Keystone's Inflation Deflation Indicator Signals DEFLATION

Very few topics create heated discussions more than the inflation versus deflation debate. At the holiday dinner table, avoid the subjects of religion, politics and most of all inflation. Each side will cite anecdotal evidence such as inflationists touting high food, energy, oil, insurance and college tuition costs, while deflationists highlight long-term weakness in commodities, lack of wage growth, falling Treasury yields and stagnant house prices to bolster their case. The flat to lower wages is very important. Inflation will not exist without rising wages; this is why you want to watch the wage component in the monthly jobs report each month. Wages remain flat so inflation remains on a milk carton (missing). The UK economy appeared to be in solid recovery mode but is now waning as realization sets in that wages are not increasing and noninflationary, or more correctly, disinflationary pressures are ongoing.

In the States, the US economy just slipped into Deflation according to Keystone's Inflation-Deflation Indicator. Three months ago the inflationists were on a roll. Oil prices were rocketing higher as well as energy costs and everyone took notice of the rising food prices choosing to eat spam instead of steak. The indicator was above 3.00 in the middle zone where inflationists and deflationists fight it out but the indicator never indicated conditions any where near inflation. Wages provide the inflation-deflation answer.

This summer during July and August, the indicator drops into disinflation playing around between 2.90 and 3.00 due to the falling 10-year Treasury yield down to 2.34% and dropping CRB Commodity Index now down to 289. With the further drop in yields last week, Keystone's Inflation-Deflation Indicator is 2.89, now under 2.90, signaling Deflation. This is a big surprise to the 95% or more of investors and traders that universally agree that deflation will never exist and inflation should be arriving any minute (due to the obscene Fed money printing).

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 (lower Treasury prices due to low demand) = higher stocks = a move towards inflation. Lower yields (higher Treasury prices due to high demand) = lower stocks = a move towards deflation.

In normal markets, copper and commodities will push and pull markets in the same direction but the central banker money overrules all market fundamentals. All price discovery is lost across all asset classes due to the 5-1/2 years of central banker intervention. No one truly knows what any asset is actually worth anymore. As long as QE is in place, and it is at $25 billion per month flooding into the markets, the stock market floats higher. The big upward move in commodities this year is what created the inflation buzz. The CRB went from 275 at the start of the year to nearly 315 at the June peak so this move pushed Keystone's indicator above 3.00. Now the CRB collapses from near 315 to under 290 over the last two months.

The economy was in disinflation and deflation for much of 2013 but this did not have a negative effect on the stock market. The Fed's easy money funds dividend and buyback programs to pump stock prices higher nullifying regular expected negative market affects. In addition, the easy money is used to help fund M&A and tax inversion strategies. The free money is making the wealthy super wealthy since they own stocks at the expense of the middle class and poor that are knocking on doors unable to find a job.

The 10-year Treasury note price is used for the denominator of Keystone's equation. The 10-year Treasury price is 100.3125 with a yield at 2.34%. The 10-year yield was over 3% to begin 2013, almost 70 basis points higher. The CRB Commodity Index is 289.93. Taking a look at the numbers;

CRB/10-Year Price = 289.93/100.3125 = 2.89

Over 3.6 = Inflation
Between 3 and 3.6 = Neutral; Inflationists and Deflationists Battle
Between 2.9 and 3.0 = Disinflation
Under 2.9 = Deflation

The indicator signals deflation from August 2013 until January 2014. Chairman Bernanke announced QE1, QE2 and Operation Twist to stop the free-fall into a deflationary spiral. In late 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 all through 2013.  In addition, China, the BOE and ECB are all pumping the markets with easy money as well.

The 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. The debt created will only end with a more drastic fall from grace than late 2008 early 2009 since a healthy market bottom was never allowed to occur (free markets were destroyed as the bad side of capitalism was not allowed to take place to clear the market; traders and investors now only want to experience the good side of capitalism, the wealthy are becoming more wealthy with higher stock prices, and if the bad side of capitalism starts to rear its head the Fed and other central bankers will save the day; free markets be d*mned ).

The pundits and analysts that say Inflation and even hyperinflation are at the doorstep are likely premature. Inflation is definitely 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 18-year stock cycle left translates a couple years, that would be 2016. The expectation remains that Treasury yields should move sideways and even leak lower for the next year or three. The 18-year bear stock market cycle should raise its head moving forward for the last four years of the cycle (now through 2018). Judging from history, it would not be surprising to see the stock market down 3 of the next 4 years.

Deflation is nasty and will surely affect everyone's lives. Since prices drop precipitously in deflation, consumers do not spend money 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. A downward deflationary spiral occurs. Europe is on the verge of falling into a deflationary funk a la Japan's lost two decades. Long-time readers of Keystone's missives fully anticipated and expected the current European deflation to occur despite the consensus saying this would not occur.

The structural unemployment problem remains in the U.S. and the current stagnant wage growth (wage deflation) reinforces an ongoing deflationary and disinflationary theme. Technology, computers and the Internet are huge deflationary machines. Robots continue to replace human's on the job. More tech and less human's will continue the structural unemployment problem for years forward. 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. At some point, everyone will have to utter the 'D' word, deflation, and show respect to the 900-pound gorilla in the room.

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 recent new highs with a disinflationary back drop. This behavior can only be chalked up to the amazing power of the central banker money-printing.

Inflation is not in sight despite the indicator moving a touch above 3.00 and the food, especially beef, prices running higher. Corn and wheat prices have plummeted back to earth. Crops are set for record high yields this year so the food inflation will continue subsiding. The stagnant wages in America will prevent inflation from occurring. When wages rise, that will tell you inflation is coming fast and Treasury yields will then rise strongly. Food price increases tend to be seasonal and weather-related and work through the system over time as is occurring now with corn and wheat prices falling.

The last time the indicator was above 3.6 signaling the existence of inflation was very briefly in May 2011. The indicator was above 3.6-ish back then but peaked out and retreated--inflation was very noticeable but it did not have legs. Over the last three years, the indicator has moved steadily lower from above 3.60 down to under 2.80 (from neutral down through disinflation into deflation) and has only recently recovered to above 3.00 in June (coming back up from deflation through disinflation into neutral territory) only to now fall back into deflation (under 3.00 and now under 2.90). The last time that inflation was strong and prevalent was in the summer of 2008 with Keystone's indicator well above 4.00.

The current answer to the ongoing inflation-deflation debate, is, Deflation; as much as everyone tries to fight it. After nearly six years of obscene Fed and other central banker money-printing, the economy is mired in deflation proving that the grand Keynesian Fed experiment, implemented by Fed Chair's Greenspan, Bernanke and Yellen, is a failure.