Deflation Scenario to be Tested

By: Greg Silberman | Sun, Jan 21, 2007
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Article originally submitted to subscribers on 12th January 2007...

Is there a limit to the amount of Money the Fed can Print?

It's obvious the Fed is willing and able to print an infinite amount of money.
So why wouldn't they?

The answer lies in the fact that if people expected a never ending blizzard of paper they would take steps to protect themselves from holding such a depreciating item. How? By buying those items whose supply remains relatively inflexible for example Gold.

Taken to the extreme, if expectations of complete and rapid money printing (debasement) became commonplace, the rush out of paper would become a MAD dash for the exits.

Therefore, in the interest of holding onto the money creation reigns, the Fed is restrained by people's expectations of how quickly their money will lose its purchasing power. That is, if expectations of inflation are low, the Fed can print a Lot and if expectations of inflation are high, the Fed can only print a Little.

Are we now entering the Print a 'Little' stage?

By 2003 the Fed had slashed short-term interest rates from 6% to 1%, the world began reflating from the Nasdaq collapse and asset prices were being fuelled by never-ending cheap money.

The problem was/is that such money had to go somewhere and the money flowed into almost every asset class including Bonds (fuelling the Housing Bubble), the stock market (large caps and emerging markets), private equity funds (fuelling M&A) and ofcourse commodities (most notably Oil and Industrial Metals).

But remember inflation expectations?

Rising commodity prices and more precisely rising Gold prices raise the red flag on inflation expectations.

To combat this, the Fed started its mini-rate rising campaign to convince the market that any inflation problem was being dealt with, thereby keeping a lid on inflation expectations.

All the while, cheap money continued to flow from other central Banks, most notably the Bank of Japan, ensuring the monetary system was well supported and lubricated whilst inflation expectations remained low.

The net result has been a global explosion in debt levels and a universal biding up of asset prices.

But alas, the laws of nature apply to markets as well. Those micro Fed rate increases have begun to take their toll. As the Yen : Dollar rate stabilized the Yen Carry Trade has also slowed. And ever so subtly the tap of Fresh Money is being stopped up.

The markets have responded through a drop in Home Building Stocks, a haphazard rise in Bond Yields and ofcourse brutal corrections in commodities such as Oil.

Now we find ourselves in a crazy situation where the Fed requires a slowdown and asset prices to fall in order to justify the next round of rate cuts and more money printing. Remember, inflation expectations must be kept low at all costs to keep the game going.

Wow! What a dangerous game.

We have entered into a Fed sponsored slowdown where an element of deflation will be allowed to enter the system. The Fed is attempting to land a debt laden Jumbo Jet. Refuel and take-off again. A lot is at stake and a lot could go wrong. Will they be successful? We'll have to wait and see.

As deflation bites over the next few months watch for a widening in risk premiums and a flight to quality which should ultimately be positive for Gold.

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Author: Greg Silberman

Greg Silberman CA(SA), CFA

Greg Silberman

Profession: Research Analyst and Newsletter Editor
Company: Ritterband Investment Management LLC

Career Brief: Greg qualified as the youngest Chartered Accountant and Chartered Financial Analyst (CFA) in South Africa in 1998 at 25 years old. After completing his traineeship with Grant Thornton he moved to London where he worked for JP Morgan Chase in their Fixed Income Swaps Division. Sick of the grey skies and cold weather Greg relocated to Atlanta, Georgia where he spent the next 4 years freelancing as a management consultant. His targeted clients were fast growing mid size US based companies and he worked across many industries including credit cards, health insurance and energy trading. Greg has recently returned from Sydney Australia where he spent the last 2½ years working in Equity Derivative Structuring for Perpetual investments a major Australian Asset Management Company.

Greg has a passion for the markets and has been writing Greg's market newsletter for 2-years. A newsletter focused on metal and energy stocks and recently non-resource small caps listed in the US and Internationally.

This article is intended solely for information purposes. The opinions are those of the author only. Please conduct further research and consult your financial advisor before making any investment/trading decision. No responsibility can be accepted for losses that may result as a consequence of trading on the basis of this analysis.

Copyright © 2006-2008 Greg Silberman

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