The Coming Dollar Deflation

by: David Bailey December 02, 2008 | about stocks: DZZ / GLD / UDN / UUP    

David Bailey

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There is a consensus out there: Gold is going up and the U.S. Dollar is toast. Like most consensus opinions about financial markets, it's dangerously wrong.

You'd think it would be simple. The market has been very clear. But when it comes to changing people's long-held assumptions, I guess an excess of information is necessary. Never fear. It's coming.

There is a shortage in U.S. Dollars. Nothing could be clearer.

  1. Yields on short-term Treasuries almost could not be lower. The Treasury is borrowing for free. People are practically paying the U.S. Government simply to assure them they will have (inflation-adjusted) slightly fewer dollars in a month or three than they have today.
  2. As if the fact that people are accepting that kind of deal is not persuasive enough, the deal is so popular that trillions – trillions – in Fails To Deliver are standing open in the marketplace.
  3. The Dollar Index has skyrocketed during a period when the U.S. Treasury and Federal Reserve have injected more dollar liquidity into the market than anyone could have imagined – more than was even legal months ago.

Yet even in the face of this huge, demonstrated demand, ideology, prejudice, assumptions or whatever still have people predicting that a cataclysmic fall in the dollar is just days away. I would remind you that even economists who predicted this crisis completely missed the direction the dollar would take. It wasn't a small miss. If you read such excellent economists as Nouriel Roubini, Brad Setser and the now-Internet-famous financier Peter Schiff, a fall in the value of the dollar was actually central to their theories of why and how a crisis would play out. About the economy and the markets, they have been mostly right. About the direction of the dollar, they have been spectacularly wrong.

They will continue to be right about the markets and wrong about the dollar, it seems. After this pause, the dollar will not fall in value, it will rise and not just a little. It seems clear to me that the worldwide demand for dollars will inevitably drive the Dollar Index to 97-100 in the next year – maybe within a few months. That's what the numbers have been telling us since July and that is what they continue to tell us – even more strongly than before. The money multiplier and (effective) velocity of money are falling off the table. Credit contraction has been so rapid and the velocity of money so crippled that even as the Fed tries to answer the world's cry for dollars, that cry gets more intense. TED spreads, while lower than before, are still absurdly high, demonstrating the significant dearth of dollar credit worldwide to which the Fed has been responding.

It's a deflation.

And in a deflation commodities deflate. Although gold is an emotional market where the price can rocket 10% in a day, gold is in a bear trend and despite some really remarkable volatility (that will probably get even more remarkable), gold will continue in a bear trend. Again, that's is what the market has been telling us since July and I see absolutely no reason to doubt the market. In fact, the evidence is getting clearer by the day. Gold is now significantly overpriced in terms of markets that have been predictive for decades - oil, silver, the dollar and even the gold lease rate. Obviously gold can change its relationship to one of these other markets any time – but all four?

Panic has put a consistent bid RELATIVE to these other markets, but unless goldbugs can drive the yellow metal's price out of this downtrend, I predict gold will be really significantly lower in the next year – like $200 lower. All this talk of gold as the next “reserve currency” will be remembered as an artifact of the commodities bubble.

When ideology and orthodoxy tell you one thing and the market tells you another, believe the market.

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This article has 42 comments:

  •  
    Dec 02 10:33 AM
    Patience, grasshopper.

    www.cnbc.com/id/280145...

    "Cost of Insuring Sovereign Debt Jumps to Record High"

    Referenced article points out the high, and growing risk of default in sovereign bonds, due essentially to the high demand for funds that governments are experiencing to fund various bailouts and stimulus packages. THESE PROGRAMS HAVE ONLY JUST BEGUN, and in many cases have not yet even begun to be funded.

    Hide in Treasuries if you choose. The "stock market is a generational buy" paradigm took more than a year to break, so too it will be with the "Treasuries as safe haven" paradigm. The herd is monumentally wrong.
    Reply | Link to Comment
  •  
    Dec 02 10:33 AM
    The market is always right. Fight it at your peril.
    The strength of gold vs these other commodities is remarkable.
    Gold's trend depends on your time horizon. I would disagree that gold is in a long term (since 2002) bear trend. But that is what makes markets and horse races.
    Reply | Link to Comment
  •  
    Dec 02 10:40 AM
    David,

    Interesting article. Any disclosures? Are you short gold?

