Is Inflation Set to Return to The Market?

The common thinking of the day suggests that the world is in a state of deflation. This is when prices for goods are going down in price. Inflation is when the prices for goods are increasing in price. The published numbers for the CPI in the developed world has been showing low numbers of inflation and occasionally deflation. There is disagreement on what the numbers mean and whether they are indicative of the state of the economy. Ignoring this possibility, is inflation set to return to the market as indicated by the CPI?

Where does inflation come from? There are two main theories. The first one comes from producing goods and the associated costs. The production of anything requires 3 main costs – labour, materials and overhead. There are some hidden costs like taxation and debt as well which are embedded in the cost of production. Looking at the trends, the cost of labour has been declining as well as the price of materials. The stagnation of wages and benefits as well as lower commodity prices are proof of these trends. The increase in automation is also adding to reduced costs for all of the inputs. The second theory involves the production of the measuring unit – money. This is what is called monetary policy, and the basis of this thinking is that if you add more currency units to an economy, the prices of goods will go up even though the actual labour, material and overhead costs have not changed. This is like issuing more shares in a corporation and diluting the value per share, even though the value of the company remains the same.

Using both of these theories, labour, commodity prices and debt servicing costs are at multi-year lows. Automation may continue to reduce the need for both of these things but there may be social consequences. Overhead costs are rising slowly – utilities, rent and taxation. On the monetary side, zero interest rates and large injections of currency units suggest that inflation will surface sooner or later. The central banks also want to have some degree of inflation because they believe it will create more consumption.

What is the future of these trends? The labour costs are not rising significantly. Commodity prices have risen in 2016, but they are down from their highs and are still relatively cheap. Overhead costs are rising somewhat due to higher real estate prices and utilities costs – but the underlying reason for this is the increased usage of debt. The debt costs are rising and may rise significantly along with the cost of taxation if interest rates rise. This is not evident in the trends but is a “black swan” event that may produce a significant increase in inflation. There doesn’t seem to be a predictable indicator of inflation returning to the market. Inflation is there within the numbers and can be unleashed unexpectedly however.

Should the Canadian Dollar Be Rising So Quickly?

The Canadian dollar was trading above 80 cents in U.S. funds before the oil shocks took place which sent oil tumbling to around $30 per barrel. The Canadian Dollar went down to around 67 cents early in 2016 before rebounding back to 76 cents where it currently trades. The Canadian dollar has been linked largely with commodities and oil in particular since Canada exports a lot of these things. The second large factor affecting the Canadian dollar in the past has been its fiscal policies and debt situation.

The common explanation for the movement in the Canadian dollar is the price of crude oil. The oil price has dropped from $100 per barrel 2 years ago to around $30 per barrel and now sits at close to $40 per barrel. The fall in oil is about 70% and the subsequent rise in oil is around 25% since its bottom. The Canadian Dollar topped out at 95 cents in U.S. funds two years ago and then bottomed out at 67 cents – it now sits at 76 cents. This represents a 30% decline followed by a 13% rise. The relationships seem to be consistent in terms of tracking the oil price to the Canadian dollar. Should oil return to $100 per barrel, this would correspond to an increase of close to 50% from its current level of $40 per barrel. If the Canadian Dollar follows this move, this would equate to a value of almost $1.2 U.S. Dollars for every 1 Canadian dollar. While this is not far-fetched, it shows that the proportions are a bit off.

In terms of the Canadian national debt, the last few years have not been very favourable. The collapse in oil is threatening to make the debt balloon much higher, combined with a new government that is promising tax cuts and higher spending.

A third possible factor is that Canada is known for is resources – mining and energy. The commodity complex has also crashed over the last two years and is only now getting looked upon for possible investment.

Comparing these results to the Australian Dollar, the picture is very similar. Since Australia is very similar to Canada in terms of its resources, export pattern and proximity to a large trading partner, the consistency is there among similar currencies.

Could there be other reasons this time for the Canadian Dollars’ trading pattern? Is the Canadian Dollar rising too quickly? It seems to be, but time will tell if the rates of change will hold up consistently in the future.

Is the Price of Gold an Indicator of Trust?

The price of gold has been acting differently in 2016 than in the last few years. The reaction to news inputs has been either non-reactive or sometimes opposed to the way it was in the past. Some examples of the change are given below.

When a central bank announces stimulus which would lead to economic growth, the price of gold would typically fall since gold is seen as a safe haven. Negative interest rates as well as higher interest rates were seen as negative factors for gold since both would lessen the appeal of a safe haven. The negative rates would ensure that economic growth is more solid and the higher rates would mean the economy is already strong and would dampen economic growth. Recently, negative rates were announced in Japan, mentioned in Canada and the U.S. as a possibility and went further negative in Europe, but the gold price continued rising. The prospect of stimulus is usually a tonic for equity markets. While this has been true to an extent, a tonic for the gold price it is not. The Fed recently discussed raising rates as well. Higher rates usually indicate overheating and would exude a sense of balance in the economy. This would mean that times are good and the safe haven trade would not be necessary.

