Inflation vs. Deflation and how the masses are positioned – deflationary pain ahead?

This debate seems to be unending – Is it Inflation or Deflation that will do us in? Notice that nobody’s thinking about a benign scenario – we appear to be doomed regardless. This reminds me of a book by Jules Vern I’ve read in forth grade, where two characters were arguing whether their “vessel” was speeding away from Earth in a parabolic or hyperbolic trajectory... both pointing to infinity, never to return.
The problem is that this debate matters a great deal to everybody who is attempting to preserve, not to mention grow, their capital. If we expect (hyper)inflation, the thing to do is to borrow to the hilt and buy gold. In deflationary scenario the above plan will bankrupt you, and the thing to do is to stay in cash or long government bonds. To put it simply, inflation punishes savers (creditors), and deflation punishes spenders (debtors).
While it is hard to make predictions, especially about the future (thank you Yogi!), please take a look at these two charts. The first one represents the ratio of total debt to total assets of American households (courtesy of Paul L. Kasriel of Northern Trust):



The second one represents the US personal savings rate:



I don’t know whether the public as a whole pays any attention to our “-flation” mumbo-jumbo, but it is clear how the masses are positioned. As a nation, we clearly are not savers. The national savings rate is close to zero. The average American household is ready for inflation to come to the rescue.
We can spend hours in clever economic arguments for and against either “-flation” scenario. However, I find it hard to believe that our old friend Mr. Market will oblige the general public. That’s not been his habit, and I don’t expect him to change. This is as clear a contrarian indicator as they come – the masses shall suffer, and the only situation in which they suffer is deflation.

Don’t Touch China with a Ten-Foot Pole.

They did it – the Chinese announced the change in their currency peg. If you thought they were manipulating their currency up until now (how is the definite US dollar peg termed “manipulation” you’d have to ask a politician), just wait and see. Instead of pegging Yuan to the US dollar, they are planning to peg it to a “currency basket”. All kinds of clever know-everythings from Morgan Stanley and the likes spew out ideas about what that “basket” is going to be. How do they at Morgan Stanley know this, down to a percentage point? Better not ask. I think the only people who know are the very Chinese who are running this show, and they are not telling anybody. I wouldn’t be surprised if the basket were to change every month, or quarter, or any time frame really, to satisfy whatever political/economic goals the Chinese authorities pursue. Meanwhile, one picture is worth a thousand words – this is a 5-year chart of the Chinese Stock market performance:


Maybe there are American investors who made money in China in the last five years – I am not one of them. I don’t believe a small American investor can find value in China on his own, and I don’t think this new currency policy changes anything. In fact, it likely will make the Chinese markets even more difficult to navigate. I wouldn’t touch Chinese shares with a proverbial ten-foot pole.

Foreign Treasury Purchases and the US Dollar

Today I will explore an area that may not concern a majority of small investors directly, as relatively few of us consider currencies as investment vehicles; nonetheless this is an issue that potentially affects all of us to some degree. I will take a look at the foreign Treasury purchases and their effect on the dollar exchange rate.
There is a much-written about idea that foreign, mostly Asian, governments purchase our Treasuries to keep their currencies from appreciating against the US dollar. To me, this appears to be a rather strange proposition – all they have to do to cheapen their currencies is create (“print”) the appropriate amounts of them to keep the exchange rates at their target levels. The Chinese can simply create 835 new remninbi for each 100 US dollars entering their economy. Should they wish to devalue their currency by 100%, all they would need to do is to print 1670 remninbi per 100 US dollars. This would be highly inflationary for their economy, of course. For example, the Russian ruble was depreciating rapidly against the US dollar in the 1990’s without a single ruble being spent on US Treasuries. So why do the Asian governments keep buying our bonds? Even more important, what will happen if they start selling them?
I believe the reason they are buying our bonds is simple – they want to export their inflation right back to the US so that we can keep buying their goods. They basically replace the dollars they receive from Americans with their respective currencies, and send those dollars right back to us. This results in the following:
· Higher bond prices in the US (lower interest rates).
· Excess money supply growth in the US finding its way into all kinds of assets – stocks, real estate, commodities, etc., while consumer prices are kept in check by the very same Asians who flood us with our own dollars.
· Inflation in the Asian countries that are engaged in this exercise stays low.
Now let’s look at the dreaded (or coveted by some Gold Bugs) scenario where the Chinese decide, for whatever reason, to start selling their Treasury bonds in the open market. It should be clear from the above analysis that the catastrophic US dollar collapse and hyperinflation, which is commonly predicted in this case, will not happen. The reason for this mistaken view is that the US debt is confused with the US currency. The Chinese DO NOT have a giant stockpile of US Dollars – the dollars have been all sent home. Instead, they hold piles of US dollar-denominated DEBT! Any attempt to redeem this debt will create a strong demand for US dollars, resulting in strengthening dollar, soaring interest rates indeed, and deflation as the money supply becomes tighter.
This scenario is not, by any stretch of imagination, any more benign than the commonly held inflationist one. The US stock market and real estate will both likely suffer. The over-leveraged real estate speculators and some homeowners will be bankrupted, resulting in further deflation. Many “hard assets, including gold, will decline in absolute terms. With both stock and bond valuations unattractive and short-term bank CDs finally paying more than a pittance small investors would be well-advised to keep a significant portion of their portfolios in cash.

On a Day Like This

My deepest condolences to all victims of the London bombings and their families.
There's only one thing I'd like to say today relating to investing: on a day like this - do nothing. Don't sell in a panic. Don't buy "the dip". I can't judge the morality of trying to earn a profit on a day like this, but submitting to emotions of greed or fear is always hazardous to one's investments.