    Vancan
    Reply | Link to Comment
  •  
    Dec 02 10:42 AM
    It looks like for the last 8 years everybody believed in the markets. The markets are down 31% !
    If it were not for the bailouts, how many more people would be out of work? Do you understand how many people have lost their homes and are living on unemployment or living in tent cities? Do you have any clue how many Americans are literally living off their soon to be cut off credit cards?
    Credit markets are tightening! Governors are meeting this very minute because they cannot balance their budgets. Historic sites, libraries etc.. are shutting down... America is broke. Our infrastructure is crumbling. We are trying to print our way out of this mess. Barack Obama just said on CNN that we cannot keep on printing money...
    You have to look at the realities of the situation. You cannot "cheerlead" this economy out of this mess. The dollar is being propped by the Fed and the central banks as long as possible..and then what??
    Are you prepared?
    Reply | Link to Comment
  •  
    Dec 02 11:16 AM
    in short, you extrapolate the current trend for another couple of months/years into the future. I mean, not that commodities had not deflated already BIG time. how much lower does oil, copper, silver, zinc, natgas have to fall till the last marginal producer gets killed. KILLED! not just shutting down for a few months but getting out of business! the inflation that had been created under greenspan has worked its way first into financial assets and home prices and later into commodities. but the current deleveraging does not at all mean that these inflationary developments of the past 15+ years now get fully reversed. however, that is exactly, what you are assuming! I have news for you: it costs about $70-$80 for most marginal producers (oil sands, russia, ,mexico, Brazil, oil shale etc) to replace a barrel of oil (exploring, drilling, processing, delivering). At $50 we are well below that. And even though countries like venezuela, iran, nigeria, russia will keep drilling at maximum even at these prices bnecause of their budgetary needs, a more than sufficient amount of marginal producers (in total at least $5-$10 mln barrels/day) will not because they need not. That means that oil is not going to stay at $50 for too long, but will eventually recover to $80-$100. Similar with Natgas. A glut is expected for 2009 but look how the producers are cutting capex and stop drilling. billions of BTUs will not come onto the market at $6.50 and lower. Copper will be in deficit 5-6 years from now at the latest, even if you allow for a prolonged, deep recession worldwide.
    there will be a period of dis-inflation. but not DEFLATION. No way. the central banks will and can prevent that at any cost and boy, will there be a cost!

    now, to your "dollar-shortage&... argument. this is true, but only very very short-term. lots of dollar-loans have to be paid back - by hedgefunds, emerging market corporations etc. BUT: there is still a HUGE supply out there. Gazillions of paper dollars are in the vaults of the Central banks of China, Japan and Europe. The shrinking US trade deficit will, ironically further contribute to a demand-shortage of dollars from foreigners. it will reduce the amount of dollars send abroad (naturally), but that means in turn that fewer dollars have to be recycled.
    make no mistake: there is still and - once the crisis starts to settle - higher than ever amount of dollars that flow around the world with an ever lower buying power with ever fewer places to go. US-treasuries are next, and biggest bubble ever that is building.

    a few years from now you will look at your own article in disbelief.
    the dollar isn't toast. fiat currencies are - and the countdown is ticking. when all is said and done commodities and especially monetary metals like gold and silver will be at highs that few can imagine right now.
    Reply | Link to Comment
  •  
    Dec 02 11:45 AM
    The doomsters missed the short term bubble in the dollar, no doubt about it.

    However, long-term, despite deleveraging I believe the US will still be up in its eyeballs in debt.

    Are the trillions of dollars in T-bills held by foreign governments being deleveraged? Of course not. They expect to be paid back on those at some point, and in US dollars.

    And the national debt. Can we just deleverage it away? I think not.

    Yes perhaps some debt will get wiped out, some mortgage debt and so forth.

    Still, in my opinion, the US will still be up to our eyeballs in debt. And we are taking on a lot of new debt in order to jumpstart the economy.

    Can this debt ever be paid back in STRONG US dollars? I sincerely doubt it. But it can be paid back by printing US dollars.

    I believe the doomsters got the US dollar right on the long-term, but were spectacularly wrong on missing the fact that short-term people would cling to US dollars even though they know that long-term they are going to be trash.
    Reply | Link to Comment
  •  
    Dec 02 11:48 AM
    By the way: Mr. Bailey contends there is a shortage of dollars.

    Yes, but we have big printing presses and it costs very little to print more dollars.

    And our economic officials have made it clear that they will print as many dollars as it takes to see that we do not have deflation.


