Inflation vs. Deflation

This important piece of historical evidence comes from the Telegraph:

America's headline CPI screamed to 4.3 per cent in November. This may be a rogue figure, the tail effects of an oil, commodity, and food price spike. If so, the Fed missed its chance months ago to prepare the markets for such a case. It is now stymied.
This has eerie echoes of Japan in late-1990, when inflation rose to 4 per cent on a mini price-surge across Asia. As the Bank of Japan fretted about an inflation scare, the country's financial system tipped into the abyss.

The emphasis is mine. I don't think it's been stressed enough. I think that this will take time to play out, but it's hard to tell. I feel as if I'm in uncharted waters, but I don't feel as if I'm alone. However, this historical argument for deflation goes a long way toward galvanizing my conviction that deflation is winning the battle right now.

Here's another juicy bit of info:

The ECB's little secret is that it must never allow a Northern Rock failure in the eurozone because this would expose the reality that there is no EU treasury and no EU lender of last resort behind the system. Would German taxpayers foot the bill for a Spanish bail-out in the way that Kentish men and maids must foot the bill for Newcastle's Rock? Nobody knows. This is where eurozone solidarity stretches to snapping point. It is why the ECB has showered the system with liquidity from day one of this crisis.

The article also says that 71% of German women want a return to the Deutschmark, a sentiment enkindled by the highest inflation in the Euro's history: 3.1%. Will a collapse of Spain's property bubble destroy the Euro? As the quote above explains, the ECB is trying to follow a dual policy of fighting inflation, while at the same time it is unable, politically, to lower rates. What does this spell for the Euro? How would George Soros play this?

My first instinct is to say that this cannot be good for the Euro's value. However, the Euro just hit all-time highs against the Pound. Will this trend continue or reverse? If interest rates hold in Euros and drop for the Pound, it will. But what will happen if the ECB faces a bank collapse such as Northern Rock? This would cause a plunge in the Euro, either from a loss of confidence, or from finally lowered rates. My own inclination is to say that rates would be lowered, as they have already stopped raising rates.

This thinking spree has caused me to wonder if there will be a new lesson in global money learned soon. When Soros broke the Pound, we learned that currency pegs cannot be maintained forever. Will we soon learn that fiat currencies cannot be maintained across different laws and economies?

General Thoughs

My thoughts today came out of Russ Winter's blog comments section. Here they are:

The question is, whether write-offs are greater than defaults. I believe that write-offs are a trailing indicator of defaults. That’s why they keep getting bigger and bigger.

If you look at money supply without credit supply, you only have half the picture. What we have been seeing for the past year is the collapse of value in goods paid for in credit (housing) and a gain in value of goods paid for with cash (oil, gasoline). Why? Because credit purchasing power is being destroyed at a faster rate than cash purchasing power. That’s why there’s been a rush to turn credit into cash at any cost (Citi’s paying 11% for cash). M3 may be skyrocketing, but it’s not even close to keeping up with derivatives (debt).
This is called deflation.

This post was in response to the guy who thinks we will very soon see new stock market/commodity records highs:

frank,
You do have one thing going for you. Stocks are paid for with a much higher proportion of cash then many other assets (I’m thinking of
bond market in particular). However, equity is what is left over after debt.
Over the coming year, I expect that earnings will not keep up with debt service expenses for companies in certain sectors. The other sectors will become more vulnerable to bad news as everyone crowds into the same play. We’ve begun to see this with market breadth narrowing recently.

Profit Taking

I felt that it could only be prudent to take a 22% profit on my Bear Stearns short. With their horrible loss today, even though they were up a little, I felt that it was the thing to do. The market's been doing very well despite the dismal news. This leads me to believe that any good news could spark a big rally. On the other hand, losses from an unexpected source, or a sign that the credit crunch was spreading beyond the banks could trigger a panic. The VIX has continued its slide, showing that fear is dissipating.

I'm up about 12% on the year. Unfortunately, the options account is down, but will most likely come back as soon as the VIX spikes again.

Trading Update

I've been up 5 out of the last 6 days. The bad news is coming in strong. Right now, I'm just waiting for a really bad day to hit the market. The last couple of days has just seen the market churn, with financials up against a 178 point loss on Monday, and down on yesterdays 60 point gain. I want to see the DOW drop a couple hundred and the VIX jump a few points. Then I will take some profits. Probably AIG, BSC. The fundamentals have really broken down for financials and homebuilders. Most corporations are paying substantially higher financing costs. This will take a huge chunk out of profits.

Recession Now

Based on California 2007-08 income and sales tax numbers, we are already in a recession (at least in California). here's the chart:

Note the upper right corner: YTD % change in personal income revenue and sales & use tax coming in at -2.4% and -4.2% respectively. At the same time, employment growth is under 0.5% and has slowed for 7 months straight. The forecast next year is for a 12% shortfall (decline in expected revenues) of $14 billion. Yup, California is already in recession. Our politicians, however, refuse to recognize this.

