The Deflationary Puzzle is Coming Into Focus

Interesting time on markets.

The Bank of Japan (BoJ) — Kuroda denied they’d take rates into negative territory — then took rates into negative territory — minus 0.1%.

Markets went wild for a day or so, but then reality set in. How bad are things to warrant this sort of action? Japan is now the fifth central bank to wander into negative territory and it won’t be the last. No doubt the Fed will be closely watching this action. It’s an each way bet the Fed’s next interest rate move could be down and not up.

Remember 2013 and PM Abe’s determination to create inflation with the boldest money printing program in history? Didn’t work.

You can lead the horse to water but you cannot make it drink. If people do not want to borrow and/or spend and/or invest in over-priced assets, no amount of carrot dangling will change their minds.

My guess is the BoJ action was more to do with weakening the Yen to maintain a pricing edge over the European and Chinese exporters. If the Japanese exporters can gain market share use to a pricing advantage, then those extra yen can be used to give workers a pay rise and boost spending. At least that’s the theory. But as we know, central banker theory and what happens practice are usually poles apart.

For instance, workers may decide to save rather than spend.

The Great Credit Contraction is a force the central bankers cannot combat. Millions and millions of boomers all around the world are changing their consumption habits as they prepare for or enter retirement.

The falling oil price has seen the previously unspoken threat of credit defaults now being openly spoken about. Markets are nervous about how much longer indebted resources companies can keep up the appearances of solvency. When that dam wall breaks, watch out below.

More job losses in the high paying resource sector are being flagged by Shell, South32, BHP et al. How many of these people will find less well paid work in the only sector of the economy that appears to be booming…coffee shops. Is it me? Does anyone else wonder how many more coffee shops and/or coffee carts our population can support? And if everyone is drinking coffee, who’s at work?

News is spreading about the four regional Italian Banks that required a bail-in in late 2015. Shareholders and bondholders lost the lot.

Italy’s headlines were dominated by the suicide of a pensioner who lost his life savings. Instead of being a depositor (earning next to nothing on his account) he invested into bank bonds (effectively lending his money to the bank for a higher interest rate return). Under the new bail-in rules — shareholders go down first, followed by bond holders and then those with deposits above the 100,000 euro deposit guarantee take a haircut. Only after everyone associated with the bank (except the executives who knew enough to not put their own money in the bank) has been turned upside down, then taxpayer funds can be called upon to make up any shortfall.

The palms of investors holding European bank bonds (think of hybrid securities) are a lot sweater these days. The risk associated with that extra few percent of return is suddenly coming into focus.

People are going to learn (again and again) that when the proverbial hits the fan it is all about return of capital not return on capital.

Italy is the world’s eighth largest economy…Italy matters far more than Greece ever did.

The rot in the European financial and socialist system is working its way through Europe.

Europe has the twin concerns of ‘how safe are our banks’ and ‘how safe are our streets’.

These may only be murmurings at this stage but you can be assured if there are more bank bail-ins and/or rapes attributed to refugees, then social unrest will move up a level.

This creates a headache for establishment political parties appealing for calm and rational thinking. No one listens. The crowd wants to hear from fringe political groups that feed them back their concerns with promises that can never be met. Remember how vocal Greece was about telling Germany where it could put its austerity measures? In the end Greece whimpered like a baby.

The Greeks are back in the streets protesting against the government they thought would rescue them from financial purgatory.

Populists politics plays out well for a little while. But these ‘big talkers and little deliverers’ cannot fix the deep set problems of too much debt and too many promises. In fact their hare-brained policies only make a really bad situation, a whole lot worse.

The only cure for the ills affecting the world is to tell people the truth — we cannot live the lifestyle we’ve become accustomed to and been promised. The gravy train has stopped. Time to take our medicine.

Debts need to be repaid. Generous welfare entitlements need to be withdrawn. Retirements postponed.

Good luck finding a brave political soul who wants to deliver that announcement? So they’ll fidget and fudge with the most politically acceptable way to put their hands deeper into our pockets. Spending cuts are taboo in this world of total appeasement.

Therefore, in the time honoured way, the market will to do the dirty work and deliver the message in its uncompromising and brutal fashion.

The market could not give a rat’s backside about who it hurts. If you’re standing in the way of the purge, you’ll cop the brunt of it…no quarter will be given.

Then and only then, will we see a political reaction to rein in spending…much like Greece and co. begrudgingly adopting austerity measures.

It shows you how far we’ve come from prudent financial management, when the word ‘austerity’ is psychologically linked with hardship. When in reality austerity means living within your means and paying your dues. What’s so wrong about that?

Back home in Australia, the RBA kept rates on hold as expected. There’s not quite enough bad news out there yet. But it’s coming.

The China slowdown. The European winter of discontent — yet another downward revision in growth. Falling commodity prices. A stronger Aussie dollar (not good for our exporters). A weakening US economy — manufacturing index slumping to its lowest level since 2009. Emerging market debt concerns. Transportation indices showing a global slump in consumption.

All these and more, are signposts on the one-way deflationary path we are headed down.

In response to these mounting pressures the RBA is going to take us much closer to the 1% cash rate. Our dollar will follow the rates down.

The gold price was one bit of bright news for the week. Moving up to US$1155 an ounce…although our stronger currency has taken some shine out of the rise in Aussie dollar terms.

Our market can’t take a trick. Looks like it’s going to launch above 5,000 points, only to succumb to gravity and fall right back down again.

Wait till the real fireworks starts on markets, people are going to long for the day when the market was close to 5,000 points.

I’m just getting this feeling that things are starting to overpower the central banks. Even though seven years of stimulus hasn’t worked, they won’t (or, can’t) give up on their academic theories. But they are running out of theories…or at least the theories they’ve tried to date. Perhaps they have something ‘nuclear’ up their sleeve we don’t yet know about.

Logic says they would have used it by now. Then again logic and central bankers are not mutual bedfellows.

Another week, another step closer to the central bank’s Wizard of Oz being revealed.

Something tells me we are going to wake up one day in the not too distant future and all hell will have broken loose on the overnight markets.

News anchors will be madly trying to interview ‘a respected economist or analyst’ to explain what happened. The fact these people never saw it coming is immaterial. They sound knowledgeable and will offer the usual reassuring words of ‘no need to panic, this could be a good buying opportunity’.


The market has a lot of work to do in clearing out the excesses in the system that have built up over the past four decades.

The time to invest will be when these not-so-respected economists or analysts sit there dumbfounded and express concern about whether the markets will ever be safe to invest in again.

But that point is a little way off.

In the meantime we watch and wait (from the safety of cash) for all the pieces of the puzzle to fall into place.


Vern Gowdie

Editor, Markets and Money

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Vern Gowdie has been involved in financial planning since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners. His previous firm, Gowdie Financial Planning was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser (IFA) magazine as one of the top five financial planning firms in Australia. He has been writing his 'Big Picture' column for regional newspapers since 2005 and has been a commentator on financial matters for Prime Radio talkback. His contrarian views often place him at odds with the financial planning profession. Vern is is Founder and Chairman of the Gowdie Family Wealth advisory service, a monthly newsletter with a clear aim: to help you build and protect wealth for future generations of your family. He is also editor of The Gowdie Letter, which aims to help you protect and grow your wealth during the great credit contraction. To have Vern’s enlightening market critique and commentary delivered straight to your inbox, take out a free subscription to Markets and Money here. Official websites and financial eletters Vern writes for:

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