Sitting on an Inflation Powder Keg

Voices of hyperinflation have been quieted down. We have agreed with participants on the matter but not on their timing.The economy has shown more resiliency than economists expected. We have been and remain bullish.

As fear dissipates, we are sitting on an inflation powder keg! Massive amounts of liquidity will move back to real assets in due time. It has been a slower process because there is a lot of fear out there.

We think that we are now nearing this inflection point and it is quite exciting. Our advisory services already look to score nicely for the first half as we have been mostly long stock indices only.

It has been brutal for many markets. Money managers have unwinded bets on the conviction of a slowing global economy.

We think the second half provides hope of picking up great plays to finish up the year strongly.

Already amongst the back drop of a slower macro economic picture bonds should have rallied. They have not and the drop took players by surprise.

It is further proof that we are turning the page. As our forecasts are right on, we have growing confidence in our outlook of a better coming future.

A massive liquidity wave is coming. We feel that it is going to be exciting. Participants are unprepared !

Yves Lamoureux http://lamoureuxandco.com/

Is the Bank of Japan losing control over rates? The theory of QE is that the central bank can manage rates down by purchasing bonds, but the bond vigilantes in Japan are pushing back.

In the US the fear is that the Fed will be unable to taper off QE. The Bernank's remarks last week were of a taper, and yet in the US the 10 year has spiked above 2%. There is a concern that if rates go above 2.2-2.25%, the biond portfolios will begin to rotate their mix of long and short bonds, essentially causing a spike in the ten-year which might shoot it to 2.5% - the so-called Bond Convexity. If this happens, expect the Fed to stop the taper and jump back in with (say) two months of QE in one month, to drive rates down. 

This would be quite a good buying opportunity of the ten year. It also may signal that even the Fed will face issues in trying to taper and avoid losing control over rates. 

Stocks: his bullish indicator has turned Yellow - time to take profits. It may shortly go into full sell mode. Neely has a similar view, that we may be in the final capitulation UP above S&P 1700 before a dramatic reversal.

Bonds: the effort to reflate the Japanese currency has caused damage to the confidence of Japanese bond investors due to a big pullback in bond prices. Ignore the bond vigilantes at your peril, Yves says! The vigilantes will work against the effort to reflate by dropping bond prices and negating monetary expansion. Instead, if this rolls into an even larger correction, it is deflationary.

Currency Wars: the drop in the Yen (30% so far) has a short term impact on Japanese profits due to increased sales (largely to China) but engenders a currency devaluation by trading partners. Already calls in Europe for a more expansion ECB approach. Profits in countries around Japan that also export to China - Korea, Hong Kong and Taiwan - are being hammered.

Deflation: The weakening of the Yen creates deflation in trading partners due to their relative currency strength, at least prior to a competitive devaluation.

US Dollar: In general it is thought to be going higher, in part due to the export of deflation by Japan combined with competitive devaluation by trading partners, and eventually Europe. Yves however thinks it is shortly to weaken, especially if the bond vigilantes thwart the super QE of Japan.

Of course, if you follow this blog, you were well prepared, as Yves called this months ago.

It now is entering what Prechter calls free-fall territory, as it has has busted below a support level (first chart) and a technical level (second chart):

Goldenfreude is the pleasure of seeing goldbugs lose their shirts. A lot of prosaic punditry trying to explain this, and getting it worng. Most of the immediate selling was out of Asia, and was caused by Abenomics, the shock and awe of massive QE by the Bank of Japan. Buyers of Japanese bonds may have been leveraging their purchases by using gold as collateral, and now are liquidating to cover as the Japanese bonds plunge. The proximate cause for the two-day rush to the doors is likely Friday's China GDP report, showing a slowdown. Commodities are also taking a bath.  

This should not have been "unexpected", the common word used by mistaken punditry. We had two large gold sell-offs during the Great Recession, both driven by expectations of massive central bank intervention:

1) July 2008, right before the Lehman debacle and following on the heels of a parabolic blow off top in oil

2) September 2011, as the Euro crisis hit and central banks intervened

You cna see what the gold plunge is predicting: another bout of central bank intervention to keep the wheels from flying off the global ecopnomy. The first out of the blocks is the Bank of Japan's QE. The punditry expects the massive BOJ QE to respark inflation. Gold is signaling the opposite, of deflation.

Milton Friedman got the punditry thinking that inflation was due to the increase in base money (central bank money and reserves), but this is too simple:

1) The Quantity Theory of Money had inflation as based on quantity times velocity of money. Velocity has plummeted in the Great Recession to levels BELOW those of the Great Depression. 

2) Modern Monetary Theory has popularized the view that the quantity of money is not based much on base money, but on bank lending, as banks create the quantity of money. Put another way, banks do NOT lend out of reserves; they lend out of opportunity and then scramble to find reserves if needed.

The striking increase of bank reserves, and QE, have done little to spur bank lending; the reserves sit in the vault so to speak. Instead, QE has spurred excessive speculation in assets, what Minsky called the Ponzi Finance stage. Asset bubbles rage back and forth across commodities (oil! corn! coal! Bitcoins!), debt and margin are used to juice returns, and as each bubble collapses the velocity of money shrinks and the speculators fall back. 

