Inflationary deflation creating a new bubble in money

Thunder Road
Report

INFLATIONARY DEFLATION:
creating a new bubble in money

Central banks versus the Long Wave

December 2012

Market Strategy
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December 2012 | Thunder Road Report

INFLATIONARY DEFLATION: creating a new bubble in
money
Excessive monetary stimulus and low interest rates create financial
bubbles. Central banks are creating the ultimate bubble in MONEY
itself, as they fight the downward leg in this Long Wave cycle.

First it was NASDAQ, then it was real estate and securitised debt, now it’s money

Source: Jeff Kubina / Foter / CC BY-ND (and for front cover)

This is the biggest debt bubble in history. Each time DEFLATIONARY
forces re-assert themselves, offsetting INFLATIONARY forces (monetary
stimulus in some form) have to be correspondingly more aggressive to
keep systemic failure at bay. The avoidance of a typical deflationary
resolution of this Long Wave is incubating a coming wave of inflation.
This will not be the conventional “demand pull” inflation understood by
most economists.

The end game is an inflationary/currency crisis, dislocation across
credit and derivative markets, and the transition to a new monetary
system, with a new reserve currency replacing the dollar. This makes gold
and silver the “go-to” assets for capital preservation.

Strategically, we are far more bullish on equities versus bonds.
Tactically, equities face a volatile period - buffeted by alternating cycles of
deflationary and re-flationary forces until they overcome bonds as the
inflationary endgame unfolds. In that scenario, equity investments
should (over time) be aligned with the growing share of real
disposable income directed towards essential expenditures, including
energy, food/agriculture, personal & household care, mobile
telephony and defence (for governments).
Paul Mylchreest The “Inflationary Deflation” paradox refers to the rise in price of almost
Market Strategy
+44 (0) 20 7107 8049 everything in conventional money and simultaneous fall in terms of gold.
paulmylchreest@seymourpierce.com
This is a marketing communication. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is
not subject to any prohibition on dealing ahead of the dissemination of investment research.

Thunder Road Report | December 2012 Executive summary

Table of Contents

Executive summary 3

Investment strategy 6
Equities 6
Gold 8
Commodities 10
Government bonds 11
Housing/Real Estate 12

Introduction – a long wave framework 13

Current long wave – forming a new bubble 16

Why is the long wave useful for investors? 19

Detailed analysis of the Kondratieff long wave 23
Spring 28
Summer 31
Autumn 36
Winter 40

Winter phase of the current long wave 46
Part 1 – 2000-2012 46
Part 2 – the approaching wave of inflation in 2013-15 53

Transition to a new monetary system 67

Have you seen this man? 71

This report is aimed primarily at equity investors. However, the Long Wave framework
applies equally to other asset classes such as gold, commodities, government bonds
and housing/real estate. The success of this framework in asset allocation during the
four long waves since 1788 is discussed below – as well as potential investment
strategies for the transition to the next long wave during 2013-15.

2 Seymour Pierce equity research

Executive summary Thunder Road Report | December 2012

Executive summary

This report reviews prospects for 2013-15.

Long wave framework shunned by mainstream My strategic framework is based on the long wave or Kondratieff Cycle, which is
despite track record on asset allocation shunned by the mainstream. However, it does have advantages:

• Back testing it (below) shows that if you can identify which of the four
phases of the long wave cycle you are in, you had an 90.1% chance overall of
identifying which asset classes – out of equities, government bonds,
commodities, housing/real estate and gold - would outperform and which
would underperform during the last two centuries; and

• It also highlighted the inevitability, if not the precise timing, of the 2008
“Great Financial Crisis.”

Once again, it is signalling that another crisis is looming on the horizon.

It’s the debt, stupid It is debt, as much as anything else, which has driven the rise and fall in the long wave
cycles of capitalist economies dating back to the Industrial Revolution. Debt brings
forward consumption – and rapid growth in debt borrows more and more
consumption from the future into the present - until the system becomes overloaded
and needs to reset. We have had three cycles in this process since 1788 and are
currently in the late stages of the fourth. This is the biggest debt crisis ever, but it
seems to be in the nature of financial markets that, periodically, the lessons of history
are forgotten.

Last three long waves resolved by deflations In their final, downward phase (known as a “Kondratieff Winter”), the “resets” of the
last three long waves have occurred via deflationary depressions in the aftermath
of financial crises. Said financial crises were the Panic of 1825, Panic of 1873 and the
Crash of 1929. Some of these “resets” were relatively short but very sharp, e.g. like
1929-33, while others were prolonged, e.g. the 23 years from 1873-96. Historically, it’s
not been until excess debt, misallocated capital and speculative bubbles have
been sufficiently purged from the system that a new long wave cycle begins.
Unpalatable as it is, we are stuck in the Kondratieff Winter of the current long wave
which is why, no matter how much money policy makers have thrown at the problem,
a robust and sustained recovery has proved elusive thus far. Indeed, today’s policy
makers are compounding the problem by piling more and more debt on top of an
existing debt mountain.

Kondratieff Winter in this cycle began with The final “Winter” phase of this long wave began with the NASDAQ crash in 2000 –
NASDAQ crash in 2000 when the debt/GDP ratio of 270% in the US economy was a similar level to the peak
during the Great Depression. US debt/GDP is currently c350%. The natural tendency
(i.e. economic gravity) towards deflation was overwhelmed by Greenspan’s use of
what were (then) unprecedented low interest rates (Fed Funds at 1%) to reflate the
economy. This led to the next bubble in real estate and securitised debt. When
Lehman crashed in 2008, it took even lower interest rates (ZIRP), a bailout of the
banking system and trillion dollar Federal deficits in the US, to reflate the
economy.

This time policy makers can create unlimited Unlike earlier cycles, we are in a world of UNLIMITED CREDIT CREATION. Central
amounts of money in contrast to previous long banks will not permit a debt deflation under any circumstances – which would
waves likely bring on systemic failure at this point in any case. Keeping the bubble inflated is
still taking trillion dollar deficits, but has recently been supplemented by open-ended
money printing (QE), not just in the US, but by other central banks in the developed
world. Apart from brief pauses, this process will continue.

This is creating the ultimate financial bubble, in MONEY itself, as every time
deflationary forces re-assert themselves, the offsetting inflationary forces (monetary

Seymour Pierce equity research 3

Thunder Road Report | December 2012 Executive summary

stimulus) have to be more aggressive. This is not sustainable and is incubating a
coming wave of inflation, which will eventually explode in currency crises.

There will still be debt reduction and deflation – The two key themes of Kondratieff Winters, DEBT REDUCTION and DEFLATION, will
just in a different form also play out in the resolution of the current long wave, just as they did in earlier
cycles. However, due to extreme policy activism in creating money on the part of
central banks, they will be in a different form:

• Debt reduction via INFLATION; and

• DEFLATION in the prices of almost everything in terms of gold.

The paradox of inflationary deflation This is the paradox of simultaneous inflation and deflation, hence the term
“INFLATIONARY DEFLATION” in the title of this report. The measurement of the
inflation or deflation merely depends on the respective definition of money.
Following the NASDAQ crash in 2000, we have had inflation measured in one kind of
money and deflation measured in another:

• Inflation in the price of almost everything, i.e. goods, services and asset
prices, in CONVENTIONAL MONEY; and

• Deflation in the price of almost everything – goods & services and asset
prices – IN HARD MONEY, i.e. GOLD.

An approaching wave of inflation is far from a This process is already fairly advanced but should accelerate as we go through 2013.
consensus view The approaching WAVE OF INFLATION across the US and the rest of the world
during 2013-15 remains far from the consensus view and, therefore, deserves
explanation.

We have been in an inflationary mega trend for Most commentators don’t appreciate that we are already in an INFLATIONARY MEGA
more than a century! TREND and, as a result, are underestimating the in situ inflationary forces. The current
price upwave, or “Great Inflation”, began in 1897. It is the fourth and most powerful in
the last one thousand years. The second, which lasted from 1496-1650, became known
as the “Price Revolution”, due to its severity at the time. The CAGR in the price level of
1.2% p.a. during those 154 years qualifies as “price stability” for today’s central bankers!

The forces which drew the last three Great Inflations to a close are NOT currently
in prospect. In the case of the first two, plague and warfare led to significant
reduction in the world population. A decline in silver supply, then the world’s money,
also contributed to the second. In the third, Britain got sound money “religion” and
adopted the gold standard in the wake of the inflationary Napoleonic Wars and the
War of 1812.

Inflation picks up sharply in the latter stages of Looking back at the last three Great Inflations, inflation accelerated in the late
these “Great Inflations” stages of all three. The recent QE3 announcement by the Federal Reserve, with
similar programmes by the ECB and BoJ, has pushed us into unprecedented situation
of open-ended money printing across the over-indebted, developed world. The
debasement of currencies has moved into a more rapid phase, which will lead to a
repeat of the late-stage acceleration of inflation seen during earlier price upwaves, in
my opinion.

Many commentators who disagree with the likelihood of a sharp upturn in inflation
point to the comatose reading for the velocity of money. They overlook two facts
compared to historic examples of hight/hyper-inflations, such as Weimar. In the early
stages of the rise in prices, the velocity of money can remain stable AND the rise in
prices can lag the increase in the money supply – just as we are seeing today. Then a
tipping point is reached, when velocity spikes upward and prices rise faster than the
increase in the money supply, as confidence in the value of the currency suddenly
plummets.


Executive summary Thunder Road Report | December 2012

Foundations of the US dollar’s reserve currency Looking at the US dollar, for example, the foundations of its reserve currency status
status are being dismantled but few are being dismantled while few commentators acknowledge the gravity of what is
commentators are paying attention taking place. Let’s briefly consider two “sacred cows” touted over the years as
necessary to maintain its status as the world’s reserve currency:

• China HAS to buy US Treasuries: because not to would jeopardise a
vital trading partner and export market – “mutually assured destruction”
for want of a better phrase. In reality, China is showing a marked
reluctance to continue financing US deficits since its holdings are down
US$160bn from the peak in July 2011 (just before S&P downgraded the
US AAA credit rating – no coincidence); and

• The dollar has a MONOPOLY on world trade: the BRICS nations signed
an accord in March 2012 to increase trade in their local currencies – it is
now policy. China is taking the leading role and has either begun trading
in local currencies or agreed currency swaps in order to permit this with
a long list of trading partners including: Germany, Japan, Russia,
Australia, Brazil, Chile, Taiwan, UAE, Thailand, Indonesia, Malaysia and
Kazakhstan. In July 2012, trade in Yuan accounted for 10% of China’s
trade compared with zero two years ago. Preparations to replace the
dollar are advancing.

Eerily similar to what happened before the last What’s happening today is eerily reminiscent of the circumstances which led to the
change to the monetary system demise of the last monetary system (Bretton Woods) in 1971. The main protagonist
back then was France - then a major trading partner of the US. France was an
outspoken critic of the existing system and the “exorbitant privilege” afforded the US
by the dollar’s reserve status. With large US deficits due to war (Vietnam) and welfare
spending, France stopped buying US Treasuries and started buying gold aggressively.
Bretton Woods collapsed as the value of the dollar and other currencies (e.g. British
pound) fell sharply and the gold price surged. We have very similar circumstances
today, with China replacing France as the main protagonist. China’s President
described the dollar’s role as a “product of the past” last year and, like France, China
has reduced its holdings of US Treasuries and is buying gold aggressively.

An inflationary crisis is looming on the horizon…. We are in the incubation period for the coming inflationary crisis – at the centre of
which is the US dollar – although its decline might lag that of other major currencies,
such as the Euro, Yen and Pound. This will not be the typical “demand pull” type of
inflation recognised by mainstream economists (at least until its late stages, when
there is a risk of a “crack-up boom”). Instead it will be caused by:

• Dramatic LOSS OF CONFIDENCE in the purchasing power of existing
currencies: due to rapidly expanding central bank balance sheets (from
monetising debt) and governments’ inability to reduce VERY high
deficits;

• Declining need for dollars as they lose monopoly on world trade; and

• Rising prices for essential commodities, like food and energy.

The term “cost push” inflation is arguably a better phrase for this type of inflation.

….leading to a new monetary system with a new When inflation leads to more serious currency crises, we will see a “reset” and the
reserve currency transition to a new monetary system. High level “insiders”, such as the heads of the
People’s Bank of China and the World Bank have signalled likely elements of the new
system. The dollar will be replaced as the reserve currency with a currency basket
based on an expanded version of the IMF’s Special Drawing Right (SDR). The SDR
is a reserve asset held by central banks which currently consists of the US dollar, Euro,
Yen and Pound. In the new system, it is likely to be expanded to include the Yuan and
possibly other BRICS currencies, and have some indirect backing by gold (at a much
higher price).


Thunder Road Rep
port | December 2012 Investment strategy

Investm
ment strategy

In a norma DEFLATION
al NARY Kondrat tieff Winter, a
asset allocation would be easy.
Gold and g government bonds would outperform, a they did in the Winter p
o as phases
of previou s long wave while equ
es, uities, commo odities and real estate w would
underperfo orm. Thanks to policy makers, this is not “normal” and deflati
t ion in
convention money is not on the agenda, so the purchasing power of curre
nal n encies
in the ove r-indebted, developed wo
d orld must bea the brunt of this long wave
ar
resolution. I wish that equities were the best asse class in this scenario, bu t that
t et s
is unlikely to be the ca – the acc
ase colade belong to moneta metals (gold &
gs ary
silver). How
wever, I would put equities in third plaace behind the monetary m metals
and essentiial commoditi (food & en
ies nergy).

Equities
s
Eq
quities normally underperform in inflation or
n Historically, equities have underperfor
e rmed during the inflationary (Summer andr)
deflation deflationary (Winter) ph
y hases of a Kondratieff long wave. While this does not augur
well, the ressolution of this long wave will be differe as discusse - with significant
w ent ed
implications for equity performance.
s

Near term, eequities should be volatile - moving in ta
andem with an alternating cycle
of deflatio nary and re- -flationary forces before w reach the final stages in the
we
resolution o what is an ab
of bnormal Kondratieff Winter.