    As people often point out- you can print dollars (or any fiat currency for that matter) but you can't print oil or gold.
    Reply | Link to Comment
  •  
    Dec 02 11:52 AM
    Some have pointed out that we currently are seeing a bubble in US Treasuries.

    I would say it probably is more appropriate to say that the US dollar is in a bubble.

    It has been pointed out by those who have studied bubbles that one characteristic of a bubble is for the asset in question to be rising in price even in the face of a flood of supply on the market. Exactly what is happening with US dollars, and perhaps most other fiat currencies.

    The dollar bubble will pop. I do not know when, but I would expect sometime next year.
    Reply | Link to Comment
  •  
    Dec 02 11:56 AM
    And I wouldn't agree with Bailey's contention that there is a "consensus" that the dollar is toast.

    However, the view does seem to have more adherents than before. Some of the "don't worry be happy" CNBC crowd who used to seem to think that ludicrous claims by economic officials that we have a "strong dollar policy" constituted an actual "strong dollar policy". Some of those commentators seem to have snapped out of their stupor.
    Reply | Link to Comment
  •  
    Dec 02 12:35 PM

    I guess I would concur though that the US dollar is not toast.


    It is more like an uncooked piece of bread sitting in an electric skillet that is shut off but connected to a timer.

    The big question is, what is the setting on the timer? March 2009? July 2011? December 2008?
    Reply | Link to Comment
  •  
    Dec 02 01:04 PM
    You are right. The dollar will strengthen until there is no more money to go into it. By that time, the on the ground U.S. economy will have deteriorated so disastrously that the dollar will also begin its plunge.

    Don't look for an economic recovery in the U.S.--there isn't going to be one. Instead, the collapse will lead to a political crisis which will be the coup de grace of the U.S.
    Reply | Link to Comment
  •  
    Dec 02 01:26 PM
    US will survive but not as we know it. Massive inflation will lead to 10 USD loaf of bread. Meat will be 125 USD/Lb. All commodities will go through the roof. China is buying up mines in Africa and South America to sustain their growth. This is a massive bait and switch for the US. Personally, i do not believe we are that bad off, but the dollar is going to be pounded big time by Gold and foreign currencies. In the short run we are going to have to be selfsustaining, but we emerge US will emerge stronger. I advise everyone to buy Chinese stocks, bait and switch back at them.
    Reply | Link to Comment
  •  
    Dec 02 01:50 PM
    Mr. Bailey, You are very wrong. Please doubt yourself because gold is going up and the dollar down. You're going to be in a terrible pickle if you're betting on the dollar. Please hedge your bets. Look at the fundamentals. The U.S. is in monumental trouble. I hope the president-elect can ameliorate the situation somewhat--he's a smart man and might change his policies before we go into a disastrous hyperinflation from which there is no return. Please, for the sake of your family, study a little more, such as at Finacial Sense Newshour or Kitco.com.
    Reply | Link to Comment
  •  
    Dec 02 02:37 PM
    Thank you all for the comments.

    First, I would remind folks that the private banking system creates a LOT more dollars than the government - or it used to.

    Second, I would refer you to yesterday's limit-down in CNY/USD.

    Third, I would refer you to Meredith Whitney's chilling and insightful article about the coming. planned destruction of what could be trillions more dollars in credit.

    Fourth, I would refer you to your local state and county treasurers (or international equivalent). I think you'll find that "the government" has a lot less money to spend than you think.

    Worldwide, we've seen - notional - what might be tens of trillions of dollars in wealth lost. Even if it that only has a probabilistic relationship with the supply of money, it still has to come from somewhere.
    Reply | Link to Comment
  •  
    Dec 02 02:48 PM
    Excellent article buddy. You closed it beautifully.
    Reply | Link to Comment
  •  
    Dec 02 04:59 PM
    To the commentators... no point trying to convince the author - just like there is no point in the author trying to convince us. He doesn't recognize that dollars will be printed until there is no deflation - so there won't be any long term deflation - they'll ensure that isn't a problem.

    I disagree with his deflation concern, in the long run. If the same thing had happened with any other currency on the planet, it would have failed by now. The USD is the reserve currency of the world - FOR NOW.

    Land and gold and assets of that nature can be considered a store of wealth, not profitable "investments"... They store value very well compared to the dollar or any fiat currency - show me ONE case to the contrary over the long term! You have a several thousand year period to show me a single fiat currency that did well in the long run and had no inflation.

