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The Reflation Trade

06/10/03 04:14:38 PM PST
by David Penn

Which of the three trains running--gold, bonds, or stocks--will continue to go investors' way?

"April is the cruelest month"? Pshaw! There was nothing cruel about the way April 2003 (or the rest of spring, for that matter) treated stocks — the Standard & Poor's 500, already in rally mode after bottoming in mid-March, was up over 8% in April alone. And while April was not particularly kind to gold or long-dated Treasuries, that which April lacked (both gold and long Treasuries were essentially flat) was more than made up for during May. Stocks continued their springtime advance, climbing almost 4% by May's end, while gold climbed more than 10% before correcting in the last week of May. Treasuries rose as high as 119-05 from 115-09.5 before, like gold, retreating from the highs late in the month. Ten-year yields on these Treasuries have fallen some 17% from mid-March to late May.

At one point late in May, investors were presented with the stunning picture of three simultaneous advances in noncorrelated asset groups. Gold was up six weeks in a row. Long Treasuries were up six weeks in a row. Stocks — as represented by the S&P 500 — were up five weeks in a row. For those schooled in traditional economics, this made little sense. If gold is an inflation hedge, bonds are a deflation hedge, and stocks are a "no-hedge-required" bet on solid, noninflationary, nondeflationary growth, then what were gold futures, Treasury note futures, and blue-chip stocks doing advancing together — like the Scarecrow, the Lion, and the Tin Man — arm in arm with investors, headed toward ever-higher highs?

If there is a wizard toward which all these asset classes are marching these days, that wizard is likely none other than Alan Greenspan, whose reign over a magical device — referred to by Federal Reserve governor Ben Bernanke as a "printing press" — appears to have drawn all sorts of undervalued and overvalued assets into a desperate pilgrimage toward Emerald City. Richard Russell, publisher of The Dow Theory Letters, has suggested that there is nothing more inflationary than a whiff of deflation. If this is true, then it becomes all the more clear how no asset class was spared the benevolence that a promise of virtually unlimited liquidity can provide.

Writing recently for Prudent Bear (, Doug Noland noted in a Credit Bubble Bulletin titled "The New New Game" that:

Over a decade ago the Fed was forced to aggressively peg short-term interest rates at a low level. This manipulation of financial profits was a desperate effort to ward off financial collapse and potential depression. Its endeavors were too successful. The ensuing rush of "innovation" toward a securities-based credit system, with the proliferation of leveraged speculation, derivatives/financial engineering/GSE risk intermediation/credit insurance, and resulting historic asset bubbles, then forced the Fed to implicitly guarantee abundant financial market liquidity.

And later,

It appears that we have returned to an environment where the stock and bond markets share a mutual benefactor — the Fed-induced liquidity deluge . . . The Fed has gone out and designed a trough that can feed all takers.


Has reflation been to blame for this recent, tripartite bullishness in generally noncorrelated markets? It is hard to argue to the contrary. For one thing, during the same time that gold, bonds, and stocks were enjoying their five-plus week rally, the dollar was taking it on the chin. In mid-April, when gold and Treasuries began moving up strongly, the US dollar index was trading around 99. By the end of the month, that same index was trading below 96. By late May, the US dollar index was fighting to stay above 93. International currencies also rallied strongly during this period — though most of them clearly had the wind at their backs by the time the spring of 2003 rolled around. The dollar had been in virtual free fall for over a year, but it may have taken the recent declines in the dollar index to finally push currencies such as the Canadian dollar, the euro, and the Australian dollar into the stratosphere.

Many stock market commentators seem largely oblivious to this phenomenon. One popular stock market observer recently articulated a list of "things you never thought would have happened if asked a year ago" as part of his explanation as to why common stocks were going up. Unfortunately, there are two problems with this formulation. First, the list (Japan's economy "improving," the liberation of Iraq, the Bush tax cut, a presidential summit in the Middle East, Internet stocks leading the market higher, no new terrorist attacks on US soil, no major telecommunications or power trading company bankruptcies or scandals, Brazil's economy "improving," Argentina's economy "improving," no severe acute respiratory syndrom [SARS] outbreak in the US . . .) is dangerously close to describing a perfect world, not just a world in which stocks — on balance — might be poised to outperform other asset classes. Second is this question: if such a perfect world is in fact at hand — even temporarily — then what are gold and Treasury notes with coupons barely outpacing the rate of inflation doing riding shotgun with stocks?