An inflationary end to this long wav presents a
ve While my e nary end to th long wave, this still presents a
expectation is for an inflation his
conundrum for equities
m conundrum for equities. On the negativ side, there are challenge including:
O ve es

• The debt-d driven over-co onsumption o recent decades has yet to be
of
pared back. But the likelihood that de will be inflated away is better
ebt
for equities than the debt deflations at t end of pre
the evious long waves;

• There rema ains a high risk that EPS est
k timates are too high, at le
east in
real terms. For the S&P 500, for examp Bloomberg consensus is for a
5 ple, s
further 10.6 EPS growth in 2013 and 11.9% growth in 2014. Mean
6% h nwhile,
corporate profits as a percentage of GD are at an all-time high;
p DP

S&P 500: EPS and for
recasts for 2013-
-14 US co
orporate profits as a % of GDP

140 40%

130 35%

120 30%

110 25%
100 20%

90 15%
80 10%

70 5%

60 0%
2010 2011 2012 2013 2014

S&P 500 EPS
S Yr-on-yr %

Source: Bloomberg

uldn’t contract a much as in
PE ratios shou as • The next tw charts show how PE ratiios have com
wo w mpressed durin the
ng
p
previous inflationary periods inflationary phases of the last two long waves, i.e. 19
e g 912-20 and 19667-80.
That said, you can see that interest ra
y ates rose signnificantly (and from
d
much highe levels) dur
er ring both per riods – somet thing which c cannot
happen this time without completely co
s ollapsing the world economy
w y;

e

Investment strategy Thunder Road Report | December 2012

S&P 500 PE ratio (left) and 10-year Treasury yields 1912-20 S&P 500 PE (left) ratio and 10-year Treasury yields 1967-80

16.0 7.0 20.0 14.0

14.0 18.0
6.0 12.0
16.0
12.0 10.0
5.0 14.0
10.0 12.0
4.0 8.0
8.0 10.0
3.0 8.0 6.0
6.0
6.0 4.0
2.0
4.0 4.0
1.0 2.0
2.0 2.0

0.0 0.0 0.0 0.0

1971

1974
1969

1976

1979
1968

1978
1970

1980
1975
1973
1972
1967

1977
1912 1913 1914 1915 1916 1917 1918 1919 1920

S&P 500 PE ratio 10-yr Treasury yield S&P 500 PE ratio 10-yr Treasury yield

Source: S&P, Federal Reserve Source: S&P, Federal Reserve

• Demographics in many western economies are unfavourable. On
average, the peak in earnings and spending occurs at approximately
48.5 years of age. The US birth rate peaked in 1961, while the UK peaked
a few years later.

On the other hand, there are some significant positives for equities:

Some real asset backing unlike government • Besides generating earnings, equities also have a reasonable degree of
bonds “real asset” backing in contrast to the paper “tokens” (bonds) of
bankrupt sovereigns. The price to book value of the S&P 500 is in the
mid part of its 10-year range;

S&P 500 price to book value (10 years)
3.50x

3.00x

2.50x

2.00x

1.50x

1.00x
Apr-21-2011

Sep-15-2011
Feb-03-2004

Jun-29-2004

Nov-19-2004

Feb-03-2006

Jun-29-2006

Nov-21-2006

Apr-22-2009

Sep-15-2009
Feb-07-2008

Jul-02-2008

Nov-24-2008
Apr-18-2005

Sep-09-2005
Apr-15-2003

Sep-09-2003
Nov-18-2002

Feb-09-2012

Jul-05-2012
Feb-09-2010

Jul-06-2010

Nov-26-2010
Apr-20-2007

Sep-13-2007

S&P 500 Index (^SPX) - P/BV

Source: Capital IQ

• In a tough economic environment, CEOs are likely to be more effective
at cutting costs than politicians;

• The balance sheet of the corporate sector as a whole is very strong at
present;

• Many companies make essential items that we use every day;

Central banks and sovereign wealth funds starting to increase weightings in
equities

Increasing equity allocations In recent years, several central banks and sovereign wealth funds have
begun to allocate a proportion of their reserves to equities. The Swiss
National Bank had 12% (about US$63bn) of its reserves in equities at the end
of September 2012, up from 10% three months earlier. The Bank of Israel


Thunder Road Report | December 2012 Investment strategy

invested 2% of its funds in equities earlier this year and plans to raise this to
10%. The Czech Republic has lifted its equity weighting to 10% and South
Korea to 5.4%. According to a Reuters report from 5 October 2012: “Sixty
percent of reserve managers consider that equities are more attractive than a
year before, according to a survey of 54 central banks”

The BIG ONE….flows from the bond market in the • As we reach the final stages of this Kondratieff Winter, the biggest
final stages potential support for equity prices in my opinion is CAPITAL FLIGHT
OUT OF THE (VAST) BOND MARKETS as the latter succumb to rising
inflation.

Thematic strategies In my scenario of a strong pick-up in inflation as we transit through 2013-15, the next
question is what equity themes are likely to be successful. In my opinion, the answer is
to align equity investment with capital preservation and changes in real personal
disposable income flows. While high quality gold and silver equities are one way of
playing capital preservation, a growing share of real disposable personal income will
be directed towards essential expenditure such as:

• Energy (especially crude oil);

• Food/agriculture;

• Personal & household care;

• Mobile telephony & networking; and

• Defence (for governments).

Below are examples of large cap. stocks which should be beneficiaries:
Pan European North America

1. Randgold Resources 1. Goldcorp
2. Fresnillo 2. Pan American Silver
3. Royal Dutch Shell 3. ExxonMobil
4. AMEC 4. Schlumberger
5. Centrica 5. Southern Corp.
6. Yara International 6. Potash
7. Syngenta 7. ADM
8. Nestle 8. Kraft Foods
9. Unilever 9. Colgate Palmolive
10. Smith & Nephew 10. Johnson & Johnson
11. Imperial Tobacco 11. Philip Morris
12. Vodafone 12. Verizon
13. ARM 13. Qualcomm
14. BAE Systems 14. Lockheed Martin

Source: Seymour Pierce

Gold
No counterparty risk in a debt crisis We are in the biggest debt crisis in history and physical gold is the ONLY financial
asset with no counterparty risk and a several thousand year track record as a store
of wealth par excellence. Furthermore, gold is the only asset which outperforms
during both inflation and deflation and we are seeing a battle to the death in these
opposing forces.

Some commentators doubt gold’s outperformance during deflations, but a study of its
performance during the Winter (deflationary) phase of previous Kondratieff long
waves and the empirical work on the subject - Roy Jastram’s 1977 study, “The
Golden Constant” with data since 1560 - should suffice.

The prospect of an eventual victory for the inflationary forces and the eruption of
currency crises make physical gold (and silver) the go-to assets in this scenario.


Investment strategy Thunder Road Report | December 2012

They continue to be shunned by many mainstream investors and are heavily under-
owned.

End game – the valuation of gold is the Some investors are fearful that they will be too late joining an 11-year bull market.
reciprocal of the value of fiat money However, in the end game, the gold price will reflect the reciprocal of the
purchasing power of existing currencies, which are being debased at an
increasingly rapid rate.

There is also evidence that gold is exhibiting “Giffen good” behaviour, i.e. demand
rises as the price increases. For example, gold ETF holdings are at an all-time high
and central banks, which had been heavy net sellers for decades, turned net buyers in
2008. China is at the leading edge of gold accumulation, with anecdotal evidence
suggesting that (once again) additional purchases have gone unreported.

Total gold in all known ETFs (millions of oz.) Central bank gold holdings since 2000 (tonnes)

90 34,000

80
33,000
70

60 32,000

50
31,000
40

30
30,000
20
29,000
10

0
28,000
30/04/11

31/10/11
31/10/04

31/10/06

31/10/09
31/10/08

30/04/10

31/10/10
31/10/05
31/10/03

30/04/0

30/04/0

30/04/0

30/04/0

30/04/0

30/04/0

30/04/12

31/10/12
31/10/07

Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Source: Bloomberg Source: World Gold Council

With regard to gold equities, there are signs that the long-running
underperformance versus bullion may be bottoming out.

HUI ‘‘AMEX Gold Bugs’’ Index versus the gold price (1-year)

10.00%

5.00%

0.00%

-5.00%

-10.00%

-15.00%

-20.00%

-25.00%
Jan-11-2012
Nov-28-2011

Dec-27-2011

May-07-2012
Jan-26-2012

Feb-09-2012

Feb-24-2012

Mar-09-2012

Mar-23-2012

Apr-09-2012

Apr-23-2012

May-21-2012

Jun-05-2012

Jun-19-2012

Jul-03-2012

Jul-18-2012

Aug-01-2012

Aug-15-2012

Aug-29-2012

Sep-13-2012

Sep-27-2012

Oct-11-2012

Oct-25-2012

Nov-12-2012
Dec-12-2011

AMEX Gold Bugs Index (^HUI)/Gold (COMEX:^GC) - Index Value

Source: Seymour Pierce Ltd

Outperformance of commodities and The next two asset classes – commodities and government bonds - bring us to
government bonds – something will have to give another conundrum with regard to this Kondratieff Winter. Since the current one
began in 2000, both have outperformed (in terms of the CRB Continuous
Commodities Index and the benchmark 10-year US Treasury), beating stocks and
real estate (albeit lagging gold). It is relatively rare for commodities and
government bonds to outperform simultaneously, since the former tend to do


Thunder Road Rep
port | December 2012 Investment strategy

well during inflationary periods and the latter du
g uring low inf
flation/deflationary
periods. In the great inflation versus deflation deb
d hese eventual ly has
bate, one of th
to give – go
overnment bo onds in my oppinion.

Commo
odities
All comm
modities might N
NOT be equal If inflation starts to pick up durin 2013, com
p ng mmodities should continue the e
outperforma ance which stretches back to 2000. Th said, if th end game is an
s k hat he
inflationary recession/depression, ther could be a marked div
re vergence bet tween
different caategories of commodities. Prices of essen
c ntial commodities, such as eenergy
and food, sh hould perform better than those of indust
m trial commodities, e.g. bulks such
s,
as iron ore, and industrial metals, like co
opper and nick
kel.

Essential commodities outperform in the late Taking a mu longer-term perspective, I went back a looked again at the late-
uch and -stage
stages of pr upwaves
rice acceleration of inflation during the first three “G
n f Great inflations” of the las one
st
thousand y years. I want ted to see what happene to the prices of ess
w ed p sential
commoditie compared to the gene
es eral price lev during these periods. Using
vel
wheat as th e proxy, the charts below su
uggest that the outperform:
ey

Final stages of first Gr
s reat Inflation: 1304-1317 Final stages of secon Great Inflation 1628-1650
nd n:

Source: The Price History of English Agriculture, M
Measuring Worth (Of
fficer/Williamson) Source: The Price History of English Agriculture,, Measuring Worth (O
o Officer/Williamson))

Final stages of third G
s Great Inflation: 18
803-1813 Final stages of fourth Great Inflation 2013-
h n:

The BIGG
GEST debt bubble in history
y

?
My guess is that the
M e diverge
ence wide
ens

Source: The Price History of English Agriculture, M
Measuring Worth (Off
ficer/Williamson) Source Seymour Pierce
e:

This gives me more co onviction rega arding the likkelihood of outperformance of
o
essential co
ommodities during the latte stages of the current price upwave.
er e e

e

Investment strategy Thunde Road Repo | December 2012
er ort r

Governm
ment bon
nds
The three decade bull market
e US governm ment bonds ha been in a bull market fo more than three decades This
ave b or t s.
has seen th e yield on the benchmark 10-year US Tre
e easury decline from over 15% to a
%
current leve of 1.66% - as shown in the chart:
el

10-year US Tr
reasury yield sin 1962
nce

Federal Reserve Bank of St Louis

Currently th real yield on the 10-year Treasury is s
he o r slightly negative and the trend in
real yield du
uring the last decade is show in the next c
d wn chart:

Real yield on 10-year US Trea
asury since 2002 (%)
2

6.0

5.0

4.0

3.0

2.0

1.0

0.0

-1.0

-2.0
Jan 01
Jan-01

Jan-11
Jan-94

Jan-04
Jan-96

Jan-99

Jan-06

Jan-09
Jan-98

Jan-08
Jan-00
Jan-95

Jan-05
Jan-93

Jan-03

Jan-10
Jan-92

Jan-02

Jan-12
Jan 12
Jan-97

Jan-07

Source: Federal R
Reserve, Bureau of La
abor Statistics

In
nexorable declin in the quality of sovereign
ne What I wou ld term as oveervaluation in the bonds of most sovere
f eigns stems fro an
om
credit overriding c
concern for ca
apital preserva
ation (at least while inflation remains rela
atively
benign) in conjunction with intervention by centrall banks. As high levels of deficit
w
spending a nd money printing continu they are b
ue, being directed towards the least
d e
productive parts of the economy, i.e. bloated go
e overnment ex xpenditure and the
purchase of dubious financial assets (e MBS and g
f e.g. government debt). The qua
d ality of
new govern nment credit is continuing it inexorable decline, while the prices of some
ts
bonds (like US, Germany, Jap UK, etc) ar close to all-
sovereign b pan, re -time highs.

On more big mov down in sovereign yields?
ne ve Perversely, it would be da
angerous to rule out one mmore plunge downwards in bond
d
yields of th “better qua
he ality” (something of a joke) sovereigns as financial markets
) a
Seymour Pierce equity research
e 11

Thunder Road Report | December 2012 Investment strategy

grasp the enormity of the economic challenges we face. With hindsight, a new all-time
low in the yield on the 10-year US Treasury might prove to be one of the most
significant inflection points in modern financial history.

It’s not just the PIIGS One-by-one, we have seen sharp falls in the bonds of over-indebted sovereigns as
markets lose confidence in their fiscal positions. We’ve seen what’s happened to the
PIIGS, but all of the over-indebted developed nations are moving in the same
direction. For example, besides its trillion dollar deficits, the NPV of the unfunded
liabilities of the US government are between 60-212 trillion dollars. Inflation is the only
way out.

Housing/Real Estate
It might be a real sset… Given its status as a “real” asset, housing/real estate normally outperforms during the
inflationary (Summer) period of a long wave. An obvious conclusion, therefore, is that
when inflation picks up in this “abnormal” Winter phase, housing/real estate is certain
to outperform. However, my sense is that it could be slightly more complicated.

….but it’s also a leveraged one Real estate/housing is (generally) a leveraged asset. During previous Summer
phases of a long wave, the economy was much less leveraged than it is now. We are in
the midst of Winter and economies are overleveraged, hence even a relatively modest
rise in interest rates could risk a significant volume of defaults in this asset class. A
period of economic hardship could also limit credit availability with a knock-on effect
on the ability of housing/real estate markets to clear.

Commercial real estate could also face further challenges from a new round of crisis
in the financial services sector and the cannibalisation of the retail sector from the
rising share of on-line sales. In summary, I expect housing/real estate prices to rise,
but to lag the increase in CPI measures of inflation. In my opinion, prime and near-
prime real estate are likely to outperform the sector.


