Deflation USA: `Way Past the Point of No Return`

[wealthyboomer]

The Economy and Deflation
Our contention last month was that the economy is moving into a critical new phase, an outright deflation in which “prices fall because people expect falling prices.” Obviously, this implies an element of recognition, as efforts to protect against indebtedness and falling prices contribute to further declines….

Japan’s deflationary turmoil is an important parallel that The Elliott Wave Financial Forecast has used to gauge deflation’s approach in the U.S. Back in January 2000, EWI compared trading in the Nikkei in late 1989 to the NASDAQ then. We observed that the Nikkei subsequently declined 65% over the next two years and forecasted a similar decline for the NASDAQ. The NASDAQ complied with a 73% retreat over the following 30 months. In late 2006, we extended the analogy to Japan’s economy with a piece titled “The Japanese Model Points Lower.” Since then, we have referred to the analogy at least five more times (see June 2010, April 2010, June 2009, October 2008 and April 2008) and warned that the U.S. faces the "same deflationary pressure.” Now, Bank of America/Merrill Lynch has just produced an extensive research report that asks, “Is the U.S. Becoming Japan?” Despite 30 charts and tables that make a powerful case, it concludes that there is just a 20% chance of it.

Deflation is way past the point of no return. The main reason many believe otherwise is they think that the Fed and the U.S. government will not allow it. But the truth is that it was the government that locked in the case for deflation with its commitment to a credit-based economy decades ago. In response to claims that the Fed would simply “expand credit for the good of the economy,” a 2004 issue of The Elliott Wave Theorist compared the situation to what would happen if the government decided that economic growth depended upon the production of Jaguars and provided them to as many people as possible. Eventually, “nobody wants any more Jaguars. They don’t care if they’re free. They can’t find a use for them.” As absurd as this sounds, it is exactly what has happened with credit, as the government decided that “the health of the nation depends upon producing credit and providing it to as many as people as possible.”

Excerpted from The Elliott Wave Financial Forecast by Steve Hochberg and Pete Kendall, published September 3, 2010

 

[wealthyboomer]

Analysis: U.S. banks prepare for deflation riskTue Oct 12, 2010
(Reuters) - U.S. banks are bracing for possible deflation and, if it comes, it will not be pretty for lenders, analysts said.

Atlanta-based SunTrust (STI.N) has set up a special committee to assess its exposure to deflation, said Nancy Bush, an NAB Research analyst briefed on the matter by the company.

Birmingham, Alabama-based Regions Financial Corp (RF.N) and Columbus, Georgia-based Synovus (SNV.N) warned investors about the potential risk of deflation in regulatory filings earlier this year.

BB&T ran its books through a stress test to gauge the bank`s performance in a scenario in which there is deflation for the next 10 years, as part of the bank`s own internal projections of various economic scenarios, Chief Financial Officer Daryl Bible said in an interview.

"It`d be challenging. We think we could survive, but there would be definite impacts on revenue and earnings," he said. Other banks have likely performed these tests as well at the request of regulators.

A spokesman for SunTrust said in an email that the bank continuously evaluates a range of scenarios, including the impact of deflation, but he said the bank does not discuss these scenarios externally.

A little deflation in theory could help banks by increasing the value of the dollars they receive from borrowers for interest and principal payments.

But deflation can feed on itself: when prices start falling broadly, people and companies often put off purchases, reducing demand as they wait for prices to fall further, said Robert Albertson, chief strategist at Sandler O`Neill in New York.

The United States experienced such a deflationary spiral during the Great Depression in the 1930s, and Japan experienced one in the 1990s.

If deflation is widespread, it can be toxic for banks. As Japanese banks discovered in the last decade, deflation means that collateral values decline, giving a bank bigger losses on failed loans. And loans may become more likely to fail, as borrowers tire of paying high rates of interest to finance assets that are worth much less than they had been previously. A second credit crisis could emerge.

"For banks, there`s no good way out of deflation," said Bush, the NAB analyst.

PREPARED

Most banks and their regulators carry out "stress tests" for deflation, said Bill Isaac, chairman of LECG Global Financial Services and a former FDIC chairman.

