No Stairway

At guitar stores everywhere, there is a blanket prohibition against playing Stairway to Heaven by Led Zeppelin. If you have never shopped for a guitar, and sat down with a shiny new axe to try it out, (a guilty pleasure of yours truly) you may be wondering what the fuss is all about. I mean, just think of the memories burned into our collective consciousness from thousands of playings of the iconic licks of that popular song . Wouldn't you want to proudly show off the results of your hours of practice to the staff and customers at Steve's Music or Long and McQuade?

Unfortunately the staff have heard the song before, probably played better, by a thousand other customers, and they are sick of it. So they universally ban its playing just to maintain their collective sanity.

It's too bad, because the song is great to play. Now, when I do play it, I feel an overwhelming guilt due to the disrepute that has befallen the performance of such a cliched relic of the past. As the noted philosopher Wayne Campbell would say..."Denied!".

U.S. CPI 1979-2017

So to, is the denial that many economists are feeling about inflation.

As the above chart depicting inflation shows, there is a 35 year decline in U.S. inflation that follows a stair step progression. Each recession since the late seventies has precipitated another step down in the data. Despite its best efforts, successive Fed reflation efforts have failed to generate a rising trend. Now the run rate is so low, the next recession will create deflation, if the progression holds. There is no stairway to economic heaven visible in this chart.

What's so bad about that? Why the thought of deflation so anathema to the central bank?

Deflation causes the holding of assets to have negative utility function. Why would anyone finance an asset whose value declines over time, assuring losses for those who finance it? The beneficial owners of real property are thus incented to sell them into a falling market, assuring more negative pressure on the price. As a result, a financial black hole develops in the economy, sucking equity value out of the national balance sheet, ultimately leading inexorably to default. Not a pretty picture, as the lost decades of Japan have shown.

The rumours surrounding the new Fed chair have recently added strength to the strong dollar. The expectations that a hawkish replacement is preferred are behind this strength.

What would be so bad about the appointment of an advocate of increased rates? Wouldn't the resultant strong dollar reflect the superiority of U.S. economic domination? Wouldn't risk averse savers finally be compensated fairly? Couldn't the political overlords in Congress claim "Mission Accomplished" in the post 2008 war on the economy. Wouldn't it be worth it just to get Rick Santelli to shut up?

Unfortunately, this would be a classic mistake of Fed policy error. The natural order of things is reversed in the post-inflation era that is now upon us. Instead of the risk to the economy from a Fed that is 'behind the curve', I see the risk of just the opposite. I'm in the camp that sees persistent deflationary bias as the dominant force to be battled. This thinking is not at odds with my previous comments supportive of a cyclical reflation scenario. The two can coexist temporarily . In fact this interplay is what will dominate the mini-rotational sector leadership battle over the next few quarters. But it is a temporary respite from the major downward trend.

In Washington, there are stirrings of a new monetary zeitgeist. The current odds-on favourite Chair candidate is Kevin Warsh, a previous Fed member who is as hawkish as they come. He would have had the Fed raising rates as far back as 2010. This would have been a disaster, one that would have piled-on to the systemic weakness from the 2013 Eurozone decline.

His thinking has a potentially dangerous emphasis on a more prescriptive approach to the economy, and it is gaining credence in Washington. I believe his possible Chairmanship could mark the beginning of the end for this cycle. He was schooled in the thought that the economy works in one direction and are always prone to an inflationary bias. Wrong! , Fake News!

The root cause of the confusion surrounding the inflation/deflation debate is the secular decline in the role of money in the economy. The hawks point to the excess supply of liquidity in the economy and its potential to unleash an inflationary spiral. Countering that argument is the persistent collapse in the velocity of money as shown below.

The utility of money has experienced a secular decline as a result of the removal of frictions that previously impeded its turnover. As usual the culprit is the computer and the internet. Financial innovation, regulatory reforms and internationalization have all played a role in the increased efficiency of the modern monetary system. We simply don't need as much money to run the economy anymore.

Aside from these esoteric monetary arguments, I point to secular deflationary forces that have been unleashed by the confluence of demographic and micro-structural efficiencies underpinned by the internet. We are pushing an inflationary rock up a hill.

I wonder if this is lost on the monetary hawks that are currently in ascendancy. They are Pavlovian in their responsiveness to inflation and the next few months should see lots of stimulative inflationary data. Should rate hikes begin to accelerate, I can see the path that the markets and economy will be take, and it won't be pretty. If a stronger dose of tough monetary love is applied from the new Fed, watch for the dreaded 2s-10s curve inversion.

Inflation, in my view is on 'No Stairway to Heaven'!

Yes, there are two paths you can go by,

But in the long run,

There's still time to change the road you're on.

And it makes me wonder.

RISK MODEL : 5/5 - risk on

The XIU is only overbought short term as the weekly RSI is rising but below the danger level of 70 . The market is still less than 10% above the 200 dma.

Sentiment has checked back from last week's spike, but is still constructive. The Vix is comatose.

Copper/Gold is supportive and accelerating.

Oil has failed to breakout to the upside as the strong dollar and weak seasonality halted the rally. I'm stopped out for now.