The Dollar Dilemma, Treasuries vs. Corporates, and more

I remember having an argument with someone last year about inflation vs. deflation. I had been solidly in the debt deflation camp, and expected a rally in the dollar and treasuries. He was solidly in the "sub-hyperinflation" camp, our exchange went something like this (Circa April 2008):

Me: The losses in the banking system are massive. Credit is contracting, we are going to see debt deflation.

Inflationist: How can you believe that? The government is printing money like mad. Look at oil! Look at commodities! The hyperinflation is obvious.

Me: I have a hypothetical for you. Suppose someone had a printing press. They ran the printing press, created currency identical to what the legitimate authority would produce, in every way. But suppose that currency was placed in a hole in the printer's backyard. Would it have any effect on the economy?

Inflationist: In your crazy world, if the money remained in the hole, no. But if it leaked out into the rest of the economy, then it would be inflationary.

Me: Lets get our terms straight. Inflation for me is a drop in the purchasing power of the currency. A rise in commodity prices can be the result of inflation but is not necessarily evidence of it.

Inflationist: I agree that inflation is a decline in currency purchasing power, and that decline is evidenced by a rise in prices.

Me: Commodity price rises can be caused by things other than simply increasing the quantity of money. For example--a stupid government policy of using corn for ethanol reduces the supply of corn, and boosts corn prices. Through substitution effects, that causes the prices of other crops and livestock to rise as well.

Inflationist: We have a fiat currency. The government will simply print money to solve its problems. We do not have a gold standard, where prior inflation is offset by higher rates, and a contraction in in the future.

Me: Lets look at this another way. In an inflationary environment the demand for cash is low, and its velocity high. People would prefer to purchase goods, services, and investments, rather than leave cash idle.

In deflation, there is strong demand for cash, and little incentive to spend. Velocity of currency is low.

Consumers, pressed by stagnant wages, crushing debt burdens, and rising commodity prices, education, and health care costs, have a high demand for cash.

State governments, with shrinking sales tax, income tax, real estate taxes, a huge unfunded pension demands, not to mention their spending on police, fire, education, and health, are also scrambling for cash.

The Federal government, with its ballooning entitlement spending, its military obligations, and the interest on past debt, also has a high demand for cash.

The internal need for U.S. dollars internally is extraordinarily high. A drop in commodity prices and a rally in the dollar is only a matter of time.

The deflationary thesis turned out to be right on target. But it is time to look at it again.



Both the weekly and daily chart suggest that while the dollar may rally from its current level at just above 80, the primary trend is down, and until otherwise, dollars should be sold on rallies.

Does that imply it is wise to buy stocks? I don't think so.



On an intermediate term basis, it would look as if the Dow is topping out, with the trend line indicator (bottom) crossing below the zero line, Volume has been weak, and the volume numbers from the DJ-30 do not match up well with those from the DIA. I would put more trust in the ETF numbers, as that is based on something that is actually traded, while the Dow industrials index numbers are aggregated from the exchange, and probably do not reflect actual trading activity.



The area to keep an eye on is the corporate bond market. They are the key to estimating the risk appetite in the market.

Currently, they are outperforming treasuries on a relative basis. That isn't something likely to go on forever. If you are fearful of inflation pushing up yields, I don't know how you can hold onto corporates in this environment. If yields on treasuries spike (and TLT drops), corporates will spike worse, pushing LQD down faster than treasuries.

What I fear is if the U.S. continues to double down on trying to inflate its way out of this, we end up with the worst of all worlds. First, our import costs will skyrocket, causing an already stressed consumer to get squeezed even more. Corporate profits get crushed both on the reduction in demand, and the increase in input costs and debt service. This assumes the system of international trade continues to function, and we don't see tariff wars, and protectionist measures of all sorts.

Second, if the U.S. dollar drops, that would probably lead to a spike in U.S. treasury interest rates, causing all other interest rates to rise. The credit markets would contract again, and this time, there isn't a whole lot the government can do. It has already backstopped the banking system. If its costs increase, and people lose confidence in the dollar, stocks, bonds, and commodities could all get real ugly, real fast.

In that scenario, any further intervention would be counterproductive--even in the short term. Printing more money simply causes the market to demand even higher interest--a vicious positive feedback loop that won't stop until the bad debt is defaulted, and misallocated capital is placed in the hands of those who can do something profitable with it.