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Wednesday, June 17, 2009


1931, again

via zero hedge -- hugh hendry of eclectica capital revisits an oft-revisited year.

I keep thinking that it would be ironic if history were to show that US policy makers were right to fear the prospects of a $54 trillion debt deflation and that they should have been more ambitious in their monetary expansion. The bond vigilantes believe that the double dip deflation of the 1930s will ensure that the Fed will be slow to raise interest rates this time around. But what if the economy stalls because the credit markets are premature in tightening monetary policy for them?

I am beginning to sense another paradoxical twist. What if the Fed is right and Angela Merkel, Zhou Xiaochuan, Warren Buffet and James Grant are wrong? And that contrary to their inclinations the American authorities are forced to moderate their monetary expansion in order not to undermine the confidence of the international community. Whilst at the same time the bond market pushes long rates higher.

Under such a scenario the debt reduction efforts of the private sector would usurp the government’s attempts at stimulus; the economy would falter once more. Back in 1931 the same thing happened. Bond prices dropped and yields rose to the level that had prevailed for the previous ten years; a feeble economy lapsed back into a deflationary spiral. Perhaps if this were to happen again, and we were once more confronted by a truly dire economic outcome, then it is conceivable that the authorities could gain the vital legitimacy necessary to engage in an unquestionably large monetary response which finally purges the system of deflation. That is when I would choose to let rip on buying commodities and cheap equities.

The key is the economy’s sensitivity to bond yields. Russell Napier argues that it would require ten-year yields of 6pc (vs. 4pc today) to knock the economy and stock market from their perch and reassert the deflationary trend. But he bases his assertion on observations taken since the early 1960s. My quibble is that today’s leverage is unprecedented and prices are falling. May’s American CPI is forecast to contract by 0.9pc YoY; they fell in April. We never had falling prices in the 1960s, 70s, 80s or 90s. I therefore maintain that it is feasible that some unquantifiable but certainly lower nominal rate could choke the economy.

Regardless, it is my contention that many are investing in risk once more almost oblivious to the notion that a heavily indebted economy is confronted by a very real tightening of monetary policy. It is not inconceivable that the macro compass could swing violently towards deflation and wrong foot them again.

hendry highlights the current similarity to this time in 2008, when bonds were being savaged, the dollar battered, oil skyrocketing and fed futures pointed to rate hikes. revisiting the comments of those days is unnerving. hendry's view of the bond market doing the job that the fed directly undertook in 1931 and tightening money drastically to bolster the dollar and choke off perceived inflation -- something it can be said to have done this time last year as well, in advance of the greatest equity crash since 1987, or indeed perhaps since 1929. while that kind of apocalypse is a very low probability, a deflationary spiral isn't given the relative lightness of fiscal stimulus to date.

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A very interesting interview with Paul Samuelson.

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