    Show me anywhere in the US where I can buy land or gold for cheaper today than I could a hundred years ago, or even 50 years ago. They may not be good investments, but they do store wealth much better than our fiat dollar. A lot of people confuse storing wealth with investing...

    In the end, fifty years from now, the people that bought an ounce of gold or an acre of land still have just an ounce of gold or an acre of land. It is a store of wealth. Holding these items alone doesn't create wealth (unless you are holding land near a city you expect to expand and value the land more highly, etc, etc). Holding these items as a store of wealth will beat the person who just holds USD's as a store of wealth.

    Inflation will continue to occur in the future. Deflation is a short-term issue. I don't see the deflation undoing what inflation has done for the last 50-100 years so it would be hard for me to consider the deflation a big problem... I expect things to get very bad in the economy and the Fed to continue adding dollars to the system. This does not bode well for the dollar in the long-term. In the last two months there has been a monetary base increase of over 75%! They aren't done either! It will affect things - maybe not today or tomorrow, but it will factor into the equation sooner or later.

    We can argue against each other for as long as we want. Time will tell the story. Time. Not you, not me, not anyone of us commentators... TIME will tell the story.
    Reply | Link to Comment
  •  
    Dec 02 05:31 PM
    All throughout history Nations that have resorted to fiat currency all have one thing in common... they debased their currencies and ultimately destroyed themselves.. It is only arrogance that would suggest that because we are the US this could never happen to us.. Arrogance to think that any company is too great to fail...The fed cannot lower interest rates any further.. rates must only go up.. ... Whatever gains we have seen in the dollar recently are temporary.. its all fluff and hype.. 2009 is going to be the year of the awakening... The people that were empowered to keep us out of this mess are the same morons trying to fix it... by throwing more money at it...

    anyone who believes the dollar is safe is NUTS
    Reply | Link to Comment
  •  
    Dec 02 06:46 PM
    <<Even if it that only has a probabilistic relationship with the supply of money, it still has to come from somewhere. >>

    If only. They simply monetize the debt, aka printing money. Treasury sells Treasuries to the Federal Reserve, which creates the money out of thin air. It comes from nowhere. That's why they say a gold-backed currency has a built-in safety valve. With a gold-backed currency, you must have something backing the money.
    Reply | Link to Comment
  •  
    Dec 02 09:09 PM
    Nabloid has this pegged pretty well. The Federal Reserve will use every power it has, including the creation of however many dollars it takes to defend the banking system and the economy. As the economy recovers (and it will) these excess dollars must be gradually removed or we will at some point experience rising inflation. Inflation and deflation are monetary phenomenoms. They are conditions created by money supply or the lack therof. There are always those who choose to ignore the Federal Reserve. From everything I see this Federal Reserve is determined to squash this deflation. If you wish to bet against them, have at it.
    Reply | Link to Comment
  •  
    Dec 02 09:19 PM
    The author may have a point. If beating deflation is so easy, why have the Japanese failed at it for almost 20 years?
    Reply | Link to Comment
  •  
    Dec 02 10:54 PM
    "In the short run we are going to have to be selfsustaining, but we emerge US will emerge stronger. I advise everyone to buy Chinese stocks, bait and switch back at them. "

    Would it not be safer to invest in US Food producers, farm equip makers and related issuers, with similar upsides?
    Reply | Link to Comment
  •  
    Dec 02 10:56 PM
    In one breath you say: "I see absolutely no reason to doubt the market", and in the next, you say: "Gold is now significantly overpriced". So which is it? The markets are beyond doubt when they agree with you? I don't know which way this is going to go, and your article didn't help me figure it out.
    Reply | Link to Comment
  •  
    Dec 02 11:51 PM
    shortage??? Actually just hoarded dollars... everyone wants them thinking that the buck is better to hold - but sooner than later this bubble will burst or deflate quickly... Why? Because the US cannot borrow it's way out of debt nor print [$$$] it's way into prosperity... and certainly with deflation taking a toll on the economy... Ben and the boys in DC will run the dollar aground - thinking that they can control inflation better than they can deal with the problems of deflation... let's all hold our breath and hope they can reign in the economy before it implodes.



