The 300 Club

Over the past few weeks deflation has taken hold. This is to be expected considering there has been a run on the banks in Greece. And there are fears this trend will spread in other European countries.


Did you know that Greek savers withdrew at least 700 million euros on Monday alone?


For the short-term, expect deflationary forces to prevail. After all, contrary to what the Fed tells us, inflation has been on a rampant surge-up for the last two years.


With a run on the banks in Greece underway, expect politicians and central banks to take drastic measures to promote growth and stability back into their respective economies. At this stage in the game, the only path to 'growth' for countries like Greece, Spain, Italy and soon France, will be to print.


Timing when inflation will start fighting back will be a calculated guess. It could reverse tomorrow or in 6 months. But in the end, it will return and in the big picture, this deflationary moment in time will look like nothing more than a blip on the radar.


Let's take a breather and get some perspective. We have all experienced the downfall in the market of late, and its brashness has been unrelenting for commodity-based equities. These stocks have been destroyed in short-order.

Now before getting too down on yourself for owning these equities, do yourself a favor. Imagine you had gone to cash 3 months ago. How would you feel right now? Would your depressed demeanour be overcome with excitement at the current valuations of blue chip gold companies and juniors alike? If you answered NO to that question, then get out of this market like all the other bears and wait for the sky to fall. If your answer was YES, then lift up that chin - you're not alone in your thinking.

Timing when inflation will take over is how many of us made small-fortunes in 2009 by investing into the greatest market rally in 70 years.


The Facts:

Deflationary forces have taken hold of the market...for now.

The US Dollar recently completed its longest winning streak in nearly 100 years (11 continuous days of increasing in value against major currencies).

There is currently a run on the banks in Greece. Greeks withdrew 700 million euros on Monday alone.

Gold is falling from the sky and has declined as much as 20% in less than 3 months.


As an investor, and one particularly vested in the TSX and TSX Venture exchanges, today's environment is one of the worst we've seen in decades. But in every crisis lies the seed of opportunity.


There are two scenarios we believe are being reviewed by the Fed right now.

1.) The Federal Reserve is planing to step up in June, if the euro zone begins to disband (because there will be a flight to the US dollar - increasing its value), and announce QE3.

2.) If deflation takes hold for too long, the debt accumulated and owed (by the US) in unfunded liabilities becomes impossible to pay. This is not some great mystery. Two to three consecutive months of deflation will trigger QE3. The time-frame for when QE3 would be launched, in this scenario, is likely late summer; the sooner the better for Bernanke given the pending election. Romney has stated that he would fire Bernanke as Fed Chairman if he is to win the presidential election.


Quick queston: Do you think the US wants to pay back its creditors in appreciating US Dollars?


Do you know what a 5% increase in the USD, against a basket of global currencies, does to the Unites States' $16 trillion in outstanding debt? China made billions last week alone thanks to an appreciating USD. Is this what the US government wants? Of course not. The US doesn't want to pay back its economic competitors in appreciating currency, while at the same time watching its economy destruct from within as exports collapse due to a lack of competitiveness.


This is not how the Fed and the world has played the currency war to this point. Currency devaluation is the name of the game. The goal of devaluation is to reclaim and steal jobs from other countries and at the same time, erode the amount owed to creditors (because the money borrowed isn't worth as much). That is the Fed's 'go to play' and it will not deviate for long.


How long can the Fed last?

If there was an alternative reserve currency to the USD, the Fed would have no more ammo. However, with the euro self-imploding, there isn't any alternative currency. This is why the USD will continue to show strength in the short-term. And this is the Federal Reserve's predicament.


How long can the Fed let the US dollar rise? If it keeps rising in value, in short-order, it could crush the US export market and send the country back into a recession. It would also render the US helpless in any attempts to lower its debt to GDP ratio. If the economy contracted under the weight of deflation, the country's interest payments on its debt would swallow up what little economic growth it had left.


Why the Fed will act:

People associate the word deflation with the Great Depression. They associate it with poverty. They associate it with asset wealth destruction. They associate it with the lost decade (or decades to be more accurate) of Japan. Low growth and high unemployment are the leading themes that come to mind in a deflationary environment. The vast majority of scholars, central bankers, governments and citizens alike, would immediately opt for inflation over deflation any day.


Without inflation the social security system of the United States, and basically the entire debt system as a whole, would collapse. The can has been kicked too far down the road and inflation is now the ONLY way out.


The Fed will use those scare tactics on politicians in closed door meetings. It has taken the United States past the point of no return. A few years of a hard fought recession, with slightly negative growth and deflation running at 1-3%, as opposed to inflation, would literally ruin the United States. Bankruptcy or a default would be a direct threat to the country.


We do not pretend to know all the answers or know exactly how this crisis is going to play out. However, we have history as our guide and the current environment suggests the Fed and other central banks will choose currency manipulation as opposed to bankruptcy.


Money Supply Not Making it Through the Log Jam

When money supply is reduced, prices contract and deflation is inevitable. The world's largest corporations and banks have forcibly reduced the money supply by hoarding cash. This is occurring during a time period where the Fed has tried to increase money supply and its velocity. Corporations and investors, due to a number of factors, are not reciprocating the Fed's actions.


The Proof is in the Numbers

The M1 Money Multiplier, seen below, is a measure of how quickly money is flowing around the economy.