Introduction – a long wave framework Thunder Road Report | December 2012

Introduction – a long wave framework

Long wave analysts anticipated the 2008 crisis In 2006, I created a framework to put the global macro picture into a strategic
context. Its foundation is the “Long Wave” or “Kondratieff Cycle” (K-Cycle). Back
then, most people were bullish – stock markets were rising, house prices were high
and unemployment was low - but they didn’t see how financial markets and the global
economy were approaching a precipice. Below is a quote from a research paper
written by Askar Akaev (and colleagues) – who is the former President of Kyrgyzstan
and now Professor for Mathematical Investigations of Complex Systems at Moscow
State University – in 2010:

“For most of the expert community, this deep economic crisis was totally
unexpected….Only those who analyzed the situation as based on the theory of
Kondratieff long waves expected a cyclic world economic crisis in 2008-2010.”

Shunned by the mainstream – no surprise Professor Akaev is exaggerating, although he might be slightly biased, having been
awarded the Gold Kondratieff Medal by the International N. D. Kondratieff Foundation
earlier this year. While an approaching crisis was crystal clear from a long wave
perspective, other analysts also predicted the crisis via alternative methods.

Surprisingly, however, hardly any analysts use a long wave framework and it is
shunned by economists (I am not one) as Wikipedia highlights:

“Kondratieff waves (also called super cycles, long waves, K-waves or the long
economic cycle) are described as sinusoidal-like cycles in the modern capitalist world
economy. Unlike the short-term business cycle, the long wave of this theory is not
accepted by current mainstream economics.”

Nikolai Kondratieff Edward R. Dewey

Source: Belleggnopdegolven Source: Cycles rsearch Institute

Paradoxically, a lack of acceptance by mainstream economists might be one reason to
take it seriously. An economic long wave was also identified by an American,
Edward R. Dewey, and this Wikipedia comment about him is priceless:

“Dewey first became interested in cycles while Chief Economic Analyst of the
Department of Commerce in 1930 or 1931 because President Hoover wanted to know
the cause of the Great Depression. Dewey reported that each economist he spoke


Thunder Road Report | December 2012 Introduction – a long wave framework

to gave him a different answer and he lost faith in the current economic
methods.”

What is it about cycles? Dewey subsequently set up the “Foundation for the Study of Cycles” (FSC) and here
is Wikipedia discussing the reaction to his work:

“Dewey noticed a peculiar reaction from people when he discussed cycles with them…
a reaction that seemed to combine amusement, skepticism, and a certain suppressed
fascination. As Dewey put it, ‘Cycles get people. Pro or con, the idea engages
strong emotions. One of our greatest problems is to keep people’s thinking about our
work on a level-headed plane.”

The high profile former Chairman of Princeton Economics, Martin Armstrong, whose
own cycle work predicted (almost to the day) the 1987 crash, 1989 crash in the Nikkei
and the beginning of the sub-prime crisis in 2007, was President of the FSC during the
1990s. According to the summary of an article about Armstrong in the New Yorker in
2009:

“Cycle theory is a kind of Gnostic offshoot of technical analysis. (The article) Mentions
other thinkers who have studied cycles and market timing, including Nikolai
Kondratieff, Joseph Schumpeter, Bill Erman, and Arch Crawford. The writer was told
repeatedly that some of the biggest investors out here view even the wackier cycle
theories with respect.”

Scepticism is understandable However, I can also understand the scepticism - as Nathan Mager, author of “The
Kondratieff Waves”, explained:

“There is a general reluctance to accept the fact that economic forces run in
preordained, mechanistic cycles, particularly those forces involving the actions of
intelligent humanity. The doctrines of free will and the human capacity for self-
determination is as deeply ingrained in us as religious belief.”

Fourth long wave needs to be interpreted in a I think Mager’s comment regarding the long wave or Kondratieff Cycle needs
world of unlimited credit creation correcting. The first three long waves of the industrial age, from 1788-1934, did indeed
run in fairly “preordained mechanistic cycles” (see below). However, the western world
was operating on a gold standard for most of that period. The current cycle needs
CAREFUL INTERPRETATION in today’s world of unlimited credit creation following
the collapse of the Bretton Woods system in 1971. Even more so, now that Ben
Bernanke and his central banking colleagues are resorting to “unconventional”
methods of monetary policy. Despite the move to un-backed floating currencies, two
key conclusions of this report are that:

• Key themes of these long waves WILL CONTINUE TO PLAY OUT; and

• Another CRISIS is looming on the horizon.

Before we get into that, let me briefly summarise some of the key aspects of these
long waves. In the 1920s, Kondratieff concluded that there was a long wave in
economic activity in the capitalist system which averages 50-60 years. In 1928,
when Lenin removed him from his position, Kondratieff had identified two full cycles of
this long wave, stretching back to the late eighteenth century, and part of a third.

Kondratieff long waves bring together economic, Key elements of Kondratieff long waves include fluctuations in the price level (CPI),
social and political issues the amount of debt in economies, GDP growth, interest rates and the
performance of different asset classes. However, it is also considerably more
complex, bringing together inter-relationships between economic activity and financial
markets with social and political issues, including investor psychology (e.g.
speculative bubbles), technological innovations, wars, revolutions, demographic
changes and labour relations. In short, many of the things which contribute to the
ebb and flow of world affairs.


Introduction – a long wave framework Thunder Road Report | December 2012

Driving force is debt While the long wave is primarily defined by prices (inflation/deflation), one of the
driving forces of the long wave is DEBT. Typically, there is a rising trend in debt for
most of the cycle’s duration followed by the extinguishing of some of that debt in its
(painful) late stage, which is known as a “Kondratieff Winter” (K-Winter). The financial
author, Bob Hoye, grasped the essence of what happens in the following quote:

"To be serious, there is only one financial history and it repeats. A great asset
inflation, otherwise known as a bubble, climaxes and collapses.”

That, in the most concise terms possible, describes the history of the western
economic system since the Industrial Revolution as I’ll explain. We are in the latter
stages of the fourth of these “Great Inflations.”

Average length is 50-60 years, but it can vary Just like empires and even human beings, capitalist economies go through a cycle
where they rise, flourish, and fall into decline. The first long wave (1788-1843) of the
Industrial Age lasted approximately 56 years and the second (1844-1896) 53 years. It’s
my belief is that that these long waves need to be Interpreted in a flexible, rather than
rigid, way. For example, they can be shorter or longer than the normally prescribed
(by Kondratieff and Dewey) 50-60 years.

The reason for this, in my opinion, is that they are also impacted by other cycles,
some shorter and some much longer (see below). This can be visualised as the
interaction of waves of different frequency and amplitude in a ripple tank. They can
also be influenced by extreme levels of intervention on the part of governments
and central banks – as is currently the case. My analysis shows that the then
uncompleted third cycle identified by Kondratieff lasted only 37 years (1897-1933),
while the current one has lasted considerably longer than the typical 50-60 years.


Thunder Road Report | December 2012 Current long wave – forming a new bubble

Current long wave – forming a new bubble

Current long wave began in 1934 The current (fourth) Kondratieff long wave has already lasted 77 years (1934- ).
Some of the reasons why the current long wave is already much longer than those that
have gone before should be obvious:

• During the three earlier cycles, the world was on a gold standard most
of the time, although it was usually suspended during wars. Then Nixon
closed the “gold window” in 1971 and everything changed; and

• In this long wave, policy makers have used an unprecedented ability
for credit creation (QE, bailouts, deficits, etc.), to subvert free market
forces which would (otherwise) have brought it to an end.

We are stuck in the Kondratieff Winter of this long wave, contrary to what many
analysts would like to believe. The problem that we face is that we haven’t
experienced much of the “payback” yet, as round after round of monetary stimulus has
kicked the proverbial can down the road. Unfortunately, the bigger the Ponzi scheme
which the bankers and politicians are allowed to create, the more problematic the
adjustment is likely to be – unless we are very lucky.

Always kicking the can

Source: Bloomberg

In this long wave, it was obvious that policy It was obvious before the crisis hit in 2008, that when it did, central bankers and
makers would try to inflate their way out of crisis politicians (who created the problem) would step in with massive offsetting
monetary easing and debt/credit creation. Back in 2007, I wrote:

“The biggest credit bubble in modern history is showing signs of unravelling in the US.
Debt/credit expansion brings forward consumption – it must either be purged in a
deflationary recession or inflated away through currency debasement.”

Greenspan started it and Bernanke is going “all Greenspan resorted to reflation in the wake of the 2001 recession and Bernanke had
in” already outlined his forthcoming inflationary strategy in speeches like the famous
“Deflation – making sure it doesn’t happen here” (“Helicopter speech”) from
November 2002. Such speeches outlined his willingness to experiment with extreme
monetary policies – hence the recently announced open-ended QE3 (while significant)
was not really surprising. Unfortunately, as J.K. Galbraith noted:

“The world of finance hails the invention of the wheel over and over again, often in a
more unstable version.”


Current long wave – forming a new bubble Thunder Road Report | December 2012

Previous Kondratieff Winters were deflationary While I sided with an eventual inflationary outcome for the resolution of this K-Cycle,
previous K-Cycles had always been resolved by DEFLATIONARY “Winter” phases.

Lenin asked Kondratieff to study cycles in the capitalist system to establish how and
when it would fail, Kondratieff concluded that the capitalist system was inherently
self-regenerating. It rose, fell, and rose again on the foundation of FREE
MARKETS and creative destruction. There lies a tragic irony in what is unfolding.

Until along came today’s central planners Heavy-handed market interventions of today’s central planners – de facto
socialist policies - have subverted free market capitalism. Rather than leaving the
system to work off the excess by its own devices, as in previous cycles, the natural
ability of free markets to self-correct has been short-circuited.

It began in 2000 with Greenspan’s response to the NASDAQ Crash and subsequent
recession. Most people still fail to realise the gigantic policy mistake made by
Greenspan in 2000 - and followed in even more reckless fashion by Bernanke.

“Easy Al” “Helicopter Ben”

Source: Bloomberg Source: Bloomberg

If only Greenspan had left things to the If Greenspan hadn’t taken what (back then) were extreme measures at the time, e.g.
markets…. dropping the Fed Funds from 6.5% in May 2000 to 1.0% in June 2003 and leaving it
there for 12 months, the subsequent mild recession would have taken the form of a
more serious debt deflation. While more painful, it would have “cleared the decks” –
ridding the system of excess debt and misallocated capital. Debt/GDP in the US
economy in 2000 was similar to the peak (1933) during the Great Depression.

US total debt/GDP from 1929-2000

350%

300%

250%

200%

150%

100%

50%

0%
1941

1961

1981
1929

1949

1969

1989
1945

1965

1985
1933

1953

1973

1993
1937

1957

1977

1997

Source: Federal Reserve, Bureau of Economic Analysis


Thunder Road Report | December 2012 Current long wave – forming a new bubble

From bubble to bubble to bubble Without Greenspan and Bernanke’s interventions, we would now be basking in the
early stages of a new cycle, instead of contemplating the problematic resolution
of the current one.

Debt is being piled on top of debt and misallocated capital on top of misallocated
capital and the bubble has moved on from equities (especially NASDAQ stocks)
and real estate/securitised debt and a new one is forming in MONEY itself.

Given the ongoing interventions by the central planners, there will be some
How will the debt be extinguished?
important differences in the way that this long wave ends and we transition to
the next one. In particular, the way in which debt is extinguished compared with
previous cycles? C.V. Myers, a market guru from the 1960s and 1970s, argued that:

“Ultimately, every penny of every debt must be paid — if not by the borrower, then by
the lender.”

Ultimately, someone will pay However, as financial blogger, FOFOA, pointed out:

“someone will pay. But there is a third option that is missing from Myers' dictum. ‘The
hit’ can be socialized…if it cannot be worked off by future labor, it will be worked off
by past labor, the net surplus of which was erroneously stored in debt and dollars. The
icing on the cake is that it is also the past labor of ‘someone else,’ if the profits can be
capitalized and the losses socialized. Precisely the process we have witnessed over
the past three years, for those with eyes to see.”

He then referenced the famous “front lawn” quote from an anonymous, but prophetic,
source in the gold market writing more than a decade ago:

“My friend, debt is the very essence of fiat. As debt defaults, fiat is destroyed.
This is where all these deflationists get their direction. Not seeing that
hyperinflation is the process of saving debt at all costs, even buying it outright
for cash. Deflation is impossible in today's dollar terms because policy will allow
the printing of cash, if necessary, to cover every last bit of debt and dumping it
on your front lawn! (smile) Worthless dollars, of course, but no deflation in dollar
terms!"

We’re going to require a new system Hyperinflation would be socially and politically unacceptable, so we are unlikely to
reach that stage. Instead the system will be changed when it begins to show signs
of impending failure. In the words of the famous trader, W.D. Gann, in his prediction
of the 1929 Crash:

“When the time cycle is up, neither Republican, Democrat, nor our good President
Hoover can stem the tide. It is natural law. Action equals reaction in the opposite
direction. We see it in the ebb and flow of the tide and we know from the full bloom of
Summer follows the dead leaves of winter.”

The Federal Reserve and other central banks would have us believe that that they can
control the ebb and flow in the natural cycle of capitalist economies. They can, but not
indefinitely. We are starting to run out of road.


Why is the long wave use for investo
eful ors? Thunde Road Repo | December 2012
er ort r

Why is t long wave use for inv
the w eful vestors?

Data used in long w
a wave analysis In my analys of the long wave, I’ve collected data ba to 1788 inc
sis ack cluding:

• Prices – pri levels and inflation (CP I) rates;
ice

• Total debt in the econom (see below
my w);

• Governmen bond yields
nt s;

• GDP growth (real and no
ominal);

• Gold price;

• Equity indices (since 180
00);

• Commodity prices; and
y

• Real estate (house) prices (since 1896
e 6).

UK da used for the first long wave and US data
ata I have used UK data for the first long wave (1788
d 8-1843) and US data since. The
U
since data for firs three long waves is complete with onlly three excep
st ptions:

• Data for equ prices for the Spring of t first long wave, i.e. 1788-
uity the w -98;

• Data on hou prices for the first two lo waves; and
use t ong d

• Private deb levels in the UK and US prior to 1912, so debt leve are
bt e , els
confined to the public (go
overnment/fed
deral) sector before then.

ealised Kondratieff long wave sh
Ide howing price Below is m infographic of an “idea
my c alised” Kondrratieff long wave with the four
w e
level, debt and GDP growth “seasons”, p
price level, deb GDP, interest rate and wh
bt, hich asset class to buy and sell:
ses d


Seymour Pierce equity research
e 19

Thunder Road Report | December 2012 Why is the long wave useful for investors?

