Tuesday, May 4, 2010

Is Deflation back?

In reviewing the charts of the 10-year treasury yield, it looks as if yields could have had a fake-out move to the upside to fool everybody into thinking the bond bear market was starting. Looking at a weekly chart of the 10-year treasury yield, there is clear negative divergence present on the MACD. This is foreshadowing an upcoming environment of falling interest rates and Deflation. It looks as it though if will be some time before the fed "raises" key interest rates again. I say "raises" because the fed is often credited with lowering or raising interest rates. However, I am including in post a chart (by Elliott Wave International) of the 3-month short term treasury bill rate plotted with the Fed Funds rate that suggests otherwise. It is clear that the 3-month U.S. Treasury Bill Yield moves BEFORE the Fed Funds rate moves, and the Fed Funds rate always follows the market not leads it. The reason is, the Fed can only take the what the market will give them, just the same as investors can only buy stocks for what someone else will sell it to them for. Now one must ask the question, what makes interest rates move? The answer is the demand for, and the supply of, money and credit. As Robert Prechter, Elliott Wave International's President, said in a Bloomberg Television Interview in November 2007 "When People's borrowing needs dry up we'll, its like a sale in a store, the rates start going down, and that's the price of money, the interest rate." I did mention that I thought Interest Rates will be rising in this Bear Market, and I do, except not until later into it. Recent downtrend confirmations in global markets suggests that Deflation will hit ALL markets as Credit Contracts on a worldwide basis, very much the same as in 2008. I have said before that I do not believe the period of contracting credit is not over, but it is just starting. It looks at the moment as though the deflationary environment is returning to global markets. On a fundamental note, world markets are falling as Greece struggles with sovereign debt issues. Ultimately, it looks as though Europe is in big trouble, and by the time this is over, the Euro could be almost worthless. In the meantime, the U.S. Dollar should benefit, as it already has. But, the U.S. Dollar has been rising since November 26, 2009, BEFORE the Greece Debt problem news started surfacing. What could be the reason? I believe its because people assume the wrong premise. People think the reason the U.S. Dollar is rising is because the Euro is falling and because of the bad news out of Greece, Spain and Portugal, and not because of a strong Dollar or the technicals related to the Dollar. I beg to differ. I made a post on November 20, 2009 calling for a bottom in the Dollar. Not because of any fundamental reason, but because there was such an abundance of pessimism in the U.>S Dollar and inflation worries, that a change in psychology was due. That is exactly what happened, as it has had a nice rise since then, and I believe it has much further to go. The Dollar is strong not because it is fundamentally strong, because no fiat currency is, but it is strong due to the fact that the U.S. Dollar is the most inflated currency in the world. There is more debt denominated in U.S. Dollars than in any other currency. There is such a huge volume of dollar-denominated debt in the world that it is not possible for it to be paid off. As the debt contracts in value because it is either being paid off in part(debt settlement) or completely defaulted upon (default), the dollars are being eliminated from the global money supply. As the dollars are are being taken out of the global money supply, the remaining dollars are becoming more valuable. This is the fundamental argument by Prechter as to why to U.S. Dollar is rising in a Deflationary Environment. So, as the demand for money and credit goes down, the price, the interest rate, goes down with it. However, eventually when credit markets return to normal, and demand comes back, it will most likely exceed the supply of credit, and that is when the Bond Bear Market will start, and people will no longer trust the U.S. Government to keep its spending down, so interest rates (the return investors will demand due to a perceived increase in risk) will be rising. In the meantime, however, Deflation seems to be taking over in financial markets, so the trend for interest rates, and most likely commodities, stocks, and real estate, is down, similar to 2008. This might come as a surprise to most after many of these markets, specifically stocks and commodities, have gone up significantly in a reflationary period, convincing everybody the worst is over and a new Bull Market has started, but the reflation is most likely over. But that is what markets do: They fool the greatest number of people possible.