Friday, November 15, 2013

Keystone's Inflation-Deflation Indicator Signals Deflation

Very few topics create heated discussions more than the inflation versus deflation debate. That is why Keystone never discusses religion, politics or inflation at dinner parties. Each side will always cite anecdotal evidence such as inflationists touting high food, insurance and college tuition costs, while deflationists wave the lower oil, copper and commodity banner, as well as flat to falling wage growth, most importantly. Inflation will not exist without rising wages; this is why you want to watch the wage component in the monthly jobs report each month.

In January and February, the U.S. slipped into disinflation and in March the U.S. slipped into deflation. The equity markets, however, print new all-time highs. In May, things change and this summer the inflation-deflation gauge moves into neutral territory. This occurs as the 10-year Treasury yield moves higher (prices lower) which raises the ratio number above 3.00. The Treasury yields move in the same direction as the equity markets since money usually moves from stocks into bonds and from bonds to stocks depending on risk-off, or risk-on, respectively. Higher yields = higher stocks = a move towards inflationLower yields = lower stocks = a move towards deflation. The asset relationships are skewed, however, since in a robust economy, commodities should be flying higher with equities but this is not the case. Copper, commodities, gold and silver continue to create a disinflationary and deflationary vibe, but the central banker money printing is instrumental in pumping equity markets higher. If commodities recover, the indicator will move upwards faster.

The note price is used for the denominator of Keystone's equation. The 10-year Treasury price is 100.344 with a yield at 2.71%. The CRB (Commodities Index) is a sick 273.84 dropping -5% in the last month alone. Taking a look at the numbers;

CRB/10-Year Price = 273.84/100.344 = 2.73

Over 4 = Inflation
Between 3 and 4 = Neutral; Inflationists and Deflationists fight it out
Between 2.9 and 3.0 = Disinflation
Under 2.9 = Deflation

Chairman Bernanke announced QE1, QE2 and Operation Twist to stop the free-falls into deflation.  Last year, however, 2012, the Fed threw the kitchen sink at the markets with the promise of QE3 Infinity, timed with the ECB's OMT Bond-Buying program, and also QE4 Infinity and Beyond, which replaced Operation Twist with outright purchases, when the markets were already somewhat elevated (the QE3 and QE4 pumps are now simply referred to as the ongoing QE3 Infinity program). This orgy of Fed quantitative easing, along with the BOJ bludgeoning the yen, creates the bullish equity markets.  In addition, China, the BOE and ECB are all pumping the markets as well.

The weak commodities, and weak demand for raw materials, such as the weak CRB Rind Index, as well as continued lackluster action in the Baltic Dry Index (BDI) and shippers, indicate a global slowdown is ongoing.  It is interesting to watch the power of the central bankers as they pump equity markets higher, but without the global economy kicking into gear it will be all for naught. Keystone's indicator went from deflation in April to disinflation in May and then neutral territory this summer but has now fallen back down through disinflation into deflation, the exact thing that Chairman Bernanke is trying to defeat for nearly 5 years.

The pundits and analysts that say Inflation and even hyperinflation are at the doorstep are likely premature.  Inflation is expected in the years ahead but it may be years away still yet.  Keystone is thinking that inflation will occur in sync with the 18-year stock cycle of 1964 (bear), 1982 (bull), 2000 (bear), and 2018 (bull). So the thought is that inflation and hyperinflation are a few years away, even if the stock cycle left translates a couple years that would be 2016. The expectation remains that Treasury yields should move sideways and even leak lower again for the next year of three. In the mean time, there may be a need to pay disinflation and deflation the respect it deserves.

Deflation is nasty and will surely affect everyone's lives. Since prices drop precipitously in deflation, consumers do not buy since next week the price will be even cheaper. This economic behavior leads to a stagnant and very sick economy with businesses closing doors due to the lack of demand. Europe is on the verge of falling into a deflationary funk a la Japan's lost two decades. A structural unemployment problem remains in the U.S. and the current stagnant wage growth (wage deflation) reinforces the ongoing deflation theme strongly.  Technology, computers and the Internet are huge deflationary machines.  Robots continue to replace human's on the job. More tech and less human's continues to challenge the unemployment picture and will foster the structural employment problem for many years. Companies are meeting EPS by laying off workers and squeezing more production out of existing workers (as evidenced by flat to lower top line revenue). These deflationary signals are ignored in the media.

Watch Keystone's formula above, you can crunch the numbers to check on the indicator every few days. It is shocking to see equity markets make new highs with a deflationary back drop. This behavior can only be chalked up to the central banker money-printing. The indicator should be above 3.00 right now to verify the strong stock market. The CRB would need to recover above 290 and 300 to confirm happy bullish times and a strong global economy ahead. The 10-year yield can pop to 2.90% and this would only send the indicator into the disinflationary camp again. A move to 2.95% in the 10-year yield would likely take the indicator above 3.00 into the neutral camp. Inflation is no where in sight. The last time the indicator was above 4.0 signaling inflation was the summer of 2008. In May 2011, the indicator was 3.6-ish and remained in neutral territory from late 2010 (when markets were saved by QE2) until the start of this year where the drop into disinflation and deflation occurred. The indicator recovered this summer into neutral territory but now falls back through disinflation into deflation. Now both sides have ammunition for the next dinner party but the current answer to the ongoing inflation-deflation debate, is, deflation.

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