Kondratieff long waves can be divided into four Just like the seasonal changes during a year, the rise and fall of the capitalist
phases or “seasons” economy during the course of a long wave can be split into four phases or
“seasons”, i.e. Spring, Summer, Autumn and Winter. In qualitative terms, they can
be summarised as:

Long wave “seasons”

Trend Season Overview

Upswing Spring The economy experiences renewed growth
Summer: Economy reaches its peak with elevated inflation levels
Downswing Autumn Sart of the decline, but masked by debt-driven consumption and
financial bubbles
Winter The pay-back – economic hardship as “excess” purged from system

Source: Seymour Pierce Ltd, Ian Gordon

Long wave analysis has strong track record on During the last 224 years, if you had been able to determine which of the
asset allocation Kondratieff “seasons” you were in, you had a VERY HIGH PROBABILITY (90.1%) of
identifying which asset classes - out of equities, bonds, commodities,
housing/real estate and gold - would outperform and (by default) which will
underperform.

Furthermore, it is worth noting that there is a set of signals which have been reliable
indicators for the transition from one phase to another.

I will provide detailed justification for these “Outperform” or “Underperform” (and
the occasional “Neutral”) later in the report.

First long wave (K-1) Here are the results for the data for K-1, the first long wave, from 1789-1843. It shows
that on 13 out of 15 occasions the performance of stocks, government bonds,
commodities and gold asset classes was in line with what would be expected in a
“classic” K-Cycle:

First long wave (K-1): performance of asset classes versus prediction

Long wave season Predicted performance Asset class Outcome

Spring Outperform Commodities YES
Underperform Gold YES
“ Govt. Bonds YES
Summer Outperform Gold YES
“ Commodities NO
Underperform Stocks YES
“ Govt. Bonds NO
Autumn Outperform Stocks YES
“ Govt. Bonds YES
“ Commodities YES
Winter Outperform Gold YES
“ Govt. Bonds YES
“ Commodities YES


Second long wave (K-2) In the second K-cycle from 1844-1896, which includes equity prices for all four phases,
on 14 of 16 occasions, asset classes behaved in accordance with the predicted
outcome.


Why is the long wave useful for investors? Thunder Road Report | December 2012

Second long wave (K-2): performance of asset classes versus prediction


Spring Outperform Stocks YES
“ Commodities YES
“ Govt. Bonds YES
“ Commodities YES
Underperform Stocks NO
“ Govt. Bonds YES
Autumn Outperform Stocks NO
“ Govt. Bonds YES
“ Commodities YES
“ Govt. Bonds YES
“ Commodities YES


Third long wave (K-3) In the third K-Cycle from 1897-1933, I have included data for housing/real estate as the
fifth asset class. During this long wave, on 18 out of 20 occasions, asset classes
outperformed or underperformed as expected and one was neutral.

Third long wave (K-3): performance of asset classes versus prediction


“ Commodities YES
“ Real Estate YES
“ Govt. Bonds YES
Summer Outperform Gold NO
“ Commodities YES
“ Real Estate YES
“ Govt. Bonds YES
“ Govt. Bonds YES
“ Real Estate YES
“ Commodities YES
“ Govt. Bonds YES
Underperform Real Estate NEUTRAL
“ Stocks YES
“ Commodities YES


Fourth long wave (K-4) – Spring, Summer and Moving on to the incomplete fourth K-Cycle (K-4), which began in 1934, my belief is
Autumn that the Autumn phase concluded with the crash of the TMT stocks in 2000. The table
below shows that during 1934-2000, K-4 was the most “perfect” K-Cycle of all in
terms of asset prices behaving according to a “classic” K-Cycle. During Spring,
Summer and Autumn, on all 15 occasions, the five asset classes outperformed or
underperformed as predicted.


Thunder Road Report | December 2012 Why is the long wave useful for investors?

Fourth long wave (K-4) up to 2000: performance of asset classes versus prediction


“ Commodities YES
“ Real Estate YES
“ Govt. Bonds YES
“ Commodities YES
“ Real Estate YES
“ Govt. Bonds YES
“ Govt. Bonds YES
“ Real Estate YES
“ Commodities YES


Uncompleted Winter phase of the current long We are currently in the uncompleted Winter phase of K-4. Thus far, four of the five
wave asset classes have performed as would be expected in a typical Kondratieff Winter.
Gold and government bonds have outperformed while equities and housing/real
estate have underperformed. The outlier has been Commodities which have
outperformed instead of underperforming. This reflects the different way in which
this long wave will be resolved – not deflationary - due to unprecedented intervention
from central banks and governments (see below) and the growth of China.

Winter of fourth long wave (K-4) so far: performance of asset classes versus prediction


“ Govt. Bonds YES
Underperform Real Estate YES
“ Stocks YES
“ Commodities NO


Before we analyse how the rest of this current long wave will play out, let’s look at the
long wave in greater depth.


Detailed analysis of the Kondratieff long wave Thunder Road Report | December
2012

Detailed analysis of the Kondratieff long wave

Dating the four long waves since 1788 We are currently in the fourth long wave since the late eighteenth century as
discussed. Kondratieff himself focused on prices/inflation in defining the cycles and I
have used a similar approach. In the table below, I have defined the beginning and
end of the respective long waves based on my own analysis and compared it with
the timing used by Kondratieff and the consensus of other analysts.

Dates of the four long waves since the Industrial Revolution

Long wave SP estimate Length (years) Consensus Length (years)

K-1 1788-1843 56 1789-1845 57
K-2 1844-1896 53 1846-1896 51
K-3 1897-1933 37 1897-1948 52
K-4 1934- 79 1949- 64
Avge 56.3 56.0
Source: Seymour Peirce, literature on Kondratieff Cycles

K-3 was much shorter than the average 50-60 In my opinion, while the long wave AVERAGES 50-60 YEARS, the duration of the
years in my opinion third cycle (K-3) was only 37 years from 1897-1933 - not the 52 years from 1897-
1948 which is the consensus. Identifying K-3 as a 52-year cycle is aesthetically
pleasing, since it would put the duration of the first three cycles into a narrow 52-56-
year range – even though the current one would still be considerably longer. However,
in my opinion, this is incorrect and (briefly) the reasons are:

• If, as everybody accepts, the current K-cycle is considerably longer than
the 54 year average, there’s no reason why a cycle can’t be shorter than
average; and

• The price index for the US economy bottomed in 1933 and recovered
during the four years 1934-37 with inflation running at 1.5-3.6% p.a.
during that period. The subsequent entry of the US into World War II
led to a surge in inflation (albeit short-lived) of between 5.0-10.9%
p.a., during 1941-43. This is at odds with the ormal characteristics of a K-
Winter.

• The short-lived and modest deflation in 1938-39 (-2.1% and -1.4%) was
caused by a policy mistake on the part of the Federal Reserve, which
raised reserve requirements after the recovery was already established.

US rate of inflation (CPI) 1934-43

12.0%

10.0%

8.0%

6.0%

4.0%

2.0%

0.0%

-2.0%

-4.0%
1934 1935 1936 1937 1938 1939 1940 1941 1942 1943

Source: Bureau of Labor Statistics


Thunder Road Report | December 2012 Detailed analysis of the Kondratieff long wave

Price level charts for first three long waves Based on my timing of the K-Cycles, here are the charts for the PRICE LEVEL (in
terms of the consumer price index) for the first three long waves:

First long wave (K-1): consumer price index 1788-1843 (rebased 1787 = 100)

240
230
220
210
200
190
180
170
160
150
140
130
120
110
100
90
1794

1824
1791

1806

1809

1821

1836

1839
1788

1818
1800

1815

1830
1803

1833
1812

1842
1797

1827
Source: ONS

Second long wave (K-2): consumer price index 1844-1896 (rebased 1843 = 100)

230
220
210
200
190
180
170
160
150
140
130
120
110
100
1844

1874
1871
1856

1859

1886

1889
1868
1850

1865

1880

1895
1853

1883
1862

1892
1847

1877

Source: Measuring Worth

Third long wave (K-3): consumer price index 1897-1933 (rebased 1896 = 100)

240
230
220
210
200
190
180
170
160
150
140
130
120
110
100
90
1921

1924
1906

1909

1936

1939
1918

1948
1915

1945
1903

1933

1942
190

1912

1930
1897

1927

Source: Measuring Worth, Bureau of Labor Statistics


2012

K-4 looks completely different due to the demise Now something which, at first sight, looks totally different – the chart for the fourth
of Bretton Woods long wave. This shows the price level from 1934 through 2011:

Fourth long wave (K-4): consumer price index since 1934 (rebased 1933 = 100)

1,800

1,600
1,400

1,200
1,000

800
600

400
200
0
1934

1954

1974

1994
1946

1966

1986

2006
1938

1958

1978

1998
1942

1950

1962

1970

1982

1990

2002

2010

While it appears to bear no relation to the three earlier charts, the same process has
been unfolding to a large extent (minus an “endgame” so far) if the data is
interpreted in light of the unprecedented ability of policy makers to create money
post-Bretton Woods. I will explain this in detail later in the report – please bear with
me.

Debt brings forward consumption – borrowing Debt is one of the MOST critical drivers of long waves, and the one which is most
demand from the future reflected in the trends in price levels/CPI, economic growth and asset prices, is DEBT:

• During the Spring, Summer and Autumn phases, rising debt brings
forward consumption/output, i.e. demand is borrowed from the future
into the present;

• In the Winter phase, the reversal of the earlier debt-driven OVER-
CONSUMPTION has the opposite effect, with the decline in
consumption/output taking citizens, firms and financial markets by
surprise; and

• The acceleration or deceleration in debt growth has a
“supercharged” effect on financial markets.

Debt is great until there’s too much of it The relationship between debt and consumption is deceptively simple, but it has
a very powerful effect on economies and markets which is under-estimated. For
many years in every cycle, nobody pays any attention, because the effects are nearly
all virtuous. Get a loan and go into debt and you don’t have to save for years for that
house, car, loft extension or factory, it’s yours tomorrow. And when everybody is
doing it!

Debt bubbles get reflected in GDP and asset Since debt brings forward consumption, the massive amount of debt in western
prices nations HAS (past tense) already been reflected in their GDP, i.e. a huge amount of
GDP was “borrowed” from the future into the past AND is still being borrowed into the
present. This debt, built up over decades and reflected in GDP numbers, is also
reflected in the prices of all the assets that you can see on your Bloomberg screen.

At the end of the Autumn phase, there is a crash In a typical long wave, debt builds up in the economy during the first three phases
in debt-driven speculative bubbles until an unsustainably high level is reached by the end of Autumn. This precipitates
a crash in the equity market, ushering in the Kondratieff Winter. When excessive debt
and misallocated capital has been purged to a sufficient extent, the cycle can



begin again. That is free-market capitalism. Correction, it WAS free market
capitalism – in this long wave, the central planners have taken control!

Lacking data on private sector debt before 1912 With regard to (total) debt levels, there is a gap in the data (as mentioned earlier)
with no figures for private sector, i.e. non-government, debt for the first two long
waves and between 1897-1912 in the third. The chart for the third long wave (K-3)
on the next page is most relevant as it shows the classic reduction in debt in the final
(Winter) phase of the long wave. A “bust” in asset bubbles (stock market and
housing/real estate) leads to a sharp reversal in the “wealth effect” and the need for
deleveraging across the private sector.

However, it’s also worth looking at the first two, where government debt peaked
during the middle of the long wave due to the costs of fighting “Peak” wars (see
explanation of Summer phase below).

In the first long wave, the British government debt peaked several years after the
conclusion of the Napoleonic Wars (1799-1815).

First long wave (K-1): debt in the economy (public sector only) in GBP millions

900

800

700

600

500

400

300

200

100

0
1791

1821
1794

1824
1806

1809

1836

1839
1788

1818
1800

1815

1830
1803

1833
1812

1842
1797

1827

Source: publicspending.co.uk

In the second long wave, the US government de-leveraged substantially from the end
of the American Civil War (1861-65), which continued right through almost to the end
of Winter.

Second long wave (K-2): debt in the economy (public sector only) in US$ bn

3.00

2.50

2.00

1.50

1.00

0.50

0.00
1871
1844

1874
1856

1859

1886

1889
1868
1850

1865

1880

1895
1853

1883
1862

1892
1847

1877

Source: usgovernmentdebt.com


2012

Classic de-leveraging in K-3 The third long wave saw a “classic” de-leveraging during the final Winter phase (after
the Crash of 1929). It might look modest, but the debt reduction was equivalent to
26% of GDP:

Third long wave (K-3): total debt in the economy in US$ bn

200.0

180.0

160.0

140.0

120.0

100.0

80.0

60.0

40.0

20.0

0.0
1901

1911

1921

1931
1899

1909

1919

1929
1905

1915

1925
1903

1913

1923

1933
1897

1907

1917

1927
Source: US Census

This is how the fourth long wave (1934 - ) has panned out so far – once again a very
different shape compared with the first three long waves.

Fourth long wave (K-4): total debt in the economy in US$ bn

60,000

50,000

40,000

30,000

20,000

10,000

0
1934

1954

1974

1994
1946

1966

1986

2006
1938

1958

1978

1998
1950

1970

1990

2010
1942

1962

1982

2002

Source: US Census, Federal Reserve

K-4 looks different (again)….thanks to money Like the earlier discussion regarding the price level/inflation, the current cycle appears
creating policy makers to bear no relation to the earlier ones in terms of debt, although we only have the data
for public debt in K-2 and K-3. However, just like the price level in K-4, the thrust of
the K-Cycle is unfolding/will unfold if the trends are viewed in the correct context.
Deflation can be measured in more than one form of money and there is more than
one way to extinguish debt.

Credit junkies gone wild…. It’s been obvious in recent years that whenever credit growth started to slow, or there
was a full-blown recession/crisis, e.g. 2008, central banks (and governments) stepped
in with “maestro-like” precision and got all “the plates spinning again” with the
provision of vast quantities of new debt/credit and easy money policies.



There will be debt reduction….just in a different The method which is used to reduce this debt burden ultimately – INFLATION THIS
form TIME - is going to have a different impact on the performances of various asset
classes.

Before we get to that, let’s look at the four phases of a Kondratieff long wave.

Spring
Conditions at the beginning of a long wave Let’s start with the upswing of the long wave and the “Spring” phase. At the
beginning, debt has been reduced, savings rebuilt and capital is widely available at
relatively low interest rates. These factors, together with low labour and raw material
costs encourage entrepreneurs to invest with the prospect of high returns.