Warren Buffett announced recently in his company’s annual report the current generation of children are the most prosperous of any generation despite the high debt and subpar economic prospects. Gold rose following that announcement in spite of the fact that Warren Buffett is a well-respected investor and has significant sway upon the markets. The typical reaction would be that equities would perform strongly and safe havens would not.

There was some upbeat U.S. manufacturing data which usually points to a stronger economy. This translates into less fear and less need for gold. Gold is rising on days when “good news” is announced as well as on days when the markets tank. The U.S. dollar strength tends to be a negative correlator to the price of gold. Lately, these two entities have been rising together.

Most recently, the U.S. announced better than expected employment numbers. The equity market reaction was typical, but gold rose with it as well. There were economists saying that the numbers were not as strong as the headline numbers suggest, but the reaction in the gold price was very swift to the upside.

There are more blogs citing the lack of trust in economic data and in central bank policies. These blog posts are not new, but the reaction to this information is new. Is the gold price an indicator of a lack of trust – specifically in central bank and monetary policy? If it is, will the gold price indicate the faith that people have via future data releases? What is driving this behaviour in the price of gold? Gold has been cited as honest money since it is the only asset that is not someone else’s liability. Gold may be resurrecting to the level of a universal currency that it always was.

Have The Markets Lost Faith In the Dollar?

The last two weeks have witnessed a remarkable change in the market perception. Since 2008, the U.S. dollar and the central banks have been the authority on what the markets are guided to do. The last two weeks have been different. The U.S. dollar has been falling versus many currencies in spite of the fact that the markets have been going down quickly. Gold which has largely been ignored for the last few years in terms of safe haven appeal is now back in vogue. The same can be said for silver which has been at multi year lows. In recent news releases, reasons for the decline in silver prices were linked to the slowdown in China and the fact that commodities in general have been taking a hit. China is still slowing down as evidenced by the devaluation of the Yuan and the poor Chinese equity market performance. The world equity markets in general have also lost value while gold and silver have been rising. Another notable trend change is in oil prices. Typically oil, gold and silver are correlated due to the pricing of all of these commodities in US dollars. In the last two weeks, oil has plunged to new lows and gold and silver have been rising. On the other side of the argument, correlation does not equal causation. Correlations can also change from time to time and also revert to moving in opposite directions instead of the same direction.

What is more peculiar about this market activity is what the catalysts are for the market reactions. The fact that the markets are valuing a safe haven so strongly is also an indicator that something is not right.

This last Fed announcement on February 11, 2016 indicated that interest rates could still rise in 2016. This caused a fall in the US dollar and oil and a rise in gold and silver. This can be justified in that higher interest rates will slow down the economy further. In every other instance, the buying of U.S. Treasury debt and dollars would accelerate after such an announcement. This time, these instruments were down after the announcement. Has the Fed lost its credibility? If markets continue to signal the way they have over the last week, the answer is a “yes”. With the Fed credibility goes the strength of the US dollar. Add to this scenario the fact that more central banks are diving into negative interest rate territory, and you have a contradiction in perspectives. Most of the world is pleading for help in reviving their economies where the U.S. is saying that everything is not only good but needs to be restrained. This does not make sense given that global economies are heavily linked.

Is the Fed Being Forced To Raise Interest Rates?

The Federal Reserve is still on track to raise interest rates in 2016. Is this making sense given what is going on in the world right now? The economic numbers have indicated subpar growth for years now in most parts of the world. China has been issuing signals that their economy is not as good as it seems. The world equity markets were stalling before the meltdown of January 2016. Recently, the high yield bond markets are also showing signs of cracking. Many central banks have been lowering their benchmark lending rates to devalue their currencies. The US dollar is showing relative strength against most other currencies: This means U.S. exports are being discouraged. The inflation picture is officially very weak around the world including within the United States. The price of commodities has crashed throughout 2015 and into 2016, which is one of the large production inputs for almost every product made. On the financial side, the existing debt around the world is crippling and raising interest rates would be a catastrophe for borrowers. Would you raise interest rates given these factors?

The Federal Reserve may be raising interest rates for these reasons. The first one is that interest rates need to be normalized because savers are being punished and existing debt is excessive. This is not news – this effect on savers and borrowers has existed since the 2008 crisis. The second reason is that the zero interest rate policy was good, but it has gone too far. There has not been great growth since 2008 so the policy did not do what was expected. The third reason for raising rates is to undo the excessive leverage in the financial system. This was a known consequence of cheap interest rates – in fact this is why interest rates are a powerful tool that a central bank has to control the economy.

