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Wednesday September 13, 2006 - 10:15:11 GMT
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Rambling and the “deflationary boom”

Key News

• The number of Britons claiming unemployment benefits unexpectedly fell for a second month in August and wage growth accelerated. (Bloomberg)
• Key Reports (WSJ):
7:00a.m. MBA Refinancing Index.For Sep 8 Wk. Previous: -0.9%.

Quotable

“Why a four-year-old child could understand this report. Run out and find me a four-year-old child. I can't make head nor tail out of it.”

Groucho Marx

FX Trading – Rambling and the “deflationary boom”

We have not believed “inflation” would spike wildly out of control because of the secular deflationary forces in the world. And we do not always see deflation as the bogeyman. It can be a cleanser for past mistakes and it can enhance the purchasing power of consumers—it is a more natural process for capitalism in that competition passes on the benefits of increasingly efficient processes—it’s those omnipotent central banks and governments that help “manage” the business cycle that seem to do much of the damage.

I may be getting in way over my head here, but it seems that the concept of “inflation” which is commonly defined by indices---CPI or PPI—is very different now, than it was when economies tended to resemble closed-loop systems. I realize that inflation is in and of itself a monetary phenomenon. But if so, why haven’t we seen more, much more, given central bank 24/7 pumping for many years? And I realize that some believe we have seen it in asset inflation—it’s the same, it’s just not showing up in the indices.

But I think we also throw around the term asset-bubble too loosely. A rocketing of the price of copper, because China can’t get enough, and Australia and Chile can’t dig it fast enough, is not the same as an asset-bubble—it is the byproduct of supply and demand. And we really haven’t seen so-called asset bubbles in many of the food commodities—which one might expect if inflation is a big problem.

Weekly Wheat Chart

Analytically, inflation doesn’t seem to be defining what’s happening in the global economy, despite the fact that central banks have flooded the world with liquidity and energy prices have risen, and housing prices have risen. I guess in the end we can avoid worry about defining these things and look to what has worked well in the past—the yield curve. It seems the yield curve never really bought into the idea of inflation either. The analytical appeal of inflation and what’s happening in the real world doesn’t seem to be connecting.

That’s why we find the concept of “deflationary boom” so appealing. It comes to us courtesy of Gavekal—a research firm we were turned-on to by a friend of CC; he resides in France—I don’t drink his wine or eat his fries, but I do accept his research recommendations (that was an attempt at a joke. Sorry.) We don’t’ know any of the players at Gavekal—but we do find their information creative, independent, honest, and consistently thought provoking. Here are a few excerpts from their theme of “deflationary boom” we initially read back from a piece they did in June, below that is a summary of recent market action they penned today. I think you may find it interesting, at the least.

From Gavekal in June ’06:

“At the heart of the deflationary boom argument is that supply is structurally higher than demand; and there are strong incentives for it to stay that way. For a start, the virtuous cycle of supply-side economics/capitalism usually ensures that the most efficient producer adds capacity and drops prices to gain market share. Moreover, there exists many political and social reasons to keep supply forthcoming, irrespective of profit (i.e.: China).

• This reality makes our central bankers jobs somewhat easier; they simply do not have to worry about supply issues. All they need to do is manage demand, always keeping it a little behind supply to contain prices. If this is done effectively, price increases stay contained.

• In terms of managing demand, the Fed overdid the demand stimulation in 2001-04, but an important lesson waslearned: low rates not only stimulate consumption in the US, but capacity expansion abroad even more. For a while, we get a window where demand surges (i.e.: US housing cycle, energy) and people believe we have entered an inflationary boom. For a brief period, it appears that demand has caught up with supply. Monetary demand stimulation at the core also creates supply stimulation at the periphery. And while this is going on, investment in capacity looks like demand.”

From Gavekal today:

“Commodities are rolling over hard, as evidenced by the –15% drop of the CRB index since the highs of May 11th, now trading at a 13-month low.

• Stocks are rebounding. As most investors are painfully aware, the second quarter was not a good quarter for equities… However, since mid-June, stock markets have experienced a major rebound, with the world MSCI gaining a healthy +7.5% since its June lows.

• Bonds are rising. Following the dissipation of the inflationary fears (and here we note that Swedish inflation fell for a third straight month to +1.2% in July) and the rising likelihood of a slowdown in economic activity, bonds have been performing very well.

• The US$ is strengthening. While still trading in a very narrow band, the US$ has nevertheless strengthened +1.9% against the Euro over the past three weeks and is now trading at US$1.2690/Euro, close to a two-month high. Yesterday’s strength in the US$ was particularly impressive given the fact that the July US trade deficit came in at an all-time record of US$68 billion (expected US$65.5 billion).”

A “deflationary boom:” Commodities going south, while bonds, equities and the dollar head north. It’s something to consider.


Jack Crooks, Black Swan Capital Black Swan Subscription-based Service

 

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