"Retail Sales Surge"

"Retail Sales Surge" is part of the Yahoo news title today. Here's the real news buried in the same article:

Half of the November increase in retail sales came from a big jump in gasoline pump prices and therefore was not seen as a sign of strength in
consumer demand. But there were widespread gains across a number of other areas from department stores to appliance and furniture stores.

Here's another logical gem:

The stronger-than-expected gain in retail sales should ease worries that the country could be in danger of tumbling into a full-blown recession.

I guess this is because sales came in at twice analyst expectations:

Meanwhile, the Commerce Department reported that retail sales jumped by 1.2 percent last month, double the gain economists had expected. It
was the biggest increase in six months and followed a much weaker 0.2 percent rise in retail sales in October.

The only conclusion left to make is that since their argument against recession doesn't hold water, there must be 100% chance of recession next year.

In other news, the credit crunch is alive and well. Libor spreads haven't responded to the Central Banks. Libor Spread:
Today: 78 bips, 1-month ago: 15 bips, 3 months: 50 bips, 6 months: 7, 1 year: 10.
The central bank threw down pocket aces, yesterday, and so far the credit monster is calling their bluff.

Derivatives.....

This headline from Seeking Alpha merits comment. "Derivatives Trade Soars to Record $681 Trillion"

I think that CDS may be propping up the equity markets by acting as ~$0 puts. (In the event of default, equity typically loses almost everything.) Hellasious on Sudden Debt says that CDS issuers are unregulated, and they provide a false security. The CDS issuer may be more likely to default on the CDS than the company it's supposedly protecting.

The total notional amount of derivatives increased 27% in the third quarter. My guess is that this explosion is a result of much more protection being bought. Perhaps some investors are wise enough to take out multiple CDS contracts. Most probably are not. My guess is that the stock market won't really drop until/if/when the CDS market starts to unwind and shrink.

"shock and awe"

Will it work? The Fed joined the ECB and the Swiss National Bank to increase the amount of dollars in Europe. This comes as the spread on one-month Libor increased again after yesterday's disappointing quarter-point cut. Libor is now 5.10%, with a spread of 85 bips, much higher than September's 55 bip spread. September's half point cut by the Fed was prompted by this Libor spread. We would have seen another one yesterday, but for the fact that they already tried that and it didn't work.
They also understand that any liquidity added to the market will be immediately siphoned off by speculators betting on gold and commodity inflation.

A Fed official told reporters that the U.S. central bank's efforts won't add net liquidity to the banking system. (Bloomberg)

This quote is more troubling to me:

The Bank of England increased the size of reserves it will auction in money market operations and widened the range of collateral it will accept on three month loans.

Right now, the flight to safety crowd is fleeing headlong into money market funds and Treasury bonds. If the Central Banks aren't careful about the collateral they accept, then the currency they print will become tainted. I expect the Pound to fall against the dollar in the coming year. Remember, their property bubble makes ours look like a model of fiscal prudence and responsibility. They were giving out 125% loan-to-value mortgage and cash out packages to people buying houses six times their earnings.

Of course, transparency won't be part of the program:

The Fed official said that the central bank won't reveal the names of those
bidding for the funds. The auctions aren't aimed at helping particular banks, he added. Officials don't expect there will be any ``stigma'' attached to lenders bidding for the funds, the official said.

Funny how nobody seems to leak what's really important. How stupid does the media think we are? Never trust a fake leak. It's really propaganda.

This leaves the Fed still faced with the dilemma: How do we get people to lend money to keep the economy going? Unfortunately, even totalitarian regimes can't force people to lend money. One way is to punish hoarders and savers by lowering rates. However, the record amount of funds flowing into money market funds (cash) shows that so far, this is a losing battle. Rates will have to go a lot lower to persuade money flows to reverse. I think that we will see some inventive "solutions" trotted out by the central banks. Now that they are acting in concert, therefore, I believe that developed world banks will lower rates along with the Fed. This will put incredible pressure on China, et alia, to let their currency float. Since their stock market is closed, and their market is priced in Yuan, I believe that it's time the short the Shanghai index (FXI).

Trades

Bought 13 MO at $77.35 today. It's now yielding as much as the 10-yr. Institutional money will pour in because it's safe.

Sold 86 CFC at $11.59. It's bounced 40% on Paulson's mortgage rate freeze. The only thing that will fix is the stock market for a couple of weeks. Then everything will just get worse. The foreclosure rate has just hit a 20+ year high. Probably the worst rate since the great depression. Nobody knows because the numbers don't go back that far.

never say never

Here's a quote from someone who (now) knows what's going on:

Some people might say Wall Street only helped distribute risk.
I say, Wall Street shifted risk away from the people who knew what was going on and onto the people who didn’t.”

Never thought I'd agree with Hillary, but there's got to be an exception to every rule. Next up: how 'bout a National Housing Plan?