Could there be other reasons? Could a possible reason interest rates are rising is because the buyers of U.S. debt are dumping Treasury bonds in search of higher yields? Maybe the Federal Reserve is running out of buyers of its debt and it if does not entice investors in some way the debt cannot be refinanced? There is an expression in trading which states: “Don’t fight the tape” or “The trend is your friend”. If a tidal wave of dissention is building up and nobody wants your debt, something unorthodox has to be done. The real truth is that markets ultimately determine an interest rate – not central banks. The market will go along with a central bank until it does not want to.

The Yuan Will be Included in the SDR – So What?

The IMF has announced that it will include the Chinese currency (the Yuan or the Renminbi) with its basket of world currencies. The SDR stands for Special Drawing Rights, which is analogous to calling the Yuan one of the reserve currencies of the world. The other currencies are the US Dollar, the British Pound, the Japanese Yen and the Euro currency.

So what? In actuality, money is based on physical resources and the capacity to produce. This is measured by the presence of physical goods or the ability to create these goods. A currency is a measure of this production and was originally measured by gold and silver resources. Since the world gold standard was abandoned and the IMF was created, the unit of measure for this production became reserve currencies. These currencies are de facto backed by gold should their value be put into doubt. It should be remembered that currencies are not value – they measure value. The real value is in what is produced.

That being said, the Yuan inclusion into the SDR basket is a big deal. Why? The optics have changed. China now has a voice at the table with respect to world currency valuations. By granting China this access, it is acknowledging that China is a world force that has to be reckoned with. The fact that the countries who gave China this access are the Western countries also says something. They could have waited for years citing lack of transparency, lack of access to Chinese markets or a number of other reasons if they did not want China included in the currency basket, but this is not what happened.

The influence of currency valuation will also be leaning more towards China in the future which will give them more credibility. The fact that China was granted this access even though they are not officially a democracy and have restricted foreign exchange markets speaks volumes as to how much influence they really have. The fact that gold is the de facto world currency may also play a part in the decision as China is adding to its reserves more quickly than any of the other reserve currency nations. Should a global currency devaluation happen, gold may once again be used as the standard of measuring value since it cannot be printed, forged or counterfeited like national or regional currencies. Whoever has the most gold may in fact “clean up the table” in this situation to use a poker analogy. Combining the Yuan inclusion with the BRICS Alliance to form a competitor to the IMF and creating lending facilities outside of the US and Europe, the tide is shifting rapidly from the West to the East.

What does it mean? It could mean many things but this inclusion is a symbol of a power shift. Look for China to become the centre of world trade, surpassing the U.S. in the coming years. China will become a consuming nation and its currency will rise in value. They will become the world’s buyer as opposed to the world’s seller. Quality will become a major theme instead of quantity because this is what buyers would prefer if they had negotiating power. China has more influence than people realize and even though this has been stated many times before, the greatest impact is still to come.



Can Excessive Debt Financing Take Down Large Corporations?

The flood of cheap money via lower interest rates has allowed everyone access to cheap debt. For corporations, this means that the cost benefit analysis of carrying debt versus the return on investment is skewed towards investments with lower returns. Lower returns may imply poorer quality since a good investment would command a higher return. This phenomenon has allowed corporate takeovers to balloon over the last 5 years. Since many takeovers are financed with debt, the takeovers are easier to orchestrate since they are cheaper to fund.

What are the risks to this kind of behaviour? The lower return on investment required to pay back the debt is one factor that has already been mentioned. Should a business decision be based on a lower return on investment, this means a company can be less prudent about what sort of investment it makes. In the case of a takeover, this translates into what sort of company it is buying. What if interest rates rise? Won’t these corporations be responsible for a much larger interest payment to finance takeovers of companies? Higher interest rates could also mean that companies being taken over may become less profitable on average due to higher interest expenses. This represents a double whammy that can make takeovers financed with low interest debt look foolish in hindsight. If many big companies are doing this, it may be setting up a crisis in corporate solvency. How likely this “crisis outcome” is depends on how many companies have enough resources to whether an interest rate hike or a change in financing requirements. A company that is sitting on a lot of cash will be able to buy much more when companies are cheaper in value; a type of deflationary scenario in the corporate world. A third risk factor is that large corporate takeovers may also set up a huge concentration of wealth in a few companies.

There has been talk about bubbles in real estate, the stock market and the bond market. There may very well be a bubble in takeovers which may reverse very quickly since interest rates can be changed in an instant and financing can dry up overnight. Since these takeover deals take months and years to play out, this can be a disaster if the takeovers are not timed right or have inadequate financing to see the deals through to completion. The talk of higher interest rates at the Federal Reserve means these risk factors may become a reality within the next year.