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Thursday, December 16, 2010

The US crisis ahead, inflation vs deflation

As previously covered, the US government bond market is a key component for the economy.
The ability for the US government to continue to deficit spend and be able to finance such activities depends on interest rates. If rates explode higher, the cost of debt rises, and will curtail government ability to continue unlimited spending.

There are two primary camps in the apocalyptic view of the world of the fate of the US, the US dollar, and debt.

View one is that Ben Bernanke and the federal reserve will be able to inflate us out of this mess. Please keep in mind that if they succeed, that will mean the cost of EVERYTHING will rise, but historically societies do NOT keep up with wages to compensate for higher cost of living. The net will be a very painful period as people struggle to pay their bills, or simply just to buy food. Part the transition expect middle class america wiped out. What will remain is the upper 5% and then everyone else. The good news is, people can pay their debt off with a much less percent of their income, since their income will go up, but the debt owed will not.

The other view is the US government becomes under such stress, they curtail their financial bottom line. This will cause more private companies to fail, more bankruptcies, and less government spending. The less credit/money available, the more deflation will take over. The US dollar will remain relatively strong, and purchasing power of people who save will be maintained.

The moment of truth
I am in the camp at the moment that we will see a currency crisis, that will result in the US dollar to go down as faith in the dollar diminishes.

The moment of final tipping point will be with a bond market crisis results in the inability for the US government to sell debt at a rate it offers. The bond market demands of the US government will default, higher prices for bonds.

It will be then that we will know if the dollar remains relatively strong, or collapses. (over time)

No matter who you talk to, if they know for a fact it will be one way or another, it is to say that you know how people will act in pressure or crisis situations.
The fact is, people are not always predictable. Keep an eye out for the bond market crisis moment and act accordingly once a new coarse is set.

What I CAN say to tip the scales is we have not had significant bouts of deflation since the creation of the federal reserve bank in 1913. See chart below and read more at The Market Ticker.

This indicates the likely (but not certain) outcome will be the USD thrown under the bus to avoid deflation.

Below is inflation vs deflation rates since 1750. Notice that once we went off a gold standard, there is only monetary inflation.

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