Banks are likely already assessing various loans they hold to determine how they might perform if deflation strikes, Isaac said.

"It wouldn`t be pleasant for the banking industry to have to deal with more deflation, it`s already been difficult enough in the housing area," he said.
To be sure, deflation may never come. Even as unemployment remains high and consumer demand is low, the consumer price index does not seem to be indicating deflation ahead, Albertson said.

Albertson thinks historical comparisons to the Great Depression or Japan are misleading, since global demand -- specifically, from emerging economies that are growing rapidly -- could still increase prices for goods in the United States, even if demand in this country remains weak.

What`s more, Federal Reserve officials have already signaled that they would be prepared to take action to prevent deflation developing.

But there is still a chance of deflation.

"I do not expect outright deflation to develop, but the slowing of the economy in the middle of this year, combined with a very low measured rate of inflation, suggests to me the risk of deflation cannot be dismissed," said Dennis Lockhart, president of the Atlanta Federal Reserve, at the end of last month.Many analysts expect the Fed to launch a renewed round of bond buying, or quantitative easing, as soon as its next policy meeting at the beginning of November. A weaker than expected September employment report last week did not help matters.
But even slow growth is a difficult scenario for banks. Sluggish loan demand has already dampened bank profits this year. Shares in banks including JPMorgan Chase and Co (JPM.N) and Wells Fargo & Co (WFC.N) are each down 5 percent year-to-date, while the S&P 500 index is up 4 percent.

"If we don`t see growth, you could see credit numbers go bad again," said Chris Whalen, co-founder of Institutional Risk Analytics. "That`s going to mean a lot of banks losing money."

 

[JDaley]

Interesting posts, deflation Japan style (asset deflation and commodity inflation) will wipe out mortgage pay down gains in tbusiness models that depend on it. With asset deflation, rents drop and as a result cash flow is wiped out or significantly reduced leaving the real estate investor with little to no gains in 3-5 yrs. If you invested in Calgary in 2006/2007 and worked against a 5 yr exit strategy, this scenario is staring right you. 100% gains in 5 yrs are not realistic now or anytime soon, especially since Canadians have amassed incredible levels of debt with real estate prices hovering near 5-9 times household incomes in many parts of the Canadian real estate market.

 

[wealthyboomer]

Bracing for a deflationary spiralDIANNE MALEYSpecial to Globe and Mail UpdatePublished Monday, Oct. 18, 2010
Ian Gordon makes a hair-raising case that the United States is in deflation’s grip.

The U.S. money supply is shrinking, the rate at which money changes hands is slowing, core consumer price inflation is zero, residential real estate prices are down 29 per cent, commercial real estate is even weaker, the real unemployment rate, including discouraged workers, is 16 per cent and pension plans are so under water they won’t be able to cover retirees’ basic needs.

So large is the nation’s debt that the U.S. economy will not recover until the debt is “washed away” by borrowers defaulting and lenders failing.

Mr. Gordon, publisher of the investment newsletter Long Wave Analyst, is a follower of Nikolai Kondratieff, who believed the economy moves in long, wave-like cycles – winter, spring, summer and fall. As he sees it, the ground is freezing and the snow is about to fall.

He outlined this frightening prospect in a recent interview with Jay Taylor of Miningstocks.com, posted on thelongwaveanalyst.ca website.

It’s an extreme view – one that few economic forecasters share – and frightening enough to send investors scrambling for long-term federal government bonds or cash. So what is Mr. Gordon investing in now?

Junior gold stocks. Gold miners did very well during the Great Depression even though the price of gold bullion was fixed at $35 (U.S.) an ounce because the cost of mining – mainly energy and labour – fell.

Growing uneasiness about the near future and the dangers that lurk, especially south of the border, is useful to focus attention on the fundamental rule of all investing – preservation of capital. As money manager Adrian Mastracci asks yield-hungry clients: “Do you want a return on your investment or your investment returned?” Mr. Mastracci is president of KCM Wealth Management Inc. in Vancouver.

Deflationary signs are flashing in the bond market as well.

“The bond market is saying the main concern over the next three to five years is deflation,” said Levente Mady, managing director of derivatives at Union Securities Ltd. in Vancouver.