The table shows the long-term interest rate (average for the year) in the first year of
each K-Cycle compared with the peak long-term rate during that long wave cycle:

Long term interest rate in first year of each long wave vs. peak interest rate

16.0%

14.0%

12.0%

10.0%

8.0%

6.0%

4.0%

2.0%

0.0%
K-1 K-2 K-3 K-4

First year Peak

Source: Federal Reserve, Homer

Innovation driven investment spending High savings and low interest rates stimulate growth in capital investment. The
rising phase of the cycle is often driven by major innovations which were conceived
during the downswing of the previous cycle, but really begin to positively impact
economic growth during the upswing:

Major innovations which helped to drive each long wave

Long wave Innovation

K-1 Steam engine, textile industry
K-2 Railways, steel industry
K-3 Electricity, Automobiles, Industrial chemistry
K-4 Electronics, petrochemicals, jet engine


Spring timings…. My timings of the Spring phase in each K-Cycle are shown in the next table:

Spring phases

Long wave Years

K-1 1788-1798
K-2 1844-1860
K-3 1897-1911
K-4 1934-1966



2012

Key characteristics of the Spring phase In bullet points, here is a summary of the Spring phase:

• Economic recovery with notable strength in investment spending
(capital goods);

• New innovations support the recovery;

• Unemployment falls and consumer spending increases;

• Growth is relatively consistent and recessions tend to be shallow
and short-lived; and

• Wars generally have a positive impact on the global hegemon.

Trough wars… Kondratieff noted that there may be additional stimulation in the Spring phase
provided by a “trough war”. Such a war usually has popular support and benefits the
global hegemon. For example, the US exited World War II with 45% of global industrial
production. Examples of trough wars in the Spring phase are:

Trough wars in Kondratieff long waves

Long wave War Dates

K-1 Early Napoleonic Wars 1793-1805
K-2 Mexican-American War 1846-48
K-3 Spanish-American 1898
K-4 World War II 1939-45

Source: Wikipedia

Catergorising the Second World War Analysts who argue that the current long wave began in 1948 point to the Korean War
(1950-53) as the trough war in K-4. This leads to a problem with categorising World
War II which, based on consensus dates for long waves, would have taken place in
Winter of the previous K-Cycle. It is usually explained away, unsatisfactorily I think, as
“Part 2” of an unresolved 1914-18 conflict. Given my belief that the start date for the
current K-Cycle is 1934, this makes the World War II a “trough” war in the Spring
part of the K-4 upswing. There is no doubt, either, that the World War II dramatically
improved the economic power of the US, in absolute and relative terms, compared
with the decimated nations of Europe and Asia.

Robust GDP growth seen in Spring The Spring season usually sees some of the highest average annual growth in real
GDP across each cycle. The table below shows the CAGR in real GDP during the
Spring season of each cycle compared with the highest rate of growth in any of the
other seasons during each cycle.

Real GDP growth in Spring versus highest growth in another season (CAGR)

6.0%

5.0%

4.0%

3.0%

2.0%

1.0%

0.0%
K-1 K-2 K-3 K-4

Spring Highest growth in another season

Source: British Economic Growth and the Business Cycle 1700-1850, Measuring Worth, Bureau of Economic Analysis



“As dissatisfied as I was, and as restless, I Living the dream in 1950s America
remember so well this feeling (we) had at the
time that the world was going to be your oyster.
You were going to make money, your kids were
going to go to good schools, everything was
possible... The future was rosy.”

The Fifties: A Women’s Oral History, Brett Harvey

Source: Envisioning the American Dream

Performance of asset classes Now let’s consider which asset classes should outperform and which underperform
during the Spring phase of a long wave – and compare that with the actual outcome.

Equities generally outperform With the economy in a recovery/growth mode, equities should perform well.
While we don’t have data on equities for Spring in K-1 (1788-1798), they outperformed
in the three subsequent cycles.

Performance of equities in Spring

Long wave Dates Summary Outperform?

K-2 1844-1860 US equity market rose 17% during 1844-60 and 69% from 1844 to the 1852 peak YES
K-3 1897-1911 DJIA rose from 30.5 in Aug 1896 to 81.2 in Dec 1911 (peak 99.7 in Jan 1906) YES
K-4 1934-1966 DJIA rose from Jul 1932 trough of 41.2 to 785.7 in Dec 1966 (oeak 995.2 in Feb 1966) YES

Source: Goetzmann, Ibbotson & Peng, Yahoo Finance, Federal Reserve, Seymour Pierce

Bullish for commodities Strong growth in investment is bullish for commodity prices and they have
outperformed during the Spring phase of each of the four long waves.

Performance of commodities in Spring


K-1 1788-1798 Silberling commodities index rose from 99 to 149 during 1791-98 YES
K-2 1844-1860 Warren & Pearson index of commodity prices rose from 79 to 123 during 1844-57 YES
K-3 1897-1911 BLS/Grilli & Yang commodity price indices rose 37% during 1897-1911 YES
K-4 1934-1966 G&Y/CRB commodity price indices rose 79% during 1934-1966 (peak +148% in 1946) YES

Source: Silberling index, Warren & Pearson, BLS, Grilli & Yang, Reuters/CRB, seymour Pierce

….and housing/real estate Economic growth, high savings levels and low interest rates should all be positive
for housing/real estate prices. While we don’t have data for the first two cycles, real
estate prices did well during K-3 and (especially) in K-4.

Performance of housing/real estate in Spring


K-3 1897-1911 Case Shiller home price index rose almost 35% during 1897-1911 YES
K-4 1934-1966 Case Shiller home price index rose just over 270% during 1934-1966 YES

Source: Case Shiller, Seymour Pierce


2012

Bearish for government bonds Spring is generally characterised by a rising trend in interest rates, particularly as this
phase progresses. This is bearish for long-term government bonds – with rising
yields implying lower prices. Once again, the predictive ability of the long wave
worked well for this asset class.

Performance of government bonds in Spring

Long wave Dates Summary Underperform?

K-1 1788-1798 Long-term yields rose from 4.08% 5.94% during 1787-98 (trough 3.33% in 1792) YES
K-2 1844-1860 Long-term yields rose from 4.85% to 5.57% (trough of 4.02% in 1853) YES
K-3 1897-1911 Long-term yields rose from 3.39% to 3.93% during 1897-1911 (trough 3.24% in 1899) YES
K-4 1934-1966 Long-term yields rose from 3.01% to 4.93% during 1939-66 (trough 2.02% in 1946) YES

Source: Homer, Measuring Worth (Officer/Williamson), NBER

...and gold With positive, but generally benign, inflation and positive real interest rates, the gold
price should do poorly in the Spring phase – and this has been the case in each
cycle:

Performance of gold in Spring


K-1 1788-1798 Gold price was flat at £4.25/oz (in decimalised form) but lost c.22% in real terms YES
K-2 1844-1860 Gold price was fixed at US$20.67/oz., but lost 12% in real terms during 1844-60 YES
K-3 1897-1911 Gold price remained almost unchanged at US$18.92-18.98/oz., but fell 13% in real terms YES
K-4 1934-1966 Gold price remained unchanged at US$35.00/oz versus 150% inflation YES

Source: Measuring Worth (Officer/Williamson), World Gold Council

Summer
Rising inflation marks the transition from Spring The catalyst for the transition from the Spring phase into the Summer is an
to Summer acceleration in inflation which is usually exacerbated by the costs/deficit
spending of a “peak” war. In the current long wave, for example, the Summer phase
began in 1966. This coincided with the surge in the US Federal deficit, due to the
escalation of the Vietnam War and LBJ’s “Great Society” welfare programmes.

Summer timings…. My timings of the Spring phase in each K-Cycle are shown in the next table:

Summer phases

Long wave Years Peak war

K-1 1799-1813 War of 1812
K-2 1861-1864 American Civil War
K-3 1912-1920 World War I
K-4 1967-1980 Vietnam War


Key characteristics of the Summer phase In bullet points, here is a summary of the Summer phase:

• Accelerating inflation due to debt-driven spending/consumption and
capacity constraints;

• A “Peak” war helps to ignite inflationary pressures in the economy
via government deficit spending;

• Growth from new innovations begins to level out;

• Attitudes to work deteriorate (e.g. Luddites in 1811-12, labour
disputes in the 1970s, etc.) and inefficiencies creep into the system;


Thunder Road Rep
port | December 2012 Detailed an alysis of the Kondratieff lon wave
K ng

• Real (rathe than nominal) econom growth begins to falt
er mic b ter as
Summer re eaches its clim
max, as rising costs/intere rates adve
g est ersely
impact inve
estment and consumption; and
c

• Interest rat move sha
tes usually reaching a peak around
arply higher, u
the end of the Summer period.
p

High rates of inflation compared to o
other phases chart highligh the inflation rate (in terms of CAGR) in Su mmer
The next c hts C
compared t the average rate of infla
to ation across ea long wave cycle: as wh
ach hole.

Inflation rate in Summer com
mpared to each lo wave avera ge (CPI %)
ong

20
18
16
14
12
10
8
6
4
2
0
K-1 K-2 K-3 K-4

Summer Full cycle

Source: ONS, Me
easuring Worth, Burea of Labor Statistics
au

Ian Gordon (www.thelong
gwaveanalyst.c
com) describe the Summer phase as whe
es en:

“the econom reaches its fullness with inflationary ab
my bundance.”

Strong debt/credit g
growth reflected in prices of
d In contrast to the Autum phase (see below), deb
mn bt/credit growth in Summ is mer
good & services
ds manifested in rising pric for goods and services, i.e. CPI inflat
d ces tion. Contribut
ting to
the inflation is usually a high level of capacity ut
n o tilisation. Look at the next chart
k
showing ca apacity utilisattion in the US economy s ince the late-
S -1960s. Despit the
te
recessions of 1969-70, 1973-75 and 1980, all of th highest rea
he adings for capacity
utilisation o ccurred during the Summer phase of this llong wave, i.e. 1966-1980.
g .

Capacity utilis
sation in US industry

Source: Federal R
Reserve Bank of St Lo
ouis

e

2012

Performance of asset classes Now let’s consider the performance of different asset classes during Summer phases.

Positive for gold Clearly, the inflationary character of Summer should be very positive for the gold
price. In the three out of the four cycles, this was clearly the case:

Performance of gold in Summer


K-1 1799-1813 Gold price rose 36% from £4.25/oz to £5.76/oz during 1799-13 YES
K-2 1861-1864 Gold price rose from US$20.67/oz. to US$42.03/oz. during 1861-64 YES
K-3 1912-1920 Gold price rose from US$18.98/oz. to US$20.67/oz., a loss of about 100% in real terms NO
K-4 1967-1980 Gold price rose from US$35.00/oz to a peak of US$850/oz. in Jan 1980 YES


The underperformance of gold in US dollar terms in K-3 (1912-20) requires
explanation. World War I (1914-18) decimated most European economies. Exchange
rates of European nations fell sharply versus the dollar. Consequently, the gold price
surged in old French francs and German marks. In French francs, the price rose from
FFr98 to FFr294 during 1913-20 and, in German marks, from DM79 to DM1,181.

Gold price in old French francs and German marks (1913-1920)

1,400

1,200

1,000

800

600

400

200

0
1913 1914 1915 1916 1917 1918 1919 1920

French francs German marks

Source: Measuring Worth

US official gold reserves rose substantially during this period, providing far greater
gold backing to the US dollar.

France, Germany and US – change in official gold reserves 1913-20

4,000

3,500

3,000

2,500

2,000

1,500

1,000

500

0
France Germany US

1913 1920

Source: World Gold Council



This probably accounts for the minimal rise in gold during this period when
measured in US dollar terms.

….and commodity prices Commodities should also be expected to outperform during the inflationary
Summer and this was the case in three out of the four K-Cycles.

Performance of commodities in Summer

Long wave Summary Outperform?

K-1 1799-1813 Silberling Commodities Index rose 24% from 149 to 185 during 1799-13 NO
K-2 1861-1864 Warren & Pearson index of commodity prices rose from 102 to 253 during 1861-64 YES
K-3 1912-1920 Grilli & Yang inex of commodity prices rose from 21.9 to 42.0 during 1912-1920 YES
K-4 1967-1980 Index of commodity prices rose from 97.8 to 284.1 during 1968-1980 YES


The exception was K-1 when they underperformed, although an explanation is
once again useful. Commodity prices, represented by the Siberling Commodities
Index, increased by 24%. However, this performance ranked third out of the four asset
classes for which we have data in that period (the others being gold, government
bonds and stocks) as can be seen in the next table. This accounts for the
“underperformance” classification.

Performance of asset classes during Summer of the first long wave cycle (K-1)

Asset class Summary Predicted ?

Gold The price rose 36% from £4.25/oz to £5.76/oz during 1798-13 YES
Commodities Silberling Commodities Index rose 24% from 149 to 185 during 1798-13 NO
Stocks British stocks fell 15% from 19.91 to 16.88 during 1800-13 YES
Govt. Bonds Long-term yields FELL from 5.94% 4.92% (i.e 17%) – so bond prices rose - during 1798-13 NO

Source: xx

Housing/real estate outperformed in the two Housing/real estate, another “real” asset, would also be expected to outperform
long waves we have data in an inflationary environment. Here we only have data for K-3 and K-4 and the
outperformance was in line with expectations.

Performance of housing/real estate in Summer

Long wave Summary Outperform ?

K-3 1912-1920 Case Shiller home price index rose 42% from 1912-20 (albeit down materially in real terms) YES
K-4 1967-1980 House price index rose 162% from 1966-1980 and about 8% in real terms YES


I need to clarify the performance in K-3. While US house prices rose a sizeable 42%,
this was a material fall in real terms compared with the almost 111% inflation
during that period. However, this was the SECOND BEST performing of the five asset
classes and accounts for its “outperformance” classification.

Performance of asset classes during Summer of the third long wave cycle (K-3)


Gold Gold price rose from US$18.98/oz. to US$20.67/oz., a loss of about 100% in real terms NO
Commodities Grilli & Yang index of commodity prices rose from 21.9 to 42.0 during 1912-20 YES
Real Estate Case Shiller home price index rose 42% from 1912-20 (albeit down materially in real terms) YES
Stocks DJIA fell from 81.7 in Ja 1912 to 71.9 in Dec 1920 YES
Govt. Bonds Long-term yields rose from 3.93% to 6.12% during 1912-20 AND inflation was over 100% YES

Source: xx


2012

Government bonds expected to underperform Moving on to government bonds and rising inflation is obviously negative for this
asset class, especially when coupled with rising interest rates - which would be
expected during a period of rising inflation. It was surprising to me, therefore, that
during the Summer phases of K-1 (1799-1813) and K-2 (1861-64) long term government
bond yields actually DECLINED – leading at times to significantly negative real interest
rates.

