When the Baltic Dry Index (BDI), an index of international ocean-going freight rates, plunged to a multi-decade low early this year it provoked excited commentary from the “economic armageddon is nigh!” crowd. An example can be found HERE. However, bearish commentary is unhelpful after the prices of useful things have fallen to the point where the suppliers of these things are financially in dire straits.

There’s always a risk that the stock price of an individual company will go to zero, but there’s never a risk that freight rates or the prices of useful commodities will go to zero. Therefore, the further they move into an area where they are low by historical standards, the lower the downside risk will generally be.

I’m lumping ocean-going shipping rates and commodity prices together in this post because they are linked. They usually trend in the same direction and reach important peaks/troughs at around the same time. A consequence is that it doesn’t make sense to be bullish on commodities and at the same time anticipating a large decline in shipping rates, or bearish on commodities and at the same time anticipating strength in shipping rates. For example, after commodity prices reversed upward during January-February of this year it made no sense to expect a continuing downward trend in shipping rates.

The link between shipping rates (as represented by the BDI) and commodity prices (as represented by the Goldman Sachs Spot Commodity Index – GNX) is illustrated below. The two indexes have been positively correlated for a long time. Divergences are not uncommon, but the divergences are always short-term.

So, here’s an idea: Rather than piling onto the bearish bandwagon, when the real price of an indispensable service or commodity drops to a multi-decade low it might make more sense to be bullish.

A popular line of thinking is that the US banking system is not making as much use of its “excess” reserves as it should be because of the interest rate that the Fed now pays on these reserves. This line of thinking reflects a basic misunderstanding of how the banking system works.

There are two reasons why it is wrong to believe that the 0.50% interest rate now being earned by US banks on their reserves is encouraging the banks to stockpile money at the Fed rather than take a risk by making more loans. The first reason is that there is no relationship between bank lending (and the associated creation of new bank deposits) and bank reserves. I’ve covered this concept in previous blog posts, including HERE, so today I’ll focus on the second reason.

The second reason is that the banking system has no control over its reserves. An individual bank can reduce its reserves by lending reserves to another bank, but banks as a group have no say in the total quantity of reserves. In other words, even if the US banking system desperately wanted to reduce its collective reserve quantity it would be powerless to do so.

By way of further explanation, there are only three ways that reserves can leave the US banking system. They can be removed by the Fed (the Fed has unlimited power to add or delete reserves), they can exit in the form of notes and coins in response to increasing public demand for physical cash, or they can be transferred to governmental accounts at the Fed. The third way will always be temporary because the government is always quick to spend any money it gets, so there are really just two ways that the banking system’s reserves can decline: a deliberate action by the Fed or increased demand for physical cash within the economy.

In other words, regardless of how many loans are made and how many new commercial bank deposits are created, every dollar of reserves currently in the US banking system will remain there until the Fed decides to change the system-wide level or until it leaks into the economy via the conversion of electronic deposits to physical cash.

An implication is that changing the rate of interest that the Fed pays on reserves will not affect the pace at which banks expand/contract credit within the economy. For example, if the Fed increased the interest rate on reserves from 0.50% to 1.00% the banks would generate more interest income from their reserves, but there would be no change in the incentive to make new loans because the banks will earn this additional income regardless of whether they lend more or less money into the economy (the creation of a bank loan doesn’t cause bank reserves to disappear). For another example, if instead of paying banks a positive rate on their reserves the Fed started charging banks, that is, if the Fed adopted Negative Interest Rate Policy (NIRP), the banking system as a whole would have no additional incentive to grow its loan book since there would be nothing it could do to avoid the cost. In fact, the cost imposed by the NIRP could indirectly REDUCE the incentive to make new loans.

As an aside, this doesn’t guarantee that NIRP won’t happen in the US, especially given the evidence that the Fed’s senior management is almost as clueless as Mario Draghi. However, the obvious failure of the policy in Europe lessens the risk of it happening in the US.

Summing up, the interest rate paid on reserves cannot be a reason for either more or less bank lending. As explained previously, the only reason that the Fed began paying interest on bank reserves in late-2008 was to enable it to maintain control of the Fed Funds Rate while it pumped huge volumes of dollars into the economy and into the reserve accounts of banks.

in Australian dollar (A$) terms.

The A$-denominated gold price (gold/A$) made a correction low in April of 2013, spent about 18 months forming a base and then resumed its long-term bull market in late-2014. It will probably soon make a new all-time high.

It is useful to follow gold’s performance in terms of the more-junior currencies, for two main reasons. First, gold tends to bottom in terms of these currencies well before it bottoms in terms of the senior currency (the US$). Second, money can sometimes be made by owning the stocks of gold-mining companies operating in countries with relatively weak currencies even when the US$ gold price is in a bearish trend.

A good example is Evolution Mining (EVN.AX), an Australia-based mid-tier gold producer that I’ve followed at TSI for the past few years. As illustrated by the following chart, EVN commenced a powerful upward trend in late-2014 after basing over the preceding 18 months (just like gold/A$). It is now well above its 2011-2012 peak.

As a gold bull market progresses, the more junior currencies and especially the commodity currencies begin to strengthen relative to the US$. This causes the mining companies with operations in the US to start doing relatively well.

Most rational people with some knowledge of economic history will realise that the US$ will eventually be the victim of hyperinflation. The hard reality is that whenever money can be created in unlimited amounts by central banks or governments, it’s inevitable that at some point the money will experience such a dramatic plunge in its purchasing power that it will be at risk of soon becoming worthless. However, knowing this is only slightly more useful than knowing that the star we call the Sun will eventually die.

The relevant question is never about whether hyperinflation will happen; it’s about the timing, and at no point over the past 20 years (including right now) has there been a realistic chance of the US experiencing hyperinflation within the ensuing two years. Furthermore, the same can be said about deflation. A sustained period of deflation (as opposed to a short-lived deflation scare) will eventually happen, but at no point over the past 20 years (including right now) has there been a realistic chance of it happening within the ensuing two years.

So, when I say that the hyperinflation and deflation arguments are both wrong I mean that they are both wrong when dealing with practical investment time-frames. They are both actually right when dealing with the indefinite long-term.

By the way, when considering inflation/deflation prospects I only ever attempt to look ahead two years, partly because two years is plenty of time to take protective measures and partly because it is futile to attempt to look further ahead than that.

How do I know that neither hyperinflation nor deflation will happen in the US within the coming two years?

I don’t know, but I do know that neither will happen without warning. We are not, for example, going to go to bed one day with government and corporate bond yields near multi-generational lows and wake up the next day immersed in hyperinflation. Also, central banks are not going to be rigidly devoted to pro-inflation monetary policies one day, to the point where theories/models are never questioned and failure is viewed as the justification for ramping-up the same policies, and the next day be willing to implement the sort of monetary policies that could lead to genuine deflation.

Some people are so committed to the “deflation soon” forecast that they ignore any conflicting evidence. It’s the same for people who are committed to the idea that hyperinflation is an imminent threat to the US economy. However, an objective assessment of the evidence leads to the conclusion that it currently makes no sense to position oneself for either of these extremes. The evidence includes equity prices, corporate bond yields, credit spreads, the yield curve, commodity prices, the gold price, and future “inflation” indicators such as the one published by the ECRI.

The evidence could change, but what it currently indicates is that the signs of “price inflation” will become more obvious over the coming 12 months. No deflation, no hyperinflation.