Deflation is a contraction in the total supply of money and credit in an economy. Inflation is an expansion of the total supply of money and credit in an economy.

In 2008, the Federal Reserve (Fed) decided to commence a policy of hyper-inflation by printing monetary tokens. The policy of hyper-inflation they call Quantitative Easing (QE) and the monetary tokens they call US dollar bills.

QE is a fancy name for the Fed’s purchase of assets such as bonds. They bought the bonds which became assets on the Fed’s balance sheet. They paid for those bonds by creating US dollars out of thin air and thus expanding the amount of dollars in the economy (the money supply). As our chart shows, since 2008 the Fed’s balance sheet and the money supply have both ballooned. This is inflation.

Now the Fed have told us that the QE policy is going into reverse – what we will call Quantitative Tightening (QT)). In fact, they have told us that the new policy (QT) will begin in the fall of this year and so, with the Fed’s balance sheet and money supply starting to contract, that is when deflation starts. How will QT work and what effect will it have?

The bonds that the Fed bought mainly consisted of US Treasuries and mortgage-backed securities (MBS). They can employ QT in two ways. First, they could sell the bonds back to the market directly. That would be quite risky because the bond market may not be able to absorb the supply and interest rates (yields) would rise quickly. The second route, the Fed’s preferred course, is to let its bonds mature but not re-invest the proceeds (which it has been doing up until now). The US dollars that the Fed receives will be tucked away inside in the Fed (in reality, in digital bookkeeping form) and so will not be part of the money supply. Thus, the Fed’s balance sheet and the money supply both contract. This is deflation.

The Fed’s balance sheet currently stands at around $4,500,000,000,000 (that is $4.5 trillion to those not used to seeing the reality of all those zeroes). They have around $2.5 trillion in US Treasuries and $1.8 trillion in MBS. The Fed’s MBS holdings represent about a quarter of the entire market and so retreating from those bonds will be a tricky process. The chart below shows that MBS bonds have already started to underperform with the yield spreads to Treasuries rising. As for Treasuries, the Fed mostly has short-end bonds and one worry about the policy of not re-investing (rather than selling) is that a huge amount matures in 2018/19 (about $777 billion). That is a big contraction in the money supply in a short space of time. The Fed will slowly deflate its balance sheet (QT on the QT), and so it may take a number of years but a huge support for the bond market is disappearing.

And how about the stock market; how will it take the Fed’s deflation policy? Since March 2009, the stock market has been a beneficiary of the Fed’s inflation of the money supply – the Quantity Theory of Money effect has been seen mainly through asset prices rather than goods and services. So it would be logical to assume that Quantitative Tightening will be bad for the stock market.

In fact, we already have a good idea of how the markets will behave over the next year or two based on our Elliott wave analysis, which is predicting bear markets in both stocks and bonds. That analysis, of course, is independent of any knowledge of the Fed’s deflation policy. But you can bet your bottom dollar (or Fed token) that the entire world will link those bear markets with the Fed’s decision to deflate.

 

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