Performance of government bonds in Summer

Long wave Summary Underperform ?

K-1 1799-1813 Long-term yields fell from 5.94% 4.92% (i.e 17%) during 1798-1813 NO
K-2 1861-1864 Long-term yields fell from 5.57% to 4.83% during 1861-64 versus 89% inflation YES
K-3 1912-1920 Long-term yields rose from 3.93% to 6.12% during 1912-20 AND inflation was over 100% YES
K-4 1967-1980 Long-term yields rose from 4.84% to 12.84% during 1967-80 (peak 15.32% in Sep 1981) YES


In K-1, I would argue that total return, i.e. 17% decline in yields (from 5.94% to 4.92%)
plus interest payments on British 3% Consols, led to outperformance versus both
Commodities (Siberling Index rose 24%) and Stocks (British shares fell 15%)… and
even bettered gold (+36%).

In K-2, however, the capital appreciation (falling yields) plus the interest payments
were not enough to compensate for the 89% inflation in the general price level.
Given that gold, commodities and stocks all rose more than 100%, it would be
inappropriate to classify any as underperformers, i.e. stocks outperformed versus the
model’s prediction of underperformance during Summer.

Performance of asset classes during Summer of the second long wave cycle (K-2)


Gold The price rose from US$20.67/oz. to US$42.03/oz. during 1861-64 YES
Commodities Warren & Pearson index of commodity prices rose from 102 to 253 during 1861-64 YES
Stocks S&P Index rose 128% during 1861-64 NO
Govt. Bonds Long-term yields fell from 5.57% to 4.83% during 1861-64 versus 89% inflation YES

Source: xx

The underperformance of government bonds during Summer K-3 and K-4 was
more “conventional” with yields rising substantially and, consequently, prices falling.

Bearish for equities Equities would also be expected to underperform during Summer of a long wave
as corporate margins are squeezed, PE ratios contract and capital flows into “real
assets” like gold, commodities and real estate. This has been the case in three out of
four Summer phases:

Performance of equities in Summer


K-1 1799-1813 British stocks fell 15% from 19.91 to 16.88 during 1800-13 YES
K-2 1861-1864 US equity market rose 125% during 1861-64 NO
K-3 1912-1920 DJIA fell from 81.7 in Jan 1912 to 71.9 in Dec 1920 YES
K-4 1967-1980 DJIA rose from 785.7 in Dec 1966 to 964.0 in Dec 1980 but compared with 154% inflation YES


The exception was in K-2 during 1861-64 which covers most of the American Civil
War. The reason for the outperformance of the stock market during these years
appears to be twofold:



• The rise in industrial production necessitated by the Civil War led to
strong profitability for some industries and the stock market responded
positively as it became clear that the Union/North would win; and

• The continuing recovery from the “Panic of 1857”. The latter was
caused by the high profile failure of the Ohio Life Insurance and Trust
Co., but also involved the over-expansion of the railway system and a fall
in grain prices.

Autumn
Catalyst for the transition to Autumn is a peak in The major catalysts for the phase transition from the inflationary Summer into the
the price level or the rate of inflation deflationary (or dis-inflationary) Autumn are the peak in the price level or, in the
current cycle, the peak in the RATE OF INFLATION which occurred in 1980. The peak in
the price level/inflation is usually (broadly) coincident with a recession, brought on by
rising interest rates. Not surprisingly, the gold price often reaches a peak around the
same time.

Catalysts for the transition from Summer to Autumn

Long wave Peak in price level/inflation Recession Peak in nterest rates Peak in gold price

K-1 Yes Yes No No
K-2 Yes Yes Yes Yes
K-3 Yes Yes Yes No
K-4 Yes Yes Yes Yes


Fed Chairman Paul Volcker famously crushed The transition from Summer to Autumn in the current cycle in 1980 was marked by
inflation in the current long wave Fed Chairman, Paul Volcker, raising the Fed Funds rate to 20% in January 1980 in
order to squeeze inflation out of the economy. This precipitated a deep recession
which began in the same month when the gold price also peaked at its (then) all-time
high of US$850/oz.

Autumn timings…. I will outline my case for the year 2000 being the end of Autumn in K-4 below, but
here is my timing of the dates for Autumn in each cycle:

Autumn phases

Long wave Years Length

K-1 1814-1825 12 years
K-2 1865-1873 9 years
K-3 1921-1929 9 years
K-4 1981-2000 20 years


Longest Autumn phase was in the current cycle We’ve been lucky (those over about 30 years of age), having experienced the
longest “feel good” Autumn phase in a long wave cycle since the Industrial
Revolution.

Key characteristics of the Autumn phase In bullet points, here is a summary of the Autumn phase:

• Economic recovery against a background of either deflation or low
inflation (disinflation);

• This is the season of “easy credit!;

• High consumer spending and asset markets are sustained by rapid
growth in debt in the private sector;

• Speculative bubbles develop in stocks, bonds and real estate;


2012

• Interest rates tend to be on a declining trend; and

• The debt-driven prosperity leads to a mistaken view that the “good
times” will continue.

Post-Bretton Woods we have seen disinflation In the first three K-Cycles, when the world was operating on a gold (or gold exchange)
rather than deflation during Autumn standard most of the time (although it was usually suspended during major conflicts),
the Autumn phase saw the onset of deflation. With the demise of Bretton Woods,
the Autumn phase (1981-2000) of the current cycle saw disinflation vis-à-vis
Summer as shown in the chart below:

K-4 has seen disinflation instead of deflation

20.0

15.0

10.0

5.0

0.0

-5.0
K-1 K-2 K-3 K-4

Summer Autumn

ONS, Measuring Worth, Bureau of Labor Statistics

Economic growth punctuated by occasional Following the severe recession which is typical of the beginning of the Autumn phase,
recessions there is an economic recovery which is maintained for most of Autumn. That said, it is
usually punctuated by the occasional recession, e.g. 1981-82 and 1990-91 in the
current cycle.

Debt/credit growth is channelled into asset A critical point about Autumn is that, with slack in the economy (lower capacity
markets utilisation rates), the vast majority of the debt/credit created during Autumn is
channelled into ASSET PRICE INFLATION, e.g. in stocks, bonds and real estate,
rather than “traditional” inflation in the prices of goods and services as measured by
the CPI.

Having your cake and eating it Julian Snyder (who wrote the introduction to the English translation of Kondratieff’s
“The Long Wave Cycle”) really captured the essence of Autumn in the following:

“this underlying slowdown reduces the forces of inflation and makes it possible for a
while for people to have their cake and eat it too, that is, to create purchasing power
artificially without causing inflationary overheating. The phenomenon is similar to
stepping on the gas in your automobile when the car is going downhill; you get more
speed without burning up quite as much energy. In economic terms, this slowing down
provides the opportunity for financial liquidity to build up somewhat and pour into the
few remaining healthy areas of the economy or into wild speculative ventures.”

Unfortunately, the longer the Autumn phase unfolds, the more it becomes dependent
on an unsustainable expansion of debt and the associated rise in asset prices
(“wealth effect”, etc). Here is Julian Snyder again:

“Because the rate of inflation is declining, people begin to think that this problem has
been solved and because they still have money in their pockets, they become suddenly
optimistic and then finally euphoric.”



Feeling good in Autumn The latter part of Autumn is a very much a “feel good” part of the long cycle. The
low inflation and high asset prices are generally accompanied by an improvement in
relations between workers and management and a loosening of moral constraints. The
“feel good” period of the fourth cycle has not been christened, but those during the
first three cycles were:

“Feel good” Autumn periods

Long wave cycle Known as Years

K-1 "The Era of Good Feeling" 1815-23
K-2 "The Gilded Age" 1867-72
K-3 "The Roaring 20s" 1922-29
K-4 Greed is good ! Mid/late-1980s-1990s


The euphoria of Autumn manifests in speculative asset bubbles. It appears that these
euphoric times lead to a “numbing of the senses”, with most people believing that
the good times will carry on indefinitely. It reminds me of several quotes from the
Wall Street movie:

“It’s all about bucks, kid. The rest is just conversation.”

“The point is, ladies and gentlemen, that greed, for lack of a better word, is good.”

“This stock is going to Pluto.”

The tag line to the movie reminded us that:

“Every dream has a price”

The sage-like character, Lou Mannheim (“Stick with the fundamentals”) cautioned
Charlie Sheen’s character:

“Kid, you’re on a roll. Enjoy it while it lasts, because it never does.”

The popping of these bubbles ushers in Winter (see below).

Performance of asset classes Now let’s consider the performance of different asset classes during the Autumn
phase.

Bullish for equities Declining interest rates and rising consumption supported by debt and rising prices for
financial assets led to equities outperforming in three of the four long waves.

Performance of equities in Autumn


K-1 1814-1825 British stocks rose from 16.88 to 77.76 during 1814-25 (trough 13.93 in 1816) YES
K-2 1865-1873 US equity market was basically flat during 1865-72, prior to the Panic of 1873 NO
K-3 1921-1929 DJIA rose from 71.9 in Dec 1920 to 248.5 in Dec 1929 (peak 381.2 in Sep 1929) YES
K-4 1981-2000 DJIA rose from 964.0 in Dec 1980 to 10,788.0 in Dec 2000 (peak 11,723 in Jan 2000) YES


The exception was K-2 when the equity market traded sideways across the Summer
phase. This seems to have reflected exhaustion following the strength during the
American Civil War.

….and government bonds The decline in interest rates during Autumn should be very bullish for government
bonds, so it’s no surprise that they outperformed in each cycle.


2012

Performance of government bonds in Autumn


K-1 1814-1825 Long-term yields fell from 4.92% to 3.54% during 1813-25 (trough 3.30% in 1824) YES
K-2 1865-1873 Long-term yields almost unchanged, from 5.54% to 5.55% during 1865-73 versus deflation of 27% YES
K-3 1921-1929 Long-term yields fell from 6.12% to 4.55% during 1920-1928 YES
K-4 1981-2000 Long-term yields rose from a peak of 15.32% in Sep 1981 to 5.24% in Dec 2000 YES


Housing/real estate also does well The same is true for housing/real estate although we only have data for the third
and fourth long waves:

Performance of housing/real estate in Autumn


K-3 1921-1929 The famous Florida real estate boom from 1920-1926 YES
K-4 1981-2000 Case Shiller home price index rose 121% from 1981-2000 and 31% in real terms YES


The outperformance during K-3 requires explanation. In K-3, house prices across the
United States as a whole were basically unchanged during the Autumn phase from
1921-29. However, there was a huge boom in real estate construction – this comment
from Ian Gordon:

“the real estate bubble of the 1920s, which was centred on the development of
suburbs outside the cities and the building of skyscrapers close to the city centres.”

Florida real estate bubble And there was a real estate MANIA during that period, even if it was narrowly focused,
i.e. the famous Florida real estate bubble. Here is Wikipedia:

“The Florida land boom of the 1920s was Florida's first real estate bubble, which burst
in 1925, leaving behind entire new cities and the remains of failed development
projects…The story includes many parallels to the modern real estate boom, including
the forces of outside speculators, easy credit access for buyers, and rapidly-
appreciating property appreciating property values… Miami had an image as a tropical
paradise and outside investors across the United States began taking an interest in
Miami real estate. Due in part to the publicity talents of audacious developers like Carl
G. Fisher of Miami Beach, famous for purchasing a huge lighted billboard in New York's
Times Square proclaiming “It's June In Miami.”

This is from Frederick Lewis Allen’s “Only Yesterday”:

“The stories of prodigious profits made in Florida land were sufficient bait. A lot in the
business center of Miami Beach had sold for $800 in the early days of the
development and had resold for $150,000 in 1924. For a strip of land in Palm Beach a
New York lawyer had been offered $240,000 some eight or ten years before the
boom; in 1923 he finally accepted $800,000 for it; the next year the strip of land was
broken up into building lots and disposed of at an aggregate price of $1,500,000.”

Commodity prices underperform Deflation, or lower rates of inflation, are obviously bad news for commodity prices
and this asset class underperformed in the Autumn of each long cycle.



Performance of commodities in Autumn


K-1 1814-1825 %
Silberling Commodities Index fell from 185 to 118 during 1813-25 (trough 106 in 1824) YES
K-2 1865-1873 W&P/BLS commodity price indices fell 44% during 1865-71 YES
K-3 1921-1929 Grilli & Yang index of commodity prices fell from 42.0 to 23.3 during 1921-29 YES
K-4 1981-2000 CRB index of commodity prices fell 2.1% during 1981-2000 YES

Source: Silberling, Warren & Pearson, Bureau of Labor Statistics, Grilli & Yang, CRB

As does gold… After the Summer peak, deflation/lower inflation lead to gold’s underperformance.

Performance of gold in Autumn


K-1 1814-1825 %
Gold price fell from £5.76/oz to £4.24/oz during 1814-25 YES
K-2 1865-1873 Gold price fell from US$42.03/oz to US$23.52/oz during 1865-73 YES
K-3 1921-1929 Gold price remained almost unchanged between US$20.58-20.69/oz YES
K-4 1981-2000 Gold price fell from peak of US$850/oz. to a trough of US$252.80/oz. in Jul 1999 YES


Winter
Catalyst for the transition to Winter is a stock In the transition to Winter, the greed seen in the asset bubbles of Autumn is replaced
market crash by fear. The “wealth effect” moves into reverse, confidence evaporates,
consumption and investment decline and companies lay off workers. With the
economy overwhelmed by debt and asset bubbles, the catalyst for the transition into
the Winter phase has been a crash in the stock market in each cycle:

K-1 - the Panic of 1825
Collapse in Latin American investments started The London stock market crashed in 1825 after the Bank of England raised interest
the crisis rates. Hardest hit were speculative investments in Latin America, primarily shares in
mining companies and the bonds of fledgling Latin American nations.

London stock price index and the Panic of 1825

Source: Federal Reserve Bank of St Louis from quotes for 50 companies in the “Course of the Exchange”

The knock-on included the failure of nearly 70 banks. The best story from the 1825
crisis was how investors were conned into buying bonds of a fictional Central
American “country”, the Principality of Poyais. Claiming to have been made head of
state, Gregor MacGregor, a Scottish soldier, adventurer and speculator, sold its
“sovereign” bonds to investors. Almost a preface to the “Dot.cons” nearly 200 years
later?


2012

K-2 – the Panic of 1873
Jay Cooke & Co. and the Northern Pacific The collapse of the Philadelphia banking house, Jay Cooke & Co., which over-
extended itself in financing the Northern Pacific Railroad, led to the “Panic of 1873”.
This caused a series of bank failures and a stock market crash after which the New
York Stock Exchange was shut for ten days. These events ushered in what is now
known as the “Long Depression” (it was known as the “Great Depression” until the
1930s). While the failure of Jay Cooke is generally viewed as the catalyst for the “Panic
of 1873”, the background was more complex and international in scope.

