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Keeping Up With Deflation

"There go my men. I must follow them. For I am their leader."

- Attributed to an Italian general

Yesterday, Don Kohn, number two man at the Fed, told the world that America's central bank would be "flexible and pragmatic."

People knew what that meant. The Fed is prepared to cut rates next month.

So encouraged by this were investors that they set about buying every stock in sight. The Dow rose 331 points. That brings the total to 546 points gained in the last two days. Not bad.

But what does it mean? Less than investors think.

We have opined that the great flood of cash and credit, enjoyed by investors for lo these many years, is now ebbing away. Yesterday's backwash seemed to contradict us. And we've been doing this for far too long to imagine that we know God's Own Plan for the U.S. economy. Anything can happen - and usually does!

But let us look at what is happening. The Fed funds rate is 4.5%. Investors now imagine that a 50 basis point cut is coming. That will take the signal rate down to 4%. But in this instance, the Fed will not be leading…it will be following. The 10-year note already yields less than 4%. Bonds have been falling since June. They are just another of the many signs of deflation - of a draining away of credit, cash - liquidity - from the markets.

In other words, now the Fed is no longer driving inflation

…it is trailing along behind deflation, trying to keep up with it.

We indented that last sentence, because we didn't want you to miss it; we are so proud of it. Remember it. Quote it to your friends. To put it another way…the Fed is no longer pulling on the string…it is pushing on it. In offering money at 4% (just a hypothesis) it will only be catching up to what investors have already been doing.

Now, it's private lenders who are doing the pulling. They're reluctant to lend into the open market; because they fear they won't get their money back. But they're happy to lend to the U.S. government. Spreads are widening - always a sign of a tightening credit market.

For example, Citibank got itself into subprime trouble and needs big money, fast. So, it turned to Abu Dhabi. But the Arabs wanted a lot more than the T-note rate. They wanted a pound of flesh - forcing one of America's leading financial institutions to pay a rate normally associated with third world hellholes and first world shysters - 11%.

Behind the subprime problem is a problem in the U.S. housing market…and in U.S. economy…and in the whole world economy.

Houses are selling at their slowest rate in eight years, Bloomberg reports. In California, sales are down 40% from a year ago.

And here's more from Bloomberg:

"The worst U.S. housing recession in 16 years will drive down property values by $1.2 trillion next year and slash tax revenue by more than $6.6 billion, according to a report by the U.S. Conference of Mayors… 'The real estate crisis of 2007 and 2008 will go down in the record books… The wave of foreclosures that has rippled across the U.S. has already battered some of our largest financial institutions, created ghost towns of once vibrant neighborhoods - and it's not over yet.'"

No, it's not over yet. In some ways, it has barely begun…because the knee-bone of consumer spending is still connected to the thigh-bone of house prices, which is still connected to the hip-bone of mortgage credit. And if one of these bones breaks, the economy stops walking forward and falls on its face.

That is what we think is happening.

There's a greater than 50% probability that the financial system "will come to a grinding halt because of losses from mortgages said Gregory Peters, Head of Credit Strategy at Morgan Stanley (NYSE:MS).

"Lenders' belt tightening stifles growth in economy," says the NY Times.

"Mortgage crisis is a drag on Atlanta economy," says the Atlanta Journal-Constitution.

Well…yes…the ankle bone is connected to the shin bone. That's the way it works. You can't take $1.2 trillion out of the consumer economy, without consumers feeling it.

And now the Fed is rushing to try to put the money back in. Alas, it is not that easy. Japan's central bank tried it for 17 years.

And America is in a much tighter spot than Japan. With a very positive trade balance, and abundant savings, the Japanese had room to maneuver. Not so the United States. Investors have already shown what they could do to the dollar. Let the Fed cut rates more and there could be a bloodbath in the currency markets…forcing spreads even wider, and pushing the U.S. economy into an even deeper crisis.

*** No milestones reached this week. At least, that's the way it looks so far. Oil has not gone over $100. Instead, it dropped to $90. The euro (EUR) did not go over $1.50. Instead, it has held steady at $1.48. And gold did not rise above $850. Instead, it fell back to towards $800.

But we think these milestones will be reached - even though we think the dominant trend of the market is in the other direction, towards deflation, not inflation.

Have we confused you yet?

Tomorrow, we will clarify. There are two, apparently contradictory trends underway. Both will be fully expressed - eventually. Inflation is unstoppable. Deflation is unmovable. How and when they collide is the story we are following.

And what an exciting story it is!

Our guess is that investors will be smacked by deflation. And then they'll be walloped by inflation. What can they do?