Historically, if M1 is over 1.0, banks are lending relatively well and money is moving at a modest pace. Staying below 1.0 tells us that banks are not actively lending to one another and velocity is weak. The Fed is going to have to print more money to ensure the M1 money multiplier breaks above 1.0 (at least).


10 Year Graph


Take note of the recession in 2001 and the M1 Money Multiplier ratio in comparison to where it is now.


5 Year Graph


The Fed needs the US GDP to expand. In order for that to happen, it needs more money in the system moving around, creating taxable transactions. The Fed needs to increase the M1 Money Multiplier and until that happens, deflationary forces will wreak havoc.


The Fed is going to force the velocity of money to increase (in hopes of increasing GDP, employment and the tax base) by once again flooding the markets with cheap money. When the velocity of money finally does begin to increase, as it did after WWI and WWII, inflation will take over (and possibly hyperinflation).



Debt Supercycle

Debt loads are hitting unprecedented levels, with 9 of the world's largest 20 economies flirting with(or above) 100% debt to GDP. This 100% level has been significant over the course of history and usually marks a point of no return - ensuring hyperinflation or a default scenario.



With the US being the world's largest economy, and home to the only reserve currency, we know that its monetary policy will determine how the world emerges from this crisis. It will likely be a race to debase.


As investors, all we can do is look to the past to determine what the central bank and government is likely to do. Most recent history has delivered a clear message. Print, print and print some more. If no one wants to buy our bonds and finance our annual deficits, we will do it ourselves. The Fed has already made this clear as it has been the buyer of last resort for US Treasuries. Heck, Bernanke blatantly stated that he would control Treasury yield curves.



A Quick History Lesson on What Happens Following High Unemployment and High Debt Levels

Prior to and during WWI the debt to GDP ratio in the United States crept up to almost 35% - the highest it had been in 55 years. In the later stages of WWI and following years, there was a prolonged period of high inflation.


Periods of US Inflation:

In 1916 inflation averaged: 7.9208%
In 1917 inflation averaged: 17.4312%
In 1918 inflation averaged 17.9687%
In 1919 inflation averaged 14.5695%
In 1920 inflation averaged 15.6069%


35 years later, following WWII, the Debt to GDP ratio climbed to an amazing 122%.


In 1946 inflation averaged: 8.3333%
In 1947 inflation averaged: 14.3590%


For another example, we can look back to the 1970's, which is perhaps the most comparable situation to today. Although debt to GDP was hovering around 40% in the 70's, the economic picture was eerily similar to today's. In the 70's economic growth was pathetic (much like today) and it resulted in double-digit unemployment (much like today). During that same period, the Fed established easy-money policies (much like today) as a way of combating the high unemployment. However, in the end, these policies were only successful at one thing: creating high inflation. Inflation rates peaked in the 70's at around 14% annually. For nearly a decade inflation rates hovered around 8% annually (on average) in the US.


30 plus years later, the US Debt to GDP ratio has climbed to over 100%. The expansion of the Federal Reserve's balance sheet is comparable to fighting a World War, except this is a currency war. There is no doubt in our mind that a prolonged period of serious inflation is quickly approaching.


The system needs to first cleanse itself of this debt super cycle before it can truly generate new and real growth. That cleansing process is going to come in the devaluation of current debts through inflation. After this point, it is very plausible that we will witness deflation for a number of years. This will come after inflation has destroyed many people's savings and it's feared once again.


Central banks attempting to maintain order, year after year, by manipulating interest rates, create an environment that increases the risk of economic bubbles. Central banks are ground zero in terms of responsibility for most, if not all, financial crises. By manipulating interest rates and controlling the money supply, central banks have proven to be successful at controlling growth and inflation over the short-term. But in the long-term, the central bank loses control and the market has a way of working itself out. This has occurred throughout history and is usually delivered in bouts of inflation (and even hyperinflation).


A Socialist Europe Will Spark Global Inflation


The austerity measures put in place for the euro zone are facing backlash from voters. These austerity measures cost Sarkozy his job given that Francois Hollande promised to spend the country out of its financial hardship and in the process, lower the retirement age to 60 - despite most other nations raising the retirement age out of necessity.


In Germany, Merkel appears to be in jeopardy of losing power to a more left-leaning party as well. On top of that, Greece is at its breaking point with austerity measures and is likely to elect a government willing to promote growth immediately - by way of spending.


The trend is starting to form in Europe. Voters want a quick fix and the only parties willing to lie and claim they can provide that are socialist groups. Soon enough the euro zone will be entirely socialist based as voters get tired of waiting for growth. Sometimes voters need to realize that much of the problems we find ourselves in today are self-inflicted and we need to take our medicine. Unfortunately, no one is willing to go through hard times to fix the problem - so socialists, with promises that will be impossible to deliver on, are elected.


The mindset of socialists is to spend in order to create growth. This is going to create dangerous levels of inflation. Just give it time.


Wrapping-up


With the US Dollar on the rise and inflation temporarily subdued, the Fed is developing some serious wiggle room to implement yet another massive round of QE. If the euro zone collapses, or member states begin departing, the shock to the market will only ensure a heavy dose of stimulus. This will be followed by a spike in inflation and a quick orderly collapse in the USD as another debt dissolving action undertaken by the largest, most powerful central bank in the world is executed.


All the best with your investments,