From Paul Mylchreest of Monument Securities
We are approaching a critical point (again) in the “battle royal” between the forces of inflation and deflation. Deflationary forces are threatening to overwhelm the reflationary push-back of the world’s central banks - although this is not reflected in most equity markets (especially the US). Open-ended QE was only announced by the Fed last Autumn, but the impact on (market-based) inflation expectations plateaued within months and has started turning down.
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I am no fan of QE, but the Fed is discussing scaling back its preferred reflationary policy tool when the economic cycle is at one of the weaker points since the recovery began in early-2009. This is probably a bluff, or would be a temporary measure at most. With recent support for scaling back from the BIS and IMF, it’s questionable whether there’s a coordinated attempt to talk the dollar up...just as BRICS nations are stepping up their efforts to undermine it (see “Encore” section)? Or is talk of bubbles impacting their fervour?
In equities, previously reliable valuation models based on ISM/PMIs are breaking down - likely due to QE. Correlations between equity markets and various other financial assets and economic indicators are also diverging as the S&P 500 powers ever higher. Currently, few people seem to (even) entertain the notion that western equity markets could see a short-term correction. Maybe that’s “correct” - in light of the mechanics of “full-blown” QE as explained in the report - but it is worryingly reminiscent of bubble mentality.
As we show in the report, the monetary system in the US has changed dramatically since the 2008 collapse of Lehman and the implementation of QE. This goes right to the heart of how NEW MONEY IS CREATED (QE not loans), who creates it (the Fed not the banks) and who gets to use it first (banks not borrowers).
As far as it’s possible to tell, this change appears to have had a very positive impact on equities via the banking system. The chart below shows the surprisingly close correlation between the S&P 500 and the “deposit to loan gap” in US commercial banks. The “deposit to loan gap” is a direct result of QE programmes and currently amounts to more than US$2 trillion. These excess deposits create an “investment need” for the banking system and the collective ability to distort asset prices. This is discussed in more detail below. The question is how much has found its way into equities and what impact will these flows have going forward.
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A decision to taper QE would obviously be negative for equities in the absence of a sufficiently strong offsetting improvement in economic fundamentals – which is difficult to envisage right now.
While QE is benefiting risk assets on the one hand, it is also disrupting the flow of collateral in the vast shadow banking system on the other. QE programmes “silo” securities which could be used as collateral several times over via hypothecation and re-hypothecation. This reduces collateral velocity and (all important) system liquidity. Recent work by the IMF and the US Treasury has highlighted this, as well as the gross shortage (multi trillions of dollars) of high-quality collateral under “stressed market conditions” (see below).
Let’s just hope we don’t have stressed market conditions.
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Encore - Inflationary Deflation: end-game update
Brief summary: Excessive monetary stimulus and low interest rates create financial bubbles. This is the biggest debt bubble in history. It is a potent deflationary force and central banks are forced into deploying increasingly aggressive (offsetting) inflationary forces. The avoidance of a typical deflationary resolution to this economic long (Kondratieff) wave is pushing the existing monetary system beyond the point of no return. The purchasing power of the developed world’s currencies will have to bear the brunt of the “adjustment”. Preparations for this by the BRICS nations, led by China, are advancing rapidly. The end-game is an inflationary/currency crisis, dislocation across credit and derivative markets, and the transition to a new monetary system. A new “basket” currency is likely to replace the dollar as the world’s reserve currency. The “Inflationary Deflation” paradox refers to the coming rise in the price of almost everything in conventional money and simultaneous fall in terms of gold.
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I think that we have crossed an important threshold in the “Gold War”. Rather than scaring investors out of gold and silver, the price collapse and the circumstances surrounding it has led to a well-publicised rush to purchase gold by investors across the globe.
Two things came together causing the perfect storm for bullion demand in both the East and West – the fall in prices in conjunction with excessive monetary stimulus AND the Cyprus “bail-in” of depositors’ money (and the realisation that other countries were formulating similar plans in the event of bank failures).
We’ve seen rising premiums against spot for bullion products and extended delivery times. There have been occasional examples of this before, notably late 2008, but never on a sustained basis, which would have dramatic ramifications.
The recognition in the gold market of the profound difference between physical gold versus and mere “paper claims” has been on the horizon for years. My sense is that there’s been a dramatic step forward in the understanding of the fractional reserve nature of these markets.
I’ve been told that a high-profile hedge fund manager and gold advocate had a similar realisation a while back. While arranging to move his gold out of the banking system, he (apparently) asked what would happen when more people realised the true situation. The reply:
”Price discovery.”
It’s a great irony that the monetary metals in the form of physical gold and silver are the only financial assets which have no counterparty risk in the midst of the world’s biggest debt crisis...and so few people see the investment case.
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Full report below