Japan is now (as John Mauldin aptly puts it), a "bug in search of a windshield." Abenomics is leading to money washing back and forth across the globe, much as Hoover wrote in his memoirs about the sovereign debt crises of the 1930s. Is Cyprus the new CreditAnstalt?  This is not how a real recovery begins, but how a false recovery ends. 

Now to Yves update:

Our target of 1450 $ is in sight!

We have been bullish through a decade of bearish action on gold. We have equally been bullish over a decade of bullish action on gold. We have always been bullish through bull and bear market on gold.

We have learned to sidestep the market when desired. This sets us apart.

We adopted a neutral stance two years ago. It was meant to suggest a long pause and/or correction. This adjustment would be a combination of time and price.

We think players do not understand the length of the cycle. Our model suggest rising rates for 30 years.

It is with great excitement that we watch what is happening.

Gold is driven by the future perception of the US dollar. It is expected to go higher. Money managers have completely redeployed funds into the buck. They were substantially under invested at the start of the year.

We have a different view. We view the euro currency in a new bull market.

Gold bugs should stand up and listen ! You will get a weak US dollar in a coming future. The way you position yourself in light of events will be exciting.

Yves

http://lamoureuxandco.com/

We are now very bullish on Chinese shares. We called the top here in 2007. It was a few weeks before the market hit 6,000 on the Shanghai Index. The piece was called Party Like Its 1999. It focused on similarities that bubbles have. The rate of ascent was becoming parabolic and was unsustainable.

For most of the punditry, it was the Chinese miracle. I guess people never learn. Participants have the hardest of times to shake off their biases once in a bubble. 

I have been a witness to long term negative sentiment toward Chinese shares in the 2003-2004 period. I felt that the sequence had the hallmark of a final C wave. I got very excited in 2005. I felt very strong that the market was prepared to go up in a final 5th wave sequence. I was right. From a base level of around 1,000 the index proceeded to trade to 6,000 in a little bit over two years.

We did explain to our subscribers recently that there are great dislocations between the economic reality and the stock index behaviour. It is even more prevalent with the Shanghai market.

Years of impressive growth have never guaranteed a higher market. Why would it matter now?

The stocks have this uncanny ability to confuse most participants anyways.

We have held to our bearish stance since 2007 to only turn to the bull camp recently.

We are very bullish. We think that we are facing a wave 3 of 3. This large sequence could in fact propel the market back to its old highs. The market could double and even triple from here. 

We remember a time where Chinese funds were the rage. They are not anymore as they have lost their popularity. Long term sentiment is very negative toward China. We believe it is consistent with the psychology of a corrective wave two.

We think Asia has the upper hand in the debate of credits versus debits. Most of our work is derived from behavioural economics. We think it better lends itself to today's environment. 

Market observers are out of touch with today's world. Do yourself a favour to dig in the past as it is very revealing of our future. 

Yves Lamoureux http://lamoureuxandco.com/

Sure, it could be a one-off, but Chnia's corporate bond market is much larger (adjusted for GDP) than the US equivalent and is highly misallocated due to easy credit and political malinvestment. While unconnected to the Euro crisis, coming so swiftly after Cyprus, it may be another harbinger that the wheels may be slowing coming off the global credit train.

Banks runs have swept Cyprus, and the government has called several days of bank holidays to get a vote on the bailout through before depositers can get their cash out. It is not clear the votes are there.  

Sunday evening in the US, currencies are racing to "risk off" (ie out of the Euro and into the USD). The S&P is approaching the point of the Triple Top, and is certainly close enough that any drop from here may signal the end. Technical signals are sending warning signs, such as this chart from Zerohedge that shows stocks again at nosebleed levels vs. forward earnings, just like the prior two tops of this Triple:

The Cyprus bank-runs are eerily like the beginning of the sovereign debt crises in 1931-2 that drove the global economy off the edge. The same sorts of events seem to be unfolding, but in slow motion as central banks dump liquidity to stem the crises.  

You might think that it can't happen here in the US, but it did, in 1933: FDR confiscated gold in exchange for paper Dollars, then re-valued the gold ratio from $20/oz to $35/oz - effectively confiscating 40%, well beyond the Cyrpus action. Because transactions in the US stayed priced in Dollars, it appeared to be a wash, but inflation began as US prices re-marked to real money.

Martin Armstrong, a student of financial history, looks at this and conjectures that when the Fed faces a similar crisis, for example when it begins losing control over interest rates and has to get more buyers of Treasury debt at low rates, Treasury may issue Savings Bonds and Congress pass a law to force purchases of them. This acts like a gold swap or deposit sweep in that the forced savings are likely to be traded into an illiquid and below-market asset, the savings bond. He calls it Patriot Act II - a good patriot woud buy the bond. 

Short term, however, this may be bullish for the US as money races to US assets as a safe haven. After an initial jitter in stocks, the on-rush of foreign capital spikes the S&P to new highs. Looking at the market since 2000, it appears to be in a trading range, but over-shot below the bottom in 2009; typically it would now over-shoot above the top of the range before the end.