Offices of Jay Cooke & Co. on Third street, Philadelphia

Source: The century illustrated magazine

….although it actually began in Europe
Firstly, after the end of the Franco-Prussian War in 1871, Otto Von Bismarck began the
demonetisation of silver and its replacement with a gold standard. Reparations, which
had been paid by France in gold, provided new capital which fuelled an investment
boom and a corresponding boom in the stock markets of the newly unified Germany
and Austria. The bursting of this bubble began with the crash of the Vienna Stock
Exchange in May 1873 and knock-on bank failures across Europe.

Secondly, the problems in Europe curtailed the flow of capital across the Atlantic,
halting the already excessive investment in railroads and industrial infrastructure.
Wikipedia:

“The American Civil War was followed by a boom in railroad construction. 33,000
miles (53,000 km) of new track were laid across the country between 1868 and 1873.
Much of the craze in railroad investment was driven by government land grants and
subsidies to the railroads…A large infusion of cash from speculators caused
abnormal growth in the industry as well as overbuilding of docks, factories and
ancillary facilities…By November 1873 some 55 of the nation's railroads had failed,
with another 60 going bankrupt by the first anniversary of the crisis.”



Demonetisation of silver Thirdly, lower silver prices had already been having a negative effect on the US where
much of the world’s silver was being mined at the time. The US Coinage Act of 1873
put the US on a de facto gold standard and a reduction in US money supply led to a
rise in interest rates in the run-up to the crisis.

K-3 – Crash of 1929
I think the chart below says it all:

Crash of 1929 – Dow Jones Industrial Average 1923-33

Source: TA Professional

From John Steinbeck’s “The Grapes of Wrath” which was set in the Great Depression
era:

“The bank - the monster has to have profits all the time. It can't wait. It'll die… When
the monster stops growing, it dies. It can't stay one size.”

Winter timings…. I will outline my case for the year 2000 being the end of Autumn in K-4 below, but
here is my timing of the dates for Winter in each cycle:

Winter phases

Long wave Years

K-1 1826-1843
K-2 1874-1896
K-3 1930-1933
K-4 2001-


Before we discuss the transition from Autumn to Winter in the current K-Cycle, let’s
review the key themes of a typical Kondratieff Winter and how asset prices have
performed during the first three cycles. The most important themes, which need
emphasizing because they are critical to the rest of this report, are:

• DEFLATION in prices; and

• DEBT REDUCTION.

Key characteristics of the Winter phase In bullet points, here is a summary of Winter:

• The economy is finally overwhelmed by excessive debt and
speculation;


2012

• Prices, employment, output and investment all fall sharply as the
economy goes into depression;

• Poor management and bad financial decisions which remained
undetected during the boom in asset prices are exposed;

• Credit markets seize up and there are widespread bank failures; and

• Debt is reduced, usually through a mixture of bankruptcies and de-
leveraging (that’s how it used to work before the advent of
unlimited credit creation).

Deflation in Winter in the first three long waves In the first three long waves, when the world was operating on a gold standard most
of the time and without the ability of massive offsetting monetary stimulus, the
deflation seen in Autumn continued during Winter:

First three long waves: deflation in Autumn continues in Winter (CPI %)

1.0

0.0

-1.0

-2.0

-3.0

-4.0

-5.0

-6.0

-7.0
K-1 K-2 K-3

Autumn Winter

Source: ONS, Measuring Worth, Bureau of Labor Statistics

Here is Ian Gordon again, capturing the essence of Winter:

“In winter, the economy dies. It dies because it is overcome by too much debt.”

Winter purges the system Painful as it is, the Kondratieff Winter serves a VITAL purpose, purging excess
debt, misallocated capital and over-consumption from the economy.

The Great Depression was a classic and severe example – a short (4 years) but very
sharp shock. The chart below shows the sharp rise in total debt during 1916-18 (after
the US entered World War I, the continuing rise during the “Roaring 20s”
followed by the decline after the crash.



Total debt in US economy 1912-1933 (US$ bn)

200

180

160

140

120

100

80

60

40

20

0

1921

1931
1914

1924
1916

1919

1926

1929
1918

1928
1915

1920

1925

1930
1913

1923

1933
1912

1922

1932
1917

1927
Source: US Census, Federal Reserve

The US$28.3bn reduction in debt during 1930-33 was equivalent to a massive 26% of
nominal GDP in 1930. In today’s terms, that would be equivalent to a c.US$4 trn
debt reduction.

Performance of asset classes in Winter Now let’s consider the performance of different asset classes during the Winter phase
of the first three long waves.

Equities underperformed in each one With a crash in stock markets ushering in each K-Winter, it’s not surprising that
equities underperformed during each of the first three cycles:

Performance of equities in Winter


K-1 1826-1843 British stocks fell from 77.76 to 17.38 during 1825-43 (trough 15.33 in 1841) YES
K-2 1874-1896 S&P fell 22% during 1873-76, further sharp falls during 1881-84 and 1892-96 YES
K-3 1930-1933 DJIA fell from 248.5 in Dec 1929 to a trough of 41.2 in Jul 1932 YES


….as did commodities With deflation and widespread economic hardship, nor is it surprising that
commodities underperformed on each occasion either:

Performance of commodities in Winter


K-1 1826-1843 Silberling Commodities Index fell from 118 to 86 during 1825-43 YES
K-2 1874-1896 BLS index of commodity prices fell 44% during 1873-96 from 83.7 to 46.5 YES
K-3 1930-1933 Grilli & Yang iindex of commodity prices fell from 23.3 to 12.6 during 1930-33 YES


We only have data for K-3 in housing/real estate After experiencing a bubble during the Autumn phase, real estate/housing should
underperform in Winter. There is a slight problem with real estate (housing) since we
only have data for K-3. Even though the Case-Shiller Home Price Index fell 24% during
1929-33, it was flat in real terms. It was the third best performing of the five asset
classes during the K-3 Winter – hence I’ve categorised its performance as neutral.


2012

Performance of housing/real estate in Winter


K-3 1930-1933 Case Shiller home price index fell 24% from 1929-1933, but was flat in real terms NEUTRAL


Government bonds outperformed Crashing stock markets and depressions, characteristic of Winter, lead to a FLIGHT TO
SAFETY. At the same time, falling prices for goods and services increase the
relative value of (a nation’s) money and “near money”, like government bonds, IF
THE GOVERNMENT IS PERCEIVED TO BE A GOOD CREDIT RISK. These factors,
with the further benefit of falling interest rates, have led to government bonds
outperforming in the Winter phase of each of the first three cycles:

Performance of government bonds in Winter


K-1 1826-1843 Long-term yields fell from 3.54% to 3.17% during 1825-43 (peak 3.79% in 1826) YES
K-2 1874-1896 Long-term yields fell from 5.55% to 3.46% during 1874-95 YES
K-3 1930-1933 Long-term yields fell from 4.73% in 1929 to 4.49% in 1933 versus 24% deflation in 1930-33 YES


Gold - the ultimate safe haven currency – also outperformed in all three, which
shouldn’t be a surprise either.

Performance of gold in Winter


K-1 1826-1843 Gold price was flat at £4.24/oz (in decimalised form) but gained c.26% in real terms YES
K-2 1874-1896 Gold price fell from US$22.99/oz to US$20.67/oz but gained 16% in real terms YES
K-3 1930-1933 Gold price pegged but revalued upwards by FDR from US$20.67/oz to US$35.00/oz in 1933 YES



Thunder Road Report | December 2012 Winter phase of the current long wave

Winter phase of the current long wave

Part 1 – 2000-2012
NASDAQ crash ushered in the current Winter The catalyst for the transition into Winter in this cycle was a crash in the equity
market as in earlier cycles. This time it centred (only too memorably) on the collapse
of TMT stocks (Technology, Media and Telecommunications) in 2000, which is best
illustrated by the NASDAQ chart:

NASDAQ Composite 1990-2003
6,000.00

5,000.00

4,000.00

3,000.00

2,000.00

1,000.00

0.00
Feb-14-1991

Sep-09-1991

Mar-29-2001

Oct-25-2001
Jun-29-1994

Mar-06-1996

Sep-26-1996

Jul-22-1999
Jun-05-1998

Dec-28-1998
Jan-02-1990

Jul-25-1990

Jan-20-1995

Aug-14-1995

Feb-11-2000

Sep-05-2000
Dec-06-1993
Oct-21-1992

May-14-1993

Jul-08-2003
Mar-31-1992

May-21-2002

Dec-11-2002
Apr-21-1997

Nov-10-1997
NASDAQ Composite Index (^COMP) - Index Value

Source: Capital IQ

US debt/GDP in 2000 matched Great Depression The TMT-driven stock market crash in March 2000 (and subsequent bankruptcies like
peak Global Crossing, Worldcom, Enron, etc) would ordinarily have brought on a debt
deflation characteristic of a Kondratieff Winter. Indeed, debt/GDP in the US
economy in 2000 was c.270% - which was in line with the peak debt/GDP during the
last K-Winter, i.e. in the Great Depression. Now we’ve gone far higher – with
debt/GDP currently

US debt/GDP 1929-2012

400%

350%

300%

250%

200%

150%

100%

50%

0%
1934

1944

1954

1964

1974

1984

1994

2004
1929

1939

1949

1959

1969

1979

1989

1999

2009

Source: US Census, Federal Reserve, Bureau of Economic Analysis

From one bubble to another This was when the Greenspan Fed stepped in, defying economic gravity and re-
levitating the US economic bubble, with real estate at the leading edge. The bubble
in real estate began to burst in the first half of 2007 and culminated with the crash of
Lehman Brothers in September 2008.


Winter phase of the current long wave Thunder Road Report | December 2012

Post-NASDAQ crash liquidity tsunami However, it wasn’t just house prices that were rising in the years running up to the
Lehman collapse. This was the beginning of the liquidity tsunami and, from 2000 to
the crash of Lehman in 2008 was an unusual period when (following the low in
equity markets), all five major asset five classes - stocks, government bonds,
gold, commodities, real estate (until 2006 anyway) and commodities were in bull
markets for most of that period. Even art and collectibles and fine wine were in bull
markets. Normally, some asset prices are rising while others are falling.

Monetary policy goes more extreme Bernanke followed Greenspan’s lead, but has been forced to resort to more extreme
monetary policies to ward off even more powerful deflationary forces since 2008.

How to solve a debt crisis This has led to the perverse policy of trying to solve a debt crisis with more debt.
Since the beginning of 2000 the total debt in the US economy has more than doubled
from US$25.4 trillion to US$54.6 trillion. Assets (i.e. debt) on the Fed’s balance sheet
have risen from less than US$800bn to more than US$2.8 trillion - and QE3 has barely
started.

Balance Sheet of the Federal Reserve (US$m)

Source: Federal Reserve Bank of St Louis

“Mailman” Bernanke – he’s delivering But if we remember Bernanke’s famous “helicopter” speech “Deflation – making sure it
doesn’t happen here” from November 2002 (and other similar ones), he is simply
delivering on what he said he would do, i.e. avoid deflation at all costs. So we will
not see a debt deflation at the end of this long wave since:

• Central bankers simply refuse to permit it UNDER ANY
CIRCUMSTANCES; and

• We are already so far past the point of no return in terms of debt,
derivatives, counterparty risk across the banking system, budget
deficits, high unemployment, welfare entitlements, etc, that
permitting debt deflation would very rapidly bring on SYSTEMIC
FAILURE.

Deflation is impossible if enough money is So what’s really happening? The first thing to understand is that if enough new money
created is created then deflation becomes impossible. Julian Snyder, writing in 1993, gets right
to the heart of what’s happening in this Kondratieff Winter:

“Most previous studies of the long wave have assumed that the downswing phase
would be accompanied by price deflation, since, in fact, this has been what
happened in each instance over the past 200 years. The fact that prices on
balance have not fallen has led many to doubt the long wave was repeating.



These people were overlooking the fact, as previously mentioned, that prices are
a direct reflection of man’s power to create nominal money. Thus, whatever the
condition of the economy, the more money you create, the more prices will rise.”

Collapse of Bretton Woods was pivotal The fundamental difference between the current long wave and previous cycle
was the demise of Bretton Woods in 1971, which opened the door to unlimited credit
creation that we are seeing today.

It has had a major impact across the Autumn and Winter phases of the current
cycle (K-4). The next two charts compare the CAGR in the CPI for the Autumn (1981-
2000) and Winter (2000- ) phases versus the three earlier cycles. The uplift to
inflation, or swing from deflation to inflation, is startlingly clear:

Autumn phase: CAGR in CPI – fourth long wave compared to first three (%)

5.0

4.0

3.0

2.0

1.0

0.0

-1.0

-2.0

-3.0

-4.0
K-1 K-2 K-3 K-4


Winter phase: CAGR in CPI – fourth long wave compared to first three (%)

4.0

2.0

0.0

-2.0

-4.0

-6.0

-8.0
K-1 K-2 K-3 K-4


Price changes shifted to the first derivative My thesis is that in the downswing part of the current cycle, i.e. Autumn and Winter
(so far), the decline in consumer prices has shifted from the absolute level typical
in previous cycles to the FIRST DERIVATIVE in this one, i.e. from a decline in the
absolute level of prices to a decline in the RATE OF INFLATION. The chart below
shows the annualised rate of inflation since the current cycle began in 1934:



CAGR in inflation during each phase of the current long wave (K-4)

7.0%

6.0%

5.0%

4.0%

3.0%

2.0%

1.0%

0.0%
Spring Summer Autumn Winter


Long wave trends become apparent Now you can see how the Kondratieff long wave is still in operation as the shape of the
chart is very similar to the charts of the absolute price level in earlier long waves,
especially the first two:

First long wave: consumer price index 1788-1843 (1787=100) Second long wave: consumer price index 1844-1896 (1843=100)

230 230

210 210

190 190

170 170

150 150

130 130

110 110

90 90

70 70

50 50
1791

1821
1794

1824
1806

1809

1836

1839
1788

1818
1815
1800

1803

1830

1833
1812

1842
1797

1827

1871
1844

1874
1856

1859

1886

1889
1868
1865

1895
1850

1853

1880

1883
1862

1892
1847

1877

Source: ONS Source: Measuring Worth

All that’s happened is that, thanks to the collapse of Bretton Woods and central bank
“activism” on a massive scale, the “monetary train” JUMPED THE TRACKS to the
first derivative.

