak of war … February 24 versus February 28 of this year.
What’s different this year is that we also have that echo of 2008 referred to in Credit Crisis Looming?. So for our history to rhyme with, we can think in terms of a mixed precedent of 2008 and 2022.
The big picture takeaway is that in spite of all that is stacked against it, cash will likely turn out to be a better than usual performer for the year as a whole. Commodities outperformance may fade by mid year. The best opportunities to trade cash for assets that do well when cash doesn’t may come towards the end of the year. Of course we’ll have plenty of opportunity to revise our outlook as the year unfolds.
A key challenge in these times is sussing out the reaction function of the markets. The west Asia part by itself isn’t hard … the higher oil prices go, the tighter monetary policy looks, and the stronger the dollar grows. That is, because of the Fed’s penchant for following lagging indicators. So paradoxically higher oil prices imply more deflation. This means, in dollar terms, lower bond prices, lower stock prices, and lower gold prices. Recently energy and broad commodities have emerged as the main counterpoint to bonds, stocks and gold, as the latter have tended to trade together.
This is complicated by the concurrent credit crisis bubbling away in the background, still not yet bringing its full weight into public markets. It may be eclipsed in the headlines by more compelling drama overseas, but it’s just as much there. In fact, if anything, it might be hurried along by the strengthening dollar as debt grows in real terms. It’s just not obvious yet how to connect the dots to asset prices from this alone. But from a fundamental perspective it should also contribute to dollar appreciation as debt represents demand for money, and if past is prologue, history affirms.
In short, it’s a deflationary double whammy. Anyone searching for an explanation for collapsing metals prices need look no further. Stock prices should fall too – and they have – if anything it’s remarkable they haven’t fallen further. Could this be the next “left behind” trade?
I feel today was somewhat a confirmation of the deflation risks.
Oil fell yet stocks have not really rallied convincingly which means the market maybe cottoning on to the deflation risk now the mask of the “oil inflation” has lifted somewhat. Further evidence: the dollar rose versus other currencies & bonds rose too. And perhaps gold rose in the first sign it is anticipating there will be a policy change? I can’t see a way out for stocks here. High oil kills them, lower oil means visible deflation.
There is so much noise in the markets right now it’s hard to tell which way is up. The only thing I can be sure of deflation-wise is that we have had some. What tomorrow will bring is a different question.
A bearish point for stocks near term is that we haven’t really seen anything resembling a capitulation. Stocks have been selling off at a sustainable pace, suggesting the selloff can, well … sustain. Combine extreme overvaluation with downside momentum and it’s not a bullish picture.
SS suggests a stock rally is not far off, and so far it’s nailed stocks. It also correctly forecast last quarter’s gold correction, but completely missed the bigger one this quarter. If stocks don’t bottom out in the next couple weeks and start to rally, then SS will have been wrong. But even if it’s not, there is still more to come later this year.
The credit crisis is fairly predictable, if not the rate at which it unfolds. The geopolitical situation isn’t. Just putting it aside for the moment we have a bull market in commodities which should run through about mid year. Oil had already started to rally back in December well before hostilities broke out, so I don’t buy the standard line that it’s all about geopolitics. As it happens, this was also the situation in 2022. Media blamed rising commodity prices on the war in Ukraine, but prices had already started to rise well before the war broke out. The fact that the Fed had been printing literally by trillions was scarcely mentioned.
But the scale of the disruption to oil supplies is much too large to just set aside, and we have no inside track on its course. This article for instance uses an explosive metaphor to make the point that there is a lag between the event and its impact; that just from what has transpired so far, there’s still a lot in the pipeline that has yet to be felt:
It’s like the sun exploding: One Wall Street firm fears $200 oil — and says it’s not too late for investors to prepare
Not that I have any particular oil price target in mind. War is inflationary, because it’s usually paid for with printed money. But the inflationary effect of this one has yet to be felt. The Fed never quelled the inflation from its post-covid moneypalooza, which led to the spectacular metals inflation of the past couple years and the oil price increases that started late last year. If past is prologue, the inflation from this cycle will come when the Fed starts cutting rates and revs up the presses to rescue a falling stock market and economy … and keeps on going long after the deflation has passed.
Quick comment on gold … it’s bargain in the neighborhood of $4000.
Reiterated … and in light of tonight’s clobbering, we may get another chance to buy in that neighborhood.
If reports from the ME are true, and that 40% of refining capacity in that region is out of action for the next 3-5 years while the refining infrastructure is being rebuilt, then this will potentially have a massive deflationary effect wrt the USD, because now the US will have to pick up the refinery slack from the destroyed ME capacity which must be paid for in USD.
There are similar issues with the supply chain for aluminum going through the ME.
Rosenberg’s outlook is compatible with what we’ve been talking about here, though he puts it in more conventional terms:
Forget stagflation. One economist says inflation is set to crater even as oil prices surge.
Up or down, cross-asset correlations have been remarkably stable this month. Gold, copper, US stocks, XS stocks, Treasuries have all been joined at the hip, with broad commodities trading counter to all the rest. That is, over recent weeks, the only asset class to provide any real ballast to the others has been commodities, based on my observations with COMT, based on the SPGSCI, due to its inclusion or energy and agricultural commodities. This, not treasuries or gold, has been the hedge for the past few weeks. How long this persists is an open question, but based on past cycles, it could well last until around mid year.
Synthetic Systems was mixed for quarter, having missed the gold correction but having absolutely nailed stocks. These patterns tend to persist, so it’s reasonable to lack confidence in its gold forecast but to expect stocks to follow the SS script next quarter.
So while we can’t rule out some spillover from this quarter’s stock declines into the first few days of the second quarter – the future is never certain – but it appears the selloff – and the broader deflationary squall – is about finished for now. We are turning bullish for the coming weeks.
President Trump’s speech threw cold water on the markets, re-igniting oil prices and the dollar while sending stock and gold futures lower. Commodities remain the only assets outperforming cash. It remains to be seen how much staying power the initial reaction may have, but it’s clear the March pattern has spilled over into April.
Bloomberg is running a headline touting how a Cayler oil trading fund returned 18% in March.
Meanwhile the passive iShares diversified commodity index fund COMT, featured in the Financology Model Portfolios, and highlighted here in December, returned over 20%.
On My Radar: Thoughts on Private Credit
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