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November 07, 2005

A Hyperinflationary Omen?
by Gary Tanashian

We have all heard the stories of Weimar-era Germans wheeling barrows full of Deutsche Marks to the bakery to buy a loaf of bread, people steeling doorknobs simply for their metal content and others burning paper currency instead of the unaffordable wood needed to keep them warm. How much of this is truth and how much is hyperbole, I cannot say. But this week I had an experience that certainly conjured up these images and more.

My company, Pan-Tec, Inc., uses state of the art, automated machining centers as part of its daily quest to provide value while based in a country where such a concept seems ever more hokey and out of touch. To this point, I have bought Japanese machine tools exclusively. Their quality and value proposition have been unequalled in my view.

Unfortunately, last week we got a sobering lesson in global trade dynamics. One of our machining centers needed a new coolant splash guard. Basically, we are talking about a piece of sheet metal, a steel rod and a sheet of rubber, all for the unbeatable price of $1,900, compliments of our trading partners in Japan, who obviously value our business at this juncture. Not.

The author holds a worn machine tool splash guard that was replaced
by an identical one for a mere $1,900. Your eyes do not deceive, it is
a piece of formed sheet metal, a steel roller rod and a rubber sheet.

Our world reserve currency (USD) has just made an all too obvious (I was just about put to sleep waiting for this) breakout and the dollar bulls are once again out crowing. I have been anticipating this for some time as it was mentioned previously on numerous occasions to keep an eye on those bullish RSI divergences in the dollar's break down in gold terms. Well, the dollar may now be on its way to fulfilling the buck bulls' "price" expectations.

Regarding the dollar's situation, a noted analyst wrote the following on Friday:

"Upon its first failure at the 90 level this Summer, the most vociferous Dollar perma-bears were quick to declare the Dollar's "counter-rally" dead based on the charts (though most aren't technicians, they'll point to charts as evidence when an obvious pattern emerges that they feel verifies their thinking). This move, however, will be much harder to explain away based on the charts. I also suspect that it's going to become increasingly difficult for the most vocal anti-Dollar extremists to sell their "Dollar collapse' and "end of American empire' nonsense as we head into 2006."

But this, and other analysis I have read focuses simply on "price" and charts. Those who read the sample Biiwii Letters I published know that one of the asset classes suggested was a good US Treasury money market fund such as Fidelity's FDLXX, as this is an environment where liquidity in the form of a "safer" paper vehicle paying ever-increasing interest is sensible as part of one's portfolio in my opinion.

Looking beyond a simple USD chart measured in foreign currencies, we see that the buck has also made a strong move vs. gold (the truest measure of the dollar's - or any currency's - ultimate strength in my opinion), and for the time-being, negated its break down in gold terms. I have been following this chart for several weeks now and have been noting the dollar's inability to break back into the channel, all the while flashing those bullish RSI divergences. On Friday, the divergences were finally vindicated in the short-term at least.

The dollar is not looking like such a sure thing when measured in the senior gold stocks, which hung very tough on Friday despite the tankage in the bullion market and dollar breakout. The miners generally lead the metal. So far at least, the miners aren't buying it. The dollar could well be about to break out here as well, which would put the fear back in Goldbugville. I believe I would become hysterically bullish the miners at around HUI 200, where ample chart support exists. There is no time like the present to get a good old fashioned deflation scare going. Even lower is very possible on the HUI, but for the time being, the dollar has shown the world its bullish intentions and the miners yawned. We will soon know whether or not that indifference was warranted.

But back to our regularly scheduled commentary. Here is a Japanese machine tool manufacturer basically flipping off American customers and their valued dollars. Why is that? I spoke at length with my local dealer who said this is not an isolated incident. He managed to help me get the price all the way down to $1000 for this gizmo that looks like it should retail for $29.95 at the local hardware store. But the Japanese representative, who I have met on a couple occasions and who has always portrayed a deep desire to gain more business from Pan-Tec and other American firms, now apparently has a "take it or leave it" attitude.

According to the American dealer, the Japanese domestic recovery is very real and their machine tool manufacturers are more interested in selling into their own market and that of China then they are the former manufacturing heavy weight, the United States. American manufacturers are aware of the dynamics at play and are focused on paying off debt and reducing their leverage in this environment where the ground is shifting beneath them. Even the machine tool dealer is following a plan to be debt-free in short order and sitting on some silver bullion.