Indeed, IBM was able to borrow $1.5-billion (U.S.) for three years over the summer at 1 per cent. Last month, Mexico borrowed $1-billion (U.S.) at 6.1 per cent for 100 years.

So how does one invest for deflation?

“It depends on how dire you think deflation is going to get,” said Michael Crofts, lead portfolio manager, bond and money market funds, at Mawer Investment Management Ltd. of Calgary. Mr. Crofts is not in the deflation camp.

In a weak economic environment, investors will want to hold fixed-income securities because yields will be falling and “there will be good returns to be had,” Mr. Croft notes. He recommends high quality dividend-paying stocks as well.

“If deflation is moderate, investors will do fine in utilities and telecoms,” he says – defensive stocks that can withstand a slowing economy and even deflation. “But talking about severe deflation, you’ll want to be retrenching out of equities and corporate bonds into government bonds.”

Mr. Mady of Union Securities is recommending investors stick to medium term, highly liquid Government of Canada 10-year bonds yielding about 2.75 per cent. “If there’s further deflation, you’ll be able to capture some capital gains.”

The bond market has a reputation for seeing into the future, sensing shifting price trends, sniffing inflation months if not years before it becomes apparent. Misreading it can prove ruinous for investors. Right now, though, the message it is sending is not clear.
Mr. Crofts and his colleagues at Mawer wonder whether bonds are really signalling deflation. U.S. inflation-linked bonds, known as TIPS or Treasury Inflation Protected Securities, are signalling inflation of 1.7 per cent a year for the next 10 years, Mawer indicated in a recent newsletter.

As well, money is flooding into the bond market as a safe haven, as aging baby boomers and pension funds shift from stocks to bonds and as Asian countries and American banks load up on Treasuries, Mawer says. “The point is that low yields do not necessarily signify deflationary expectations.”

Mr. Mady sides more with deflation, arguing that bond yields may have more to do with the declining credit quality of the U.S. bond market than with inflation expectations. “With the huge deficits the U.S. government is running, perhaps the real interest rate premium the bond markets want is rising.”

Rob Boeckh, co-editor with his father Anthony Boeckh of the Boeckh Investment Letter, is also suspicious of the bond market. Anthony Boeckh is former editor of the prestigious Bank Credit Analyst and author of The Great Reflation: How Investors Can Profit From the New World of Money.

The bond market has been “heavily distorted by government intervention,” Rob Boeckh says. “Quantitative easing (the Fed buying bonds) and a healthy appetite for Treasuries will keep a lid on bond yields for the foreseeable future.”

 

[wealthyboomer]

Bernanke: Talking Inflation, Walking DeflationFri, 15 Oct 2010Federal Reserve Board Chairman Ben Bernanke said on October 15 that the Fed is ready to start its next round of quantitative easing, if needed. The new stimulus involves the purchase of long-term

U.S. Treasuries and keeping interest rates low for longer than expected in the hopes of improving the grim economic outlook.

According to Bernanke, current inflation numbers are well below the Fed`s objective of 2% -- i.e., deflation, not inflation, is the main concern. But while Bernanke believes that the Fed`s intervention will stimulate the economy, reduce unemployment and prevent further deflation, Elliott Wave International`s Senior Global Bonds Analyst Bill Fox believes that QE2 will do "nothing to alleviate this issue."

Bill had this to say to his Interest Rates Specialty Service subscribers in the October 14 End-Of-Day commentary:
"Bernanke speaks at the Boston Fed’s conference, and we are all awaiting just how aggressive the language will be for further liquidity infusions via the printing press known as QE2. A policy which had limited success the first time... and somehow doing more of it this time around will cure the ills of the U.S. economic malaise?
"Bernanke fears deflation, but his response leaves one to wonder if he knows what deflation is. The purchase of Treasuries on a massive scale may allow the Federal Reserve to manage rates out in the belly of the curve at the margin, but deflation is about deleveraging of existing debt, and QE2 does nothing to alleviate this issue."

With the possibility of a post-election announcement November 3, most wait patiently to see if and when Bernanke and Co. decide to pull the trigger on this new stimulus.

Source: Jason Lureman - Elliott Wave International