The one answer that critics like Doug Noland and Richard Daughty (the latter the author of the Mogambo Guru newsletter) continue to point to is the Federal Reserve Board's willingness to create liquidity through the medium of the credit markets. Noland, who has worked this beat since before this beat had a name, sees this "reliquefaction" showing up in an interesting variety of places, including in the market for advertising dollars:

I would view surging advertising spending (at rising prices!) as an "inflationary manifestation" at the margin — an early "success" for reliquefaction. It makes sense that management, emboldened by collapsing corporate yields, newfound credit availability, and seemingly endless liquidity, would move quickly to increase marketing expenditures. After all, it's a lot easier and less risky than expanding plant and equipment and/or adding employees.

Or, as Fox Television Entertainment Group chairman Sandy Grushow noted in Noland's piece, "For whatever reasons, there just seems to be a tremendous amount of money in the marketplace."

Noland's critique goes far beyond giving the "advertising agencies and the blessed LeBron Jameses of the world" their proper due. Clearly, he sees reliquefaction as part of the problem, rather than a guide toward a solution:

I would further argue that such spending is an excellent example of our contemporary "monetary" economy that is sustained only by continued rampant credit creation and monetary injection. Sure, our financial sector can create additional claims, and this resulting purchasing power is easily spent on television advertising. But what true economic wealth-creating capacity is being added to support these new claims?


The reason it is worthwhile to analyze reflation and, perhaps, to profit from the reflation trade is that doing so helps traders and investors to, in Noland's words, focus on the "ramifications and consequences of The New New Game."

In many ways, the reflation trade is not unlike chasing hot money flows during the go-go years of emerging markets investing in the 1990s. Like the money pouring into Southeast Asian countries in the first half of the 1990s, the money made available by the Federal Reserve does not represent the fruits of productive enterprise so much as it does a sort of stipend or even a voucher. By this, I don't mean to suggest that some mandate states that this Fed-created credit can only be spent on certain specific goods and services. But it does mean that the route through which this "money" enters the economy will be a strong determinate as to which sectors of the markets and the economy respond. In this way, reflation is very much like inflation, which, as legendary Austrian economist F.A. Hayek observed more than 30 years ago:

. . . Produces the general state of euphoria, a false sense of well-being, in which everybody seems to prosper. Those who without inflation would have made high profits make still higher ones. Those who would have made normal profits make unusually high ones. And not only businesses which were near failure but even some which ought to fail are kept above water by the unexpected boom. There is a general excess of demand over supply — all is saleable and everybody can continue what he had been doing.

Hayek refers to the notion of full employment, the economic aspiration of a whole set of economists, democrats, laborers, and revolutionaries throughout the 20th century. Yet it is easy to overlay an as-yet-unspoken aspiration of "full investment" (an aspiration borne of the penultimate stages of the bull market era) upon this same inflationary or reflationary terrain. In such an instance, rather than guaranteeing full employment (as a condition in which there are more opportunities to produce than there are producers), Hayek's 21st-century planners end up steering the economy toward a condition in which there is more capacity — or opportunity — to consume financial assets than there are assets to consume. Credit expansion is every bit the main mechanism for the creation of this capacity (from stock market margins to home mortgages) as wage inflation was for the creation of full employment in the theories and imaginations of inflationists throughout most of the 20th century.

Especially noteworthy is the idea that this process manages to keep businesses that "ought to fail" in business. More than one market commentator has railed against the unfairness of allowing a telecommunications corporation like WorldCom to declare bankruptcy, rid itself of its liabilities, and then reenter the marketplace a few years down the road with advantages in cost-structure that its competitors that managed to avoid bankruptcy do not enjoy. Even more glaring is the criticism US observers have laid on Japan's "zombie corporations," which American economic partisans insist would have been allowed to go bankrupt under the US's far more efficient business culture. While that may certainly be true, it avoids the argument of the US's own zombie corporations that, while arguably possessing better balance sheets than their Nikkei-listed cousins, are no less card-carrying members of the economic undead.


What does this suggest about investing and trading in an era of reflation, however fleeting it may turn out to be? For those who see the rising bond, stock, and gold markets of the spring of 2003 as wholly manufactured by reflation, it means, at a minimum, that some caution should be deployed before attempting to fade any of these advances. As Jeffrey Saut, chief equity strategist at Raymond James, put it succinctly in an article by Aaron Task at "This is a liquidity-driven rally with too many dollars chasing stocks." The subtext of this observation is that great sport will likely be made of those bears who attempt to short the rally before the rally has exhausted itself. Indeed, Noland is convinced that much of the rally's staying (and rising) power is based on repeated attempts by bearish market timers to call a top and, in their failure, being squeezed into covering their positions at higher prices.

