By: Mick P | Sun, Feb 8, 2009
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An Occasional Letter From The Collection Agency

Whilst the great inflation/deflation debate continues (it's deflation that wins, the inflationistas are being misled by the Fed's actions with its bail out facilities) we need to look at some startling new facts and projections that have appeared in the public arena. My worry, as you can gather from the title of this article, is that we face a global depression that cannot be avoided even if the events discussed below favour the results that the Central Banks et al seek.

Events are moving to a point were attempts to disguise the effects of certain outcomes can no longer be hidden.

The Federal Reserve.

"The Federal Reserve on Tuesday announced the extension through October 30, 2009, of its existing liquidity programs that were scheduled to expire on April 30, 2009. The Board of Governors and the Federal Open Market Committee (FOMC) took these actions in light of continuing substantial strains in many financial markets.

Regular readers will know that the extension comes as no surprise to me and I expect further extensions to happen for sometime to come. Clearly the supposed purpose of all these schemes, to recapitalise Banks (and just about anything else) and allow the credit markets functionality to return to a state of "normality" has failed. The extension reflects the Fed's position as lender/borrower of last resort, rather than any ongoing success in achieving the aims they were designed for.

Fear not readers for the Fed is readying itself for the next stage of the battle to defeat deflation, as the Chairman so presciently foresaw:

Within the next few days we will see the ideas in this speech, now set up as a theory, tried in actual market conditions. Its success or failure will set the future direction of the global economy. The enabling agent to allow this test to go ahead is:

The US Treasury:

Below is a copy of the tentative Treasury issuance schedule through to the end of March, showing the future pattern:

With the increase of debt issuance upward pressure will be exerted upon yields. This counter-acts the Feds attempts to keep both short term rates and those further out along the curve at a level the Fed perceives as conducive to encouraging credit markets to allow the flow of funds to re-start. The real test of course is whether buyers turn up at the auctions. A failure will force the Fed to enact its statement from the last FOMC minutes:

To control rates the will have to step up to the plate and bid at prices that keep yields within its targeted band. We don't know exactly what the boundaries of the band are but we can look at recent yield levels to garner some idea from previous support and resistance levels:

Courtesy of

Bond yields are in a move higher as you would expect, bond buyers know what the increase in market supply will do to prices if no one (in essence foreign buyers) turns up for the auctions and bond yields are acting accordingly as long positions are closed.

The Fed will end up reacting to the results of the auctions; if buyers insist on higher yields (by setting lower prices) the Fed will step in and start buying across the curve, indeed if they are looking at the yields across the curve now they may well be feeling some concern that the plan to hold rates at low levels may already be under attack.

If the Fed fails to react to higher yields or failed auctions (when not enough bids are received to cover the issuance) bond markets will take fright as the Feds credibility to back up the words from the FOMC minutes is destroyed. Without a buyer of last resort supporting the market then a bout of panic selling, even dumping could take place. In some ways this would suit the Fed as it would begin its intervention at a lower price level and if the policy is successful the balance sheet would benefit from appreciating prices as yields fall back.

Why do I think Fed intervention is inevitable?


The ability of Foreign Central Banks to buy US issued debt has been a function of increasing dollar flows taken in payment for exports to the US and re-circulated back (to stop domestic inflation) by buying US debt.

As the IMF says "Global output and trade plummeted in the final months of 2008". The requirement to re-circulate dollars back into US debt will also be severely curtailed just at the time when the US wishes to raise debt issuance. The need for the re-circulation of dollars is not going to increase anytime soon:

Indeed a further contraction of "available" dollars, produced in exchange for goods imported into the US, is more likely that the chart above suggests. The IMF has a tendency to be optimistic in its views. To enable the US Treasury to issue new and increasing amounts of debt in an environment of decreasing need, when world trade has almost halved, leaves the Fed no alternative but to put its words into action.

If however the Fed decides not to deploy the printing presses and its unconventional policies then the result will be as the IMF states:

In the IMF paper, "Gauging Risks for Deflation" the work of Kumar and others is reproduced, showing the overall vulnerability to deflation for the world:

The IMF have the risk indicator flattening off in 2009, again this seems optimistic considering that the downside risks are much, much greater than any possible upside to the current situation. As it happens, the IMF do have an important caveat to the indicator, which may:

Of more concern is the IMF risk assessments for the G3 (US, Eurozone & Japan) based on the Global Projection Model. This agrees with my interpretation of GB Eggertsson's work, available here. I quote from the IMF paper:

As a cautionary note I would mention Japan in the early '00s often presented future inflation and GDP charts with an upside bias, that bias was not fulfilled until 2006 and even then the rise was weaker than earlier projections suggested. However the risk of inflation in the G3 even using the IMF projections is low and remains low for some time. Unless inflation fulfills the upper percentile sustained projection of 2-2.5% I think the Fed will continue the Zero Interest Rate and Quantitative (Credit?) Easing policies.

I see nothing that supports a hyperinflationary environment in the G3 in the medium term. If the IMF red projection line (mid 50th percentile) is accurate, inflation, growth and price levels will not engender a credible expectation of future inflation and monetary and fiscal stimulus will fail. That failure will lead to a period of extended deflationary forces acting upon the global economy.

The initiation of increased debt issuance by the US Treasury begins next week. Any sign of weakness in the Fed's response to low prices or failure at the auctions will cause major disruption in the bond market. However such disruption should be short term as long as the Fed responds vigorously to put right its previous inaction.

Even if the Fed is successful and keeps interest rates along the curve artificially low, there is no guarantee that the expected result of increased inflation expectations will occur in the future. Without the future threat of inflation business and consumer spending patterns will remain "tight" and a continuing hoarding of cash and cash like assets will remain attractive, even in an environment where real interest rates are negative. Only when a point is reached when cash, held as an asset, shows a depreciation will it become viable to swap cash for other assets that will give a higher return. This is why many schemes are failing, the dollar has become an asset in its own right:

Coutesy of

Looking at the chart, is it just me or is the Dollar waiting for news?

Some have put forward an idea that US taxes should be cut for Businesses who wish to repatriate overseas profits, allowing an injection of cash into the US domestic economy. However with the main theme of investing already focused on highly liquid uptrends (see US Treasuries until recently) the increase in demand for Dollars as profits are converted from other currencies would cause further appreciation of the Dollar. This would make the hoarding of cash more attractive and negate the attempts to loosen the flow of funds. Indeed the suggestion of such a repatriation, especially from the US Treasury, would cause longs to take positions prior to the event occuring, pre-emptively causing the uptrend to strengthen, encouraging an acceleration of savings. Thus such a scheme would encourage the very conditions that the Fed and US Treasury are attempting to thwart.

Until economic conditions are conducive to the deployment of savings to allow profitable investment then the hoarding of cash and cash like assets will continue. I very strongly suspect we will have to live through a global depression before such economic conditions appear.



Mick P

Author: Mick P

Mick P (Collection Agency)
About Collection Agency

An Occasional Letter From The Collection Agency in association with Live Charts UK.

For some years now I have written an ongoing letter, using macro-economics, to try and peer into the economic future 6 to 18 months ahead. The letter was posted on a financial bulletin board to allow others discuss its topic.The letter contains no recommendations to buy or sell, indeed I leave that to all the other letters out there and to the readers own judgement. The letter is designed to make us all think about what may be coming, what macro trends are occurring and how that will affect future trends and how those trends will filter down to everyday life and help spot weak or strong areas to focus on for trading or investing.

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