My greatest concern is the inability of central banks to turn off the money spigots without inviting the kind of economic downturn that they made unprecedented efforts to avoid over the past six years and the commodity charts illustrate this ebb and flow battle against deflation in a clear way:
With the Fed winding down QE3 and threatening to raise short term interest rates next year, markets are starting to factor in the impact of Fed policy in a world that otherwise seems to be losing the battle against the deflationary juggernaut.
For sure, the release of the latest FOMC minutes on Wednesday sparked an impressive "short covering" rally on that afternoon which eased the US Dollar's inexorable rise (another deflationary indicator). However, the market promptly did an "about face" on Thursday, erasing any gains and by the end of the trading week the Dow Jones industrial Average registered a net loss for 2014! This five day 60 minute chart of the S&P 500 below shows the "whipsaw" the market experienced this week:
The market initially loved what the Fed had to say in their September meeting. From the Fed minutes:
"During participants’ discussion of prospects for economic activity abroad, they commented on a number of uncertainties and risks attending the outlook. Over the inter meeting period, the foreign exchange value of the dollar had appreciated, particularly against the euro, the yen, and the pound sterling. Some participants ex-pressed concern that the persistent shortfall of economic growth and inflation in the euro area could lead to a further appreciation of the dollar and have adverse effects on the U.S. external sector. Several participants added that slower economic growth in China or Japan or unanticipated events in the Middle East or Ukraine might pose a similar risk. At the same time, a couple of participants pointed out that the appreciation of the dollar might also tend to slow the gradual increase in inflation toward the FOMC’s 2 percent goal."
Market perceptions that the central bank was "talking down" the Dollar and an actual statement that reflected that the Fed was considering the economy outside the usual parameters of the US excited market participants that the inevitable increase in short term interest rates might be delayed. However, persistently bad data out of the Euro zone all week and some tepid data out of the US sobered up the market and the slide continued on Thursday and Friday. The fact that we continued to sell on Friday was especially concerning to me because I expected a flat day as my indicators were signalling that the selling momentum was waning.
I was asked a number of times this week, "Where are we going from here?". I appreciate the confidence others have in me to predict where these markets are going but sometimes my crystal ball doesn't work the way I like. Nevertheless, I'm going to post some charts that will be helpful in determining broad market direction so my readers can make their own decision on what to do.
What we can't ignore any longer is what I have dubbed "the deflationary juggernaut" that is attempting to strangle the world's economy. To that end, we must focus on Europe where deflationary pressures are most apparent and appear to be mounting. The following chart is a ratio chart that I "stole" from Michael Gayed of Pension Partners in New York City. Michael is a student of inter market analysis as I am and he has much insight into the direction of global markets:
While I respectfully disagree with Michael that the ratio is stalling I do agree that the ratio is a very helpful indicator in measuring the EU's battle with deflation and that it must be watched closely.
I have been of the mounting conviction that Europe's battle with deflation is the key to the direction of the global economy and financial markets. As a major consuming geo-political bloc its economic health is pivotal to recovery expectations in the US. We're no longer an island. We need Europe to consume or we hurt and Emerging Markets hurt even more.
Another chart that must be watched is the five year break even inflation rate in this country:
The fact that the break even inflation rate is dropping is a warning not only of disinflationary forces gaining momentum in our country but a reinforcement that we cannot "go it alone"; we need Europe to participate in a global economic expansion.
Some would argue that the next chart is all we need in order to understand where inflation/deflation is heading:
But let's look for some useful ratios that may be predictive market direction:
Central bank manipulations have bought as much time as they can. With the Fed stopping their buying spree this month you would think there would be upward pressure on interest rates. Instead, the supply that is available in the Treasury market is being gobbled up in a 'flight to safety" trade. This is apparent when looking at any chart of the Treasury market Here's a weekly chart the iShares Barcleys Seven to Ten Year Treasury ETF (IEF):
Most relevant to this entire discourse is the future direction central banks will take to stop insidious deflation. Already the European Central Bank (ECB) and the Bank of Japan (BoJ) are in various stages of monetary easing although the ECB is hamstrung because of EU political strictures. Japan's QE actually dwarfs our QE proportionally. At the same time the Fed is trying to normalize monetary policy but market price action is implying that they are flirting with the prospect of, at the least, recession, and at most, deflationary depression. The proof of my radical thesis has been presented in the charts above.
It appears that the classic "liquidity trap" that opponents of Fed policy warned us about when Bernanke and company implemented QE may be upon us. The experiment to "buy time" has ended. All efforts so far to force feed growth thru monetary stimulus have not had the desired effect. It may be time to take our medicine unless ...
... the Fed changes their forward guidance concerning interest rates. But to do so implies that we are caught in "a liquidity trap". After pumping unprecedented liquidity into our banking system which has overflowed into global risk assets, interest rates are so low that they can go no lower. The analogy of "pushing on a string comes to mind". The implication was not lost on Gold and is perhaps the implicit reason why Gold popped on Wednesday after the FOMC minutes were released:
Indeed, the message of gold may be prescient if my thesis is correct. Either way, it seems the Fed is caught between "a rock and a hard place".
I sincerely hope my thesis is wrong.
Have a great week!
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