    On Dec 02 10:33 AM SWRichmond wrote:

    > Patience, grasshopper.
    >
    > www.cnbc.com/id/280145...
    >
    > "Cost of Insuring Sovereign Debt Jumps to Record High"
    >
    > Referenced article points out the high, and growing risk of default
    > in sovereign bonds, due essentially to the high demand for funds
    > that governments are experiencing to fund various bailouts and stimulus
    > packages. THESE PROGRAMS HAVE ONLY JUST BEGUN, and in many cases
    > have not yet even begun to be funded.
    >
    > Hide in Treasuries if you choose. The "stock market is a generational
    > buy" paradigm took more than a year to break, so too it will be with
    > the "Treasuries as safe haven" paradigm. The herd is monumentally
    > wrong.
    Reply | Link to Comment
  •  
    Dec 02 11:54 PM
    good read, but i disagree that the dollar is strong. maybe the 'last to die' relative to the rest of the world, but with our debt-base, it's certainly not healthy in any frame-of-reference.

    your comments about schiff, roubini, setzer, etc. indicate a naive assumption that their predictive time-frames mirror yours. they may not know exactly when, but they've all nailed this one to the 't', with facts and causal substance beyond 2-4 years back. my trend analysis of their results keeps me vested in their 'graphs', over any of the recent dips in the gold 'graphs' of these last few months.

    lastly, like anything of value, fluctuation will continue to occur with gold, and it will, by force of world-banks, IMFs, and play-makers at large, be beaten from its 'natural value', and it will return thus, as it it always has. i think it will be sooner rather than later, and when considering a place for my money, gold is hardly the 'dangerous' repository.

    be well,
    --ikk
    Reply | Link to Comment
  •  
    Dec 03 12:04 AM
    "When ideology and orthodoxy tell you one thing and the market tells you another, believe the market." things are what they are despite what we believe they should be.

    David, you presented facts. i for one am in the inflation camp. if i was shown six months ago the money creation curves, i would have bought gold and euros - and i would have been screwed. there is an element of this situation which is not understood by the deflationist and inflationists. it is larger than velocity of money which is a topic for another time and place.

    one thing for sure, everyone needs to stay on their toes. just look at the rapid changes in the dollar and gold indexes. i think everyone can agree that quick changes spell instability.

    a final point - even with all this money being created, we must remember we are in a recession. a tipping point will logically be a recovery cycle where people and business start shifting from a defensive to an active behavior.
    Reply | Link to Comment
  •  
    Dec 03 12:07 PM
    I would only point out that governments are not always capable of preventing either inflation or deflation.

    Governments that face huge debts don't like deflation but they don't always get inflation for Christmas, as world economic history teaches us.

    Most history savvy investors know the history of the Great Depression but they don't often study the other severe depressions and deflations that have occurred throughout American history and world history.

    Economic and financial crises don't usually respond to moral outrage but when they do, we get movements like Nazism which everyone thinks they DON'T want but when things get bad enough everyone seems to approve of.

    Maybe now is the time to begin a diligent study of the many deflationary periods of the American past. We know about the Great Depression but what about the others? Were they preventable or not?
    Reply | Link to Comment
  •  
    Dec 03 12:09 PM

    To the original article writer - xactly, and thanks for the being rational when few are.
    Reply | Link to Comment
  •  
    Dec 03 12:55 PM
    This article is a waste of time. First of all, the current consensus is that deflation is here, along with "king dollar" forever. The writer is obviously a short-term trend follower. These type of people NEVER make money over any term longer than a few months.
    Reply | Link to Comment
  •  
    Dec 03 01:11 PM
    David, David, David: Your statement, "believe the market" would be correct if it were not for the 1) no uptick regulation much less any real regulation or enforcement of any regulations, 2) big foreign cash cows, China and Japan, have been and continue to prop up the dollar as they hold so many dollars and don't wish to lose their buying power, 3) naked scheduled short selling by them and investment groups in USA on hourly, daily, weekly, monthly transacting guide stocks, commodities, and currencies prices, 4) Congress and the Fed continue to use the money presses and borrowings to fund the corrupt, the manipulators, the manipulated, and their cronies with no help to "Main Street", etc. etc.
    ALL MEAN THAT THE "MARKET" IS "NOT REAL" - THEREFORE ANY CHARTS, HISTORICAL PATTERNS, EVEN YESTERDAY, LAST WEEK OR LAST MONTH'S MARKET RESULTS SERVE NO GUIDANCE AS TO
    THE DIRECTION OF THE FUTURE MARKET.
    Reply | Link to Comment
  •  
    Dec 03 01:19 PM
    I'm not hearing anyone mention that the U.S. began cutting rates looong before EU & Asia...which still have a TON of room to cut. We're at 1%, many of those nations are still at 4-6%. The dollar strength is *relative*. When those countries catch up...watch out dollar!!!
    Reply