We're still buying gold - on dips. The price is back to a record set in 1980. But if you look at a chart of gold and compare it to one of gold in the '70s, you see a different pattern. Back then, gold rose slowly…and then took off in '78…soaring in a big spike to $850. So far this century, we've seen nothing like that. Gold has steadily gained ground. But there has been no spike.

That spike stage is typically the final stage of a bull market - when taxi drivers start talking about which gold stocks to buy…and TV presenters ask whether the price will go to $5,000 an ounce. We've seen none of that. Just steady price appreciation. The real excitement is still ahead.

*** We mentioned a few days ago that popular attitudes to free trade are changing. Americans have come to believe that they are on the short end of the stick…that they gain less from free trade than they lose to it.

In a theoretical sense, they are surely wrong. Free trade is good for everyone. But it is better for some than for others.

If protective tariffs and trade barriers really made any sense, Indiana could improve its lot in life by prohibiting goods coming in from Ohio. California could benefit by excluding Wisconsin cheese. Pennsylvania could protect itself from Virginia hams. West Virginia could develop a thriving auto industry by prohibiting imports from Japan…or Michigan.

Adam Smith and the laissez faire economists demonstrated long ago that free trade improves standards of living for everyone, by allowing people to do what they do best. No convincing evidence to the contrary has ever been presented.

But just because it is stupid doesn't mean it won't be popular. If this were not so, television wouldn't be nearly as successful as it is…and no recent candidate for president of the United States would have been elected.

Here too…there go the voters. Our leaders must follow. Expect a shift in political rhetoric…a shift against free trade.

*** Another thing you can expect is more government meddling in the credit markets. The feds can't really permit millions of homeowners to lose their houses, says colleague Dan Denning:

"This sounds like a job for a new federal agency to buy the debt from the bankers at an agreed upon discount, say 50 cents on the dollar. The agency then becomes the landlord of the ARM borrowers…and is free…on behalf of the government of the United States and the American people…to re-set the loan at a fixed rate for a different maturity.

"The financial markets get transparency and the risk is moved off bank balance sheets on to the Fed or the Federal Home Loan Banks. Stocks rally!

"Borrowers get a reprieve from the hangman's noose. Stocks rally!

"The Fed gets order back in the credit markets and some measure of control of the situation. Stocks rally!

"I'm not saying the dollar would respond well to this massive socialization of housing losses.

"But…we live in the 21st century. All financial losses are socialized. The only question right now is how this one will be managed.

"We have some clue with the fact that the Atlanta Federal Home Loan Bank has loaned - get this - $51 billion to Countrywide Financial… (NYSE:CFC) since September 30th. I'm not kidding. California is not in Atlanta, in case you were wondering.

"I would have suggested Fannie (NYSE:FNM) and Freddie (NYSE:FRE) as the preferred bail out vehicles. But they need bailing out themselves, faced with write-downs in the value of their own mortgage portfolios and a regulatory inability to purchase mortgages. Congress could simply change the limits on the size of the GSE portfolios…and the Fed could loan them the money to purchase the toxic stuff from other lenders. But it's likely these two have been sullied too much to be saviors.

"Or the Fed could just load up the garbage on its balance sheet and extend the term of its loans…trading cash for trash for as long as the trade takes. Come to think of it, the Fed's been turning cash into trash for years, so this is probably the least exotic option.

"…But I'd say the trade of the decade is still a good one: sell the dollar, buy gold. In fact, I think you're going to see the liquidation of all sorts of higher-risk assets…bonds, emerging market stocks, and high-yield currencies….to maybe buy call options on 90-day t-bills. Or precious metals.

"Either way, I'd expect something big, but low-key. The action of the Atlanta FHLB was very low profile…lest taxpayers realize it was back-door bailout of Countrywide. But you know, this seems like the kind of bailout everyone can get behind…unless you own a lot of dollars and are counting on them to retain their value.

"If you're one of those people, you know, a saver…well sorry. Good behavior should be its own reward. But don't expect to get paid for it.

"Meanwhile, I expect the formation of a pseudo-public ARM/CDO slush fund, like the Resolution Trust Coporation. Banks might even capitalize this entity a little, to make it less obvious bad loans are being transferred from the private sector the public balance sheet.

"Heck, they might even sell shares in the thing. Why not an IPO and let people buy shares in the recovery of the housing market. Pay a dividend (those IO loans need to keep performing), and make it tax deductible. Don't just socialize the risk, make it investable!"

Until tomorrow,

Bill Bonner
The Daily Reckoning

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