Jay’s Inflation/Deflation Watch

Austrian economists define inflation simply as an increase in the money supply and that is a definition I subscribe to. Not surprisingly, we have had an enormous amount of inflation since Nixon detached gold from the dollar in 1971.

But our fiat money system is really “fake” money, or sometimes referred to as counterfeit money, as it created out of thin air, and worse yet, behind each unit of currency is debt. And as the Austrians will tell you, that’s problematic because when money is created by fiat rather than by the market, it prohibits price discovery of capital, which leads to bad investment decisions, which leads to the following picture where debt is growing exponen­tially while income grows, at best, in a linear manner. 

This mal investment caused by Keynesian Federal Reserve policy has resulted in the destruction of our manufacturing base and has led to a reallocation of wealth from the middle classes to Wall Street and Washington. California is the poster child for that. 

Regarding my Inflation/Deflation Watch, the individual components in the Watch and their performance since the stock market bottom on March 9, 2009, are shown in the chart above. Note that the largest gainers were equity items that benefitted most from Federal Reserve manipulation of interest rates. Wall Street has gotten rich at the expense of Main Street. While copper has fared well, thanks no doubt to mal investment in China, commodities by and large have been huge laggards.

Of course, Michael Oliver’s work has been assuring his subscribers that a major market tectonic move is underway with stocks, bonds, and the dollar rolling over and with precious metals and commodities moving higher. While Michael’s work is purely technical, there is good precedent from a fundamental point of view for buying that notion. Now I want to share with you some of the evidence for an emerging bull market in precious metals and commodities that I shared in my talk in Vancouver, which, by the way, you can view here: https://www.youtube.com/watch?v=EdHigAdDnb­Y&feature=youtu.be.

My talk was titled, “2018 – A Year of Epic Market Disruptions? Part 2.” Following are some key slides that I used in my talk to point out that, based on the credit cycle, we are very near the point where you should expect a major correction in stocks and bonds and a significant rise in commodities, especially gold, as we enter the next credit crisis, which I believe is all but inevitable.  

In the slide directly on your left, I outlined the four phases of the credit cycle. Of course, they tend to blend into each other such that some characteristics of one phase will also be evident in the next phase. But historically a very predictable key to the direction of various markets is the shape of the yield curve. So in my talk, I displayed the yield curve next to a chart of the S&P 500 at both the tops and bottoms of each of the last two major cycles. Below are those four slides; the most important one for us now, showing that a yield curve that is flattening, is sending a warning to holders of mainstream assets like stocks and bonds. Below on your left is the yield curve on March 24, 2000, when the dot-com bubble peaked at S&P 1,527.46. It is important to note that at the Dot Com Bubble peak the yield curve actually became inverted. The 2-yr. note yield was actually higher than 30-yr. yields.

The slide upper right is a snapshot of the yield curve and the S&P 500 at the bottom of the dot-com bubble collapse. With stocks in the tank and the economy in recession, demand for money all but disappeared, sending short-term rates decidedly lower. And of course the Fed is pumping money into the system as well, thus distorting rates and stimulating the next bull market in stocks. I would call your attention to the fact that despite a recession triggered by the collapse of the dot-com bubble, precious metals and commodities (measured by the Producer Price Index, PPI) gained significant ground while stock prices collapsed.

Fed Chairman Alan Greenspan pumped huge amounts of money created out of nothing into the banking system following the dot-com bubble collapse, thus distorting price discovery for capital once again. That created the housing bubble, which, when it collapsed, nearly brought down the global financial system.

The slide below on your left shows a yield curve at the S&P peak during the housing bubble. Note that while the yield curve was not inverted at this peak as it had been at the dot-com peak, it had greatly flattened with 2-year rates rising from 2% to 3.8%, thus indicating the demand for money as the economy was overheating. Given the dynamics of Phase 4 of the credit cycle (see above cycle slide), the expansion continues until rates rise to the “threshold of lethality,” where the system becomes illiquid and seizes up, resulting in the bursting of yet another Fed-created bubble—the one above being the housing bubble, which peaked in October 2007.

The slide above on your right shows the position of the yield curve after the stock market and overall financial market crisis. Short-term rates collapsed as demand for money all but dried up. This was a real deflation even as government economists define deflation. Prices of nearly everything, including most commodities, fell. But gold rose dramatically as faith in the financial system was greatly in doubt. If you look at my Inflation/Deflation Watch chart, you can see that it measured outright deflation in the entire system, with the IDW registering a low of 84.77 from a starting point of 100 on January 31, 2005.

Where Are We in June 2018?

We have seen record S&P levels and we see a yield curve that is becoming decidedly flatter though with yields across the entire curve much lower than the last cycle. That’s because with each bubble, debt grows relative to GDP, which means that the amount of fake money that needs to be produced to lower interest rates to stimulate growth must be massively greater than at the bottom of the previous cycle. Again, given the dynamics of the credit cycle, the system keeps exploding until it hits the next threshold of lethality. And because of the pathology of the system due to fake money and government intervention that prevents proper price discovery of capital, the economy becomes ever less productive and whatever wealth is created tends to be allocated disproportionately toward the top 1%, resulting in the American economy looking more and more like the banana republic economics of South America in the past.

Michael Oliver’s work at this point in time convinces me of the likelihood of a bull market in commodities in general. But I am most convinced that gold will rise to protect wealth, given its pattern of rising through both expansion and contractions of the past 15 years. And with that, gold shares should do very well too when the next leg up for gold gets underway.

About Jay Taylor