Wednesday, February 22, 2006

Deflation scares and the debt limit

The U.S. Senate might wait until mid-March to raise the U.S. borrowing limit. Sen. Grassley

To the extent the main impetus behind the inflationary bent to the US economy is the accommodation of government deficits, that the debt has hit its Congressionally mandated limit has and will likely cool some of the pro-inflation trade flows. Prices of some commodities may fall, the curve may invert a bit further and the US$ might rally further in FX markets. As I don't expect the trend, if it does manifest further, to last, I will both be preparing myself for further albeit temporary declines in my main precious metals holdings, and looking for opportunities to add to the inflation trade in the next month.

Market participants, as my friend Stephen Plant often reminds me, have a tendency to create their own reality- generating a mythology to justify the most recent price changes. Don't be surprised, given the unseen as of yet but expected effects of past tightening of the short end particularly with respect to the mortgage market, to hear and read fears of coming deflation. January's warm weather boosted strength might give way to February's snapback to weakness in economic data. Who knows, maybe the stock market will take a bit of a dive if the deflation fears get some traction in equity index prices. Japanese fiscal year end is another factor which tends to tighten credit markets at that time.

The key to remember, at least for me, is that there is always ebb and flow. The Fed has suggested it will be "data driven", perhaps knowing that the next string of data will be weak, justifying a pause in its tightening. A bit of a stock market swoon, and weak February economic data released in March, might be just the ticket for the next burst of inflationary finance. Once the black box and hedge fund crowd starts piling into the deflation trade, Congress can raise the debt limit and the Fed will be more able to accommodate those deficits without complaint.

To the extent further declines are not seen in commodity prices, equity markets remain bouyant and the quantification of economic activity remains robust the next manifestation of inflation related speculation might be quite strong.

2 comments:

diogenes said...

dave,

that last paragraph might make that guy interested in language happy but i would rather know what you really mean.

john

Dude said...

If, over the next few weeks, Gold stays above $535, Oil stays above $58, and the Dow stays above 10,750 then the next time the funds start piling into those markets they are likely to move substantially higher.