But what of the average American? How can 4/5 of the US economic juggernaut, AKA the massive services sector, really know in a visceral way what is in play here? The economy is humming along, growth is generally unabated and despite some pesky inflation problems, all systems are go. I am not being sarcastic here. My company is quite busy, as we do 90% of our business in one of the most pervasive "services" sectors, healthcare. Biiwii.com has never been about being bearish for the sake of bearishness. That is a fool's endeavor as the perma-bears can attest to. We are in an age where price is everything. The price of the dollar is up, but its value is seriously in question in my opinion. We are trading on goodwill, the shelf-life of which is anyone's guess. The price of the stock market has remained buoyant (was there ever any doubt as commentator after commentator began issuing crash alerts in October?) as can be seen on the chart of the S&P 500. Perma-bears that think the 1225 area resistance is in the bag, had better think again. "Price" is everything baby! Again, those doom and gloomers with their "value" propositions need not apply.

There is an interplay at work between inflation and deflation that I will not pretend to fully understand. But I do know that our "resilient" economy has been resilient only to the extent that the bond market says it is. When I see signs like Japanese companies wanting 1,000+% markups on our dollars, I wonder how desirous they are of holding yet more of our treasury debt, which after all is simply dollar denominated debt. As stated many times previously, I believe deflation is inherently a good thing, as the Japanese may be finding out now while they emerge from a 1.5 decade long cleansing of excess. Not that Japan doesn't still have its problems (I wonder how much of their "structural problem" has simply been written off the books), but perhaps they are coming to value their new status as an economic machine restarting from a point of relatively solid fundamentals.

Japan is a mature manufacturing economy. Their patience with the American debt-for-consumption model may be wearing thin. China on the other hand, may provide the US with a longer leash, as it is still in the process of using the "resilient" economic system to its advantage in building infrastructure, technological bases, natural resource bases and trade networks. Maybe we have an indefinite amount of time left to keep our debt model running. Certainly some perma-bears must now be coming to believe it will never end. Or maybe the US is becoming increasingly isolated on the global stage and the ascendant powers of Japan (mature, sophisticated economy), China (manufacturing giant) and India (technology center) will increasingly set the terms of global trade.

Is it reasonable to extrapolate one hideously over-priced machine tool splash guard into a global trade nightmare (for the US) scenario? No, of course not. But it can not be disputed that the great American consumption machine is at the heart of its economy. Nor can it be disputed that it is an M3 liquidity spigot that primarily keeps the consumption game going.

I have a colleague (un-named, as I'll let him speak for himself at this point) who has long been looking at the prospect of the United States being put in a position where it is forced to an inflection point; monetize its own debt or watch the whole enchilada unravel. In this regard, I would expect that two things come into play. First, a strong dollar (technically deflationary) would make US Treasury bonds more attractive and second, with the bond market being the primary source of "juice" for a liquidity-dependant economy, the seeds of continued inflationary growth would be planted. It is important to retain the distinction here that inflation pertains to money supply, not prices, as analysts such as Jim Puplava and Steve Saville have often stressed.

I am not a "bond guy" and I don't pretend to be an economics Ph.D. (I usually go to work in Jeans, and shorts in the summer ), but I can see that there is a mix going on here, whereby the "extremist" dollar bulls / deflationists and the "extremist" hyperinflation / "end of the American empire" folks are all correct in part. What nobody has figured out however, is what the results will be when this all shakes out. Dow 13,000 or Dow 3,000? In my opinion it's all in play. But that 1,900 USD gizmo which probably sells for 1/10 the price in Asian currencies has got me paying as much attention to the "anti-dollar extremists" as any other group of know-it-alls, no matter what the dollar's "price" is doing.

Post Script:
I would like to add that I am aware that I tend to note the folly of the perma-bears much more often than that of the perma-bulls. There is a reason for this. While I sympathize with the bearish view that looks at the unsustainable nature of the American economic system, I also realize that trying to pick an end point to a structure that has been in force for decades upon decades is tricky at best. As for the perma-bulls, who I will define here as the vast mainstream stock broker, investment bank, financial advisor and economist communities, let's just say that it is in their interest to strictly define bullishness in terms of price and extrapolate price trends ever forward. Put simply, most of these entities don't seem to care what type of risks people take on in the never ending quest for return. For that, they do not have my respect as I feel they should, and in some cases they do, know better.

Personally, I hope the enchilada stays wrapped for a good long time. I hope the dollar holds together and I hope the fiat fun wagon rolls on indefinitely. But when I look under the hood, I see a lot of moving parts in there, some of which look pretty worn. Please consider all views and weight them against your own instincts.

Charts courtesy of stockcharts.com

Gary Tanashian
http://www.biiwii.com/

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