Monday, August 30, 2010


I highly recommend the article penned by Machinehead that was posted at earlier this week. You can find the post here. DEFLATION DEMON. As many of you read this article it may be easy to understand, others may be challenged with these concepts. Please stay with the article and don't quit reading!

As I wrote last year, we are and have been in the grips of deflation and it is that very economic condition that is the bane of all central bankers. Without inflation you have a grinding atrophy of financial muscle that leads to stagnation and joblessness. In a way, think of deflation as the mechanism that destroyed Madoff's ponzi scheme. In that example, deflation is the continuous calls for redemptions that are unmatched by new capital inflows (suckers). As the deficit between outflows and new inflows become significant enough, the house of cards falls apart. Likewise, in an economy when deflation sets in, new growth stops and leverage is destroyed along with all the bets and hopes for new economic opportunity.

If you are left wondering what deflation looks like, we have the Japanese example, which seems mild in comparison to the collapse we are seeing in Greece. In the US, we can only hope that we receive the measure that Japan has. Although it has lasted over a decade, the story has not fully been written and as Kyle Bass speculated in the videos we posted, we might see much worse to come (Kyle Bass Part I and Kyle Bass Part II -) I think Kyle is suggesting that the future collapse of Japan and the US may look more like what is pictured in Der Spiegel in an article titled (Tensions Rise As Austerity Measures Backfire) .

Anyway, the article written by Machinehead is quite good and when you read the speech from 2002 given by Bernanke and also my post from last year titled PUBLIC ENEMY #1 Deflation you get the entire picture of what is to come. I think this will also solidify in your mind why I am so convinced that the only real step left is a concerted attempt to devalue the US dollar in an attempt to break loose from the deflation that is attacking our economy.

Machinehead ties up his thoughts nicely and concludes with the thoughts that the next steps ahead are to drive the value of the dollar lower by several key ways. Specifically he is advocating the outright purchases of other foreign currencies. We've discussed this option several times and I've felt strongly that this would of course be one plan that would be implemented. Machinehead goes further though and suggests that the FED and Treasury would take additional steps concerning gold. First, the author suggests that the US would write up the gold assets we own which are currently held on our US balance sheet at a price of $42 or so. While this is only an accounting trick, it would essentially value our US assets at a greater level. Further, he states that the US should state that we'll actually be looking to purchase more gold. The announcement that our government would buy gold would actually depress the dollar. Of course, this would also send gold much higher too. All of these attempts are intended to break the back of deflation and kindle an inflationary fire that gets asset levels higher. And of course, their hope is that when you have inflation you will get growth.

Once again, read the article, I think it is absolutely nailing the course we will take as we race to devalue our currency. If only the other countries would sit idly by and let us unilaterally save ourselves by harming them. The problem with working on our own is that all of the other countries in the world have significant interest in lowering the value of their own currencies.

From a trading perspective, Machineheads conclusions reinforce the soundness of the strategy for investment I laid out in the August update titled (Throwing Down The Gauntlet) where I advocated getting out of the US and into emerging markets. In that strategy if the Fed is effective in devaluing the dollar you will win due to currency gains, but also because many of these emerging market targets are natural resource rich and will benefit from the resulting inflation. The only two questions that remains are whether the emerging markets can decouple from the slow growth or deflationary pressures that grip the US economy and if the Fed can actually be effective at all. We'll see how this plays out, we'll probably need a few bags of popcorn to see it all unfold.


  1. Nice piece.
    Saut alluded to emerging market emphasis as 40% of SPX profits are from foreign operations with roughly 15% of those profits attributable to the emerging markets.

  2. Keith, thanks. Yes, I read Jeff every Monday and I think he has been reading my blog :)
    Obviously that trade has risk and I don't want to write it up to seem as though it doesn't. Any market dislocation in Europe or the US will obviously impact and be felt in the emerging areas. I think longer term though, that I'd rather place wagers on economies growing at 8% and more rather than one in which we hope to stablize at 3%.
    The other trick is the understanding that "Patience is also a trade". The timing is everything and although in this environment you don't get paid for sitting on the sidelines, you do perserve precious capital. All it will take is another flash crash and I we may endure a 200 point drop on the S&P500 in response with no ensuing recovery.



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