How does a bout of reflation end? There are two possible outcomes. The first is that those in control of reflation determine that the project has gone on long enough and, essentially, declare victory and let the market forces restore their own sense of value on the recently reflated marketplace. This would require a conviction that deflationary concerns were indeed overblown — a conviction that would virtually "dare" deflation to do its worst.

As much as Federal Reserve officials have claimed that deflation was unlikely, as well as assured the markets that the Fed was prepared to do anything it can to make sure "IT" doesn't happen here (as Fed governor Bernanke's historic address to the National Economic Club was partially titled), there are more than a few observers who are already convinced that deflation is, at worst, a fraud, and, at best, a convenient distraction. On the day that the S&P 500 hit 960 for the first time since the autumn of 2002, The Wall Street Journal published an editorial titled "The Seinfeld Deflation," noting that:

Looking ahead, the case for deflation seems even less convincing. The dollar, which has fallen decisively against the euro over the past year, may well fall some more. A weaker dollar generates inflationary pressure by raising the dollar-price of imports, while at the same time making imports less competitive and allowing domestic companies to raise prices.

The editorial concluded:

As a monetary gambit, in other words, uttering the word deflation has so far been a great tactical success. We suppose that's worth the price of scaring people about an economic threat that isn't very likely.

Putting aside for a moment both the insights of Hayek with regard to the inconsistency of price increases during inflationary episodes, as well as the reporting of Barron's Michael Kahn, who recently noted that indexes based around multinational corporations have actually lagged the S&P 500 since mid-March, it is interesting to note that both the editorial board of the Wall Street Journal and contrarian analysts like Doug Noland of Prudent Bear believe that there is, in some ways, less to the current fears about deflation than meets the eye — even if Noland's take on the Fed's "use" of the deflation threat is far more wary than (if not the complete opposite of) that of the editors at The Wall Street Journal.

Of course, a second outcome is that a failed reflation turns into outright inflation, with bond prices crashing and commodity prices — especially gold — soaring. One old economic canard suggests that nations are more willing to err in the opposite direction of that which has been their most problematic historical environment. In other words, Europe, which was crippled with hyperinflation in the 1930s (the time of the greatest economic crisis in modern history), is more likely to err in favor of tolerating deflation, rather than risk revisiting the horrors of inflation. Conversely, the United States, which experienced deflation during the Great Depression of the 1930s, is more likely to roll the dice with inflation than it is to allow deflationary psychology to take hold. This is backed up by the vigorously antideflationary comments from the Greenspan Fed. But it is also the more likely outcome, as seen by commentator Martin Wolf, who wrote in the Financial Times that:

In the post-bubble contractionary phase, the worry is deflation. But if the response is to generate a rising tide of private and public debt, the end game is more likely to be the writing off of that debt via inflation. It seems entirely plausible that 10 or, perhaps, as long as 20 years from now, economists will be far [more] worried about inflation than about deflation.

David Penn may be reached at


"The Seinfeld Deflation" [2003]. The Wall Street Journal, Editorial: May 29.

Faber, Marc [2002]. Tomorrow's Gold: Asia's Age Of Discovery, CLSA Books.

Hayek, F. A. [1996]. "Can We Still Stop Inflation?", The Austrian Theory Of The Trade Cycle. Ludwig von Mises Institute: Auburn, AL.

Kahn, Michael [2003]. "Getting Technical: Don't Blame The Dollar For Rally's End," Barron's Online: May 21.

von Mises, Ludwig [1998]. Human Action, Ludwig von Mises Institute: Auburn, AL.

Noland, Doug [2003]. "You Just Gotta Love Congressman Ron Paul," Credit Bubble Bulletin, May 23.

_____[2003]. "The New New Game," Credit Bubble Bulletin, May 30.

Task, Aaron L. [2003]. "Stocks Hit Resistance After Soaring Most Of Day," June 2.

Wolf, Martin [2003]. "The Fine Line Between Deflation And Inflation," Financial Times: May 28.

Current and past articles from Working Money, The Investors' Magazine, can be found at

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine,, and Advantage.

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