But that’s only the story so far….because I think it’s going to jump the tracks again
as policy makers print so much money that inflation picks up as confidence in the
purchasing power of currencies evaporates.

Also seen in velocity of money Meanwhile, there is another way to strip out the effects of excessive monetary creation
and see the Kondratieff long wave in operation and that is via the velocity of
money. Look at the chart below of the velocity of money in the US since 1959. Please
note this is for the MZM aggregate, i.e. money with zero maturity (liquid money: M2 -
time deposits + money market funds). You can see the peak during 1980-81 – precisely
at the end of the Kondratieff upswing (Summer) – and the almost continuous decline
since:


Thunder Road Rep
port | December 2012 Winter phas of the curre long wave
se ent

Velocity of M oney (MZM – money with zero maturity)

r

This gives aanother insight into how the mechanics o f the long wa are still pl
t ave laying
out in the current cycle with unlimite credit. I’ll return to the subject of m
e ed e money
velocity late but let’s con
er, ncentrate on deflation and d
d debt reduction.

Deflation and debt reduction will take on
d n The deflatio
onary tendenc is being ov
cy verwhelmed b the sheer extent of mon
by e netary
different form from previous long waves
ms s creation, bu is still there if you kno where to look! Debt reduction will also
ut ow r
follow and, just like defla
ation, it will be in a differen form from previous cycle
b nt es.

urning deflation into inflation
Tu Knowing th at Kondratieff Winters are deflationary, b recognising back in 200 that
f d but g 07
central bank would try to inflate their way out of the coming crisis was a conun
ks o w e s, ndrum.
By siding w an inflation
with nary outcome, rather than a deflationary outcome, it se
, eemed
that I was a
arguing that th time is diff
his ferent – usuallly a dangerous stance in fin
nancial
markets. Ho could what is normally a deflationary process be inflationary?
ow y

I realised th I’d already solved it. The “Gold War” report that I wrote in 200 was
hat y 07
sub-titled wwith the famou quote of J.P. Morgan “Go is money and nothing else”
us old
The realisat ion was a way to combine:
y

• Massive credit expansio and any/a means of monetary stimulus
on all
leading to loss of purcha
asing power (
(inflation); and
d

• Falling prices & debt reduction ty
ypical of a Kondratieff W
K Winter
(deflation).
.

Para
adox of inflationa deflation
ary It boiled doown to solving the paradox of how we could simulta
g x aneously experience
inflation an deflation. It depends on the defin
nd nition of monney. There ca be
an
INFLATION MEASURED IN ONE KIND OF MONEY A
N AND DEFLATION MEASURED IN
ANOTHER, hence “Inflatio onary deflation
n”.

Facsimile Real

Source: Clip Art Source: Clip Art
p

e


Although the process is quite well advanced, it still has a lot further to go.

Lows in gold price signalled start of Kondratieff If you look at a chart of the gold price you can see the double bottom either side of
Winter the NASDAQ crash of 2000 – the latter being the catalyst for the beginning of the
Winter phase of this cycle in my opinion. Here is the chart of the gold price during
1996-2004:

Gold price 1996-2000 (US$ oz.)
500.00

450.00

400.00

350.00

300.00

250.00

200.00

Jan-11-2001

May-22-2001

Oct-02-2001

Apr-14-2004

Aug-23-2004
Jan-02-1996

May-10-1996

Sep-19-1996

Mar-25-1999

Aug-03-1999

Dec-10-1999
Feb-26-1998

Jul-07-1998

Nov-11-1998

Mar-14-2003

Jul-23-2003

Dec-01-2003
Feb-13-2002

Jun-24-2002

Oct-31-2002
Apr-24-2000

Aug-31-2000
Jan-29-1997

Jun-09-1997

Oct-15-1997

Gold (COMEX:^GC) - Day Close Price

Source: Capital IQ

Since gold has always outperformed during a K-Winter, this supports my argument
that the current K-Winter began in 2000, marking the onset of the inflationary
deflation.

CPI in absolute and gold terms Now let’s look at prices, in terms of the CPI for the US, measured in different forms of
money. Since 2000, we’ve obviously had inflation in the cost of most goods and
services when measured in current US dollars - as captured by the CPI inflation data
in the left hand chart below. When the same data is measured in terms of gold, we
see deflation as per the right hand chart.

US consumer price index 2000-2012 US consumer price index in terms of gold 2000-2012

240.0 0.8

230.0 0.7

220.0 0.6
210.0 0.5

200.0 0.4

190.0 0.3

180.0 0.2

170.0 0.1

160.0 0
Jan-11

Jan-11
Jan-01

Jan-01
Jan-04

Jan-04
Jan-06

Jan-09

Jan-06

Jan-09
Jan-08

Jan-08
Jan-05

Jan-05
Jan-03

Jan-03
Jan-00

Jan-02

Jan-10

Jan-12

Jan-00

Jan-02

Jan-10

Jan-12
Jan-07

Jan-07

Source: Bureau of Labor Statistics Source: Bureau of Labor Statistics, Kitco

S&P 500 in absolute and gold terms Let’s look at “risk assets” like equities, housing/real estate and commodities which
would normally underperform during a K-Winter.

Since 2000, equity prices, measured by the S&P 500, are almost unchanged. In
terms of gold, however, the “deflation” in equity prices is stark to say the least:



S&P 500 2000-2012 S&P 500 in terms of gold 2000-2012
1700 200

100
1500

0

1300
-100

1100 -200

-300
900

-400

700
-500

500 -600
Jan-12-2001

Jul-20-2001

May-17-2011

Nov-18-2011

Jan-12-2001

Jul-20-2001

May-17-2011

Nov-18-2011
Feb-25-2004

Aug-31-2004

Feb-25-2004

Aug-31-2004
Mar-20-2006

Sep-22-2006

Apr-24-2009

Oct-28-2009

Mar-20-2006

Sep-22-2006

Apr-24-2009

Oct-28-2009
Apr-14-2008

Oct-16-2008

Apr-14-2008

Oct-16-2008
Mar-08-2005

Sep-12-2005

Mar-08-2005

Sep-12-2005
Jul-10-2000

Jan-31-2002

Aug-07-2002

Feb-12-2003
Jan-03-2000

Aug-19-2003

May-06-2010

Nov-09-2010

May-29-2012

Jan-03-2000

Jul-10-2000

Jan-31-2002

Aug-07-2002

Feb-12-2003

Aug-19-2003

May-06-2010

Nov-09-2010

May-29-2012
Apr-02-2007

Oct-05-2007

Apr-02-2007

Oct-05-2007
S&P 500 Index (^SPX) - Index Value S&P 500 Index (^SPX)/Gold (COMEX:^GC) - Index Value

Source: Capital IQ Source: Capital IQ

House prices in absolute and gold terms Housing/real estate is even worse, as these charts for US house prices show:

S&P Case-Shiller Home Price Index for the US 2000-2012 S&P Case-Shiller Home Price Index in terms of gold 2000-2012

220 50.0
45.0
200
40.0
35.0
180
30.0

160 25.0
20.0
140 15.0
10.0
120
5.0

100 0.0
Jan-01

Jan-11
Jan-04

Jan-06

Jan-09
Jan-08
Jan-05
Jan-00

Jan-03

Jan-10
Jan-02

Jan-12
Jan-07
Jan-01

Jan-11
Jan-04

Jan-06

Jan-09
Jan-08
Jan-05
Jan-00

Jan-03

Jan-10
Jan-02

Jan-12
Jan-07

Source: S&P Case-Shiller Source: S&P Case-Shiller, Kitco

Commodity prices in absolute and gold terms It’s not surprising, given the extent of monetary stimulus (and the growth of
China), that commodity prices (represented by the Reuters/CRB Continuous
Commodity Index) have fared well in current dollar terms. Having said that, even
the trend in commodity prices when measured in gold is sharply down:

Reuters/CRB Continuous Commodity index 2000-2012 Reuters/CRB Continuous Commodity index in gold 2000-2012
800.00 150.00

100.00
700.00

50.00
600.00
0.00

500.00 -50.00

400.00 -100.00

-150.00
300.00
-200.00

200.00
-250.00

100.00 -300.00
Jan-12-2001

Jul-20-2001

May-19-2011

Nov-22-2011

Jan-12-2001

Jul-20-2001

May-19-2011

Nov-22-2011
Feb-26-2004

Sep-01-2004

Feb-26-2004

Sep-01-2004
Mar-21-2006

Sep-25-2006

Apr-28-2009

Oct-30-2009

Mar-21-2006

Sep-25-2006

Apr-28-2009

Oct-30-2009
Apr-16-2008

Oct-20-2008

Apr-16-2008

Oct-20-2008
Mar-09-2005

Sep-13-2005

Mar-09-2005

Sep-13-2005
Jan-03-2000

Jul-10-2000

Feb-01-2002

Aug-08-2002

Feb-13-2003

Aug-20-2003

May-10-2010

Nov-11-2010

May-31-2012

Jan-03-2000

Jul-10-2000

Feb-01-2002

Aug-08-2002

Feb-13-2003

Aug-20-2003

May-10-2010

Nov-11-2010

May-31-2012
Apr-04-2007

Oct-09-2007

Apr-04-2007

Oct-09-2007

Reuters CRB Continuous Commodity Index - Index Value Reuters CRB Continuous Commodity Index/Gold (COMEX:^GC) - Index Value


Government bonds in absolute and gold terms Then we get to government bonds which would be expected to outperform during a
K-Winter. So far they have – significantly - helped by falling interest rates and a
flight to safety. In gold terms, however, even the “risk free” US Treasury has been
decimated:



US 10-year Treasury yield (Inverted) 2000-2012 US 10-year Treasury yield (Inverted) in terms of gold
1.00

100.00%
2.00
0.00%

3.00 -100.00%

-200.00%
4.00
-300.00%

5.00 -400.00%

-500.00%

6.00
-600.00%

-700.00%
7.00

Feb-14-2003

Oct-02-2006

Nov-05-2009
Sep-03-2004

May-14-2010

Nov-19-2010
Jan-12-2001

Jul-20-2001

Mar-14-2005

Apr-10-2007

Oct-12-2007
Sep-16-2005

May-27-2011

Dec-01-2011
Mar-28-2006

Apr-21-2008

Oct-24-2008

May-04-2009
Jan-03-2000

Jul-10-2000

Feb-01-2002

Aug-08-2002

Aug-21-2003

Mar-01-2004

Jun-08-2012
Jan-11-2001

Jul-18-2001

May-06-2011

Nov-09-2011
Feb-20-2004

Aug-25-2004

Mar-15-2006

Sep-18-2006

Apr-16-2009

Oct-20-2009
Apr-04-2008

Oct-07-2008
Mar-03-2005

Sep-06-2005
Jan-03-2000

Jul-07-2000

Jan-28-2002

Aug-01-2002

Feb-07-2003

Aug-13-2003

Apr-27-2010

Oct-29-2010

May-16-2012
Mar-26-2007

Sep-26-2007

United States Treasury Constant Maturity - 10 Year (%TCMSY10) - Rate Value 10 Year US Treasury Index (^TNX)/Gold (COMEX:^GC) - Index Value


Performance versus long wave prediction The table below compares the performance of the different asset classes so far in
this Winter phase (since 2000) versus what would have been predicted by the long
wave model:

Performance (so far) of asset classes during Winter of the current fourth long wave cycle (K-4)


Gold Outperform Gold price rose from US$256/oz to US$1,731/oz (high of US$1,920/oz in Aug 2011) YES
Govt. bonds Outperform Long-term yields fell from 6.79% in Jan 2000 to current level of 1.62% YES
Real Estate Underperform Case Shiller house price index rose from 100.0 in Jan 2000 to 145.9 (peak 206.5 in 2006) YES
Stocks Underperform DJIA rose from 9,929 at NASDAQ high (Mar 2000) to 13,021 (high 14,093 in Oct 2008) YES
Commodities Underperform Reut/CRB Continuous Commodity Index rose from 204.3 in Jan 2000 to 572.1 (high 690.1) NO

Source: Federal Reserve,

What is unusual is the simultaneous outperformance of government bonds and
commodities. It is more evidence of the INFLATIONARY DEFLATION paradox.
Something is going to give – and this is the focal point of the great inflation
versus deflation debate, where I believe that inflation prevails.

Monetary train set to jump the tracks again Having shifted from absolute declines in prices to declines in the first derivative
(inflation), I expect the monetary train to JUMP THE TRACKS for a second time with
a rebound in the rate of inflation some time in 2013. This will eventually develop
into an inflationary crisis, causing disruption across the currency, credit and derivatives
markets. The end game, I believe, will be the transition to a new monetary system with
the replacement of the US dollar as the world’s currency.

This view is a long way from the current consensus, so it deserves some explanation.

Part 2 – the approaching wave of inflation in 2013-15
We are already in an inflationary mega-trend
The most powerful inflationary trend of the last The commentators who dismiss the prospect of inflation maybe don’t appreciate that
1,000 years we are already in the midst of an INFLATIONARY MEGA-TREND and one which is
by far the most powerful during the last 1,000 years. This price upwave or “Great
Inflation” is the fourth of the last millennium. The first one began in the twelfth
century, the second in the late-fifteenth century, the third in the early eighteenth
century, while the current one began in 1897. Each one lasted for between about
eighty and one hundred and fifty years.



The four “Great Inflations” of the last millenium

Price upwave Dates

First Great Inflation 1180-1317
Second Great Inflation 1496-1650
Third Great Inflation 1733-1814
Fourth Great Inflation 1897-


The usual suspects The driving forces for these inflations were similar in each case:

• Population growth – increasing pressure on available resources;

• Governments (or kings) running large deficits, usually as a result of
fighting wars; and

• Expansion of the money supply with currency debasement.

Pictures tell the story The trends in price levels in the first three great inflations, along with the unfinished
fourth, are shown below.

First Great Inflation 1209-1317 Second Great Inflation 1496-1650

Source: The Price History of English Agriculture, 1209-1914, Purchasing Power of British Pounds Source: Purchasing Power of British Pounds from 1245 to Present, Measuring Worth
from 1245 to Present, Measuring Worth

Third Great Inflation 1733-1813 Fourth Great Inflation 1897-

Source: Purchasing Power of British Pounds from 1245 to Present, Measuring Worth Source: Purchasing Power of British Pounds from 1245 to Present, Measuring Worth



Today’s price stability is yesterday’s Price The second great inflation of 1496-1650 was considered so SEVERE at the time that
Revolution….go figure (as they say) this period became known as the “Price Revolution”. The CAGR in the price level
during that time was below 1.5% p.a. - something which Ben Bernanke and other
central bankers of today would label as “price stability”. It just shows how far
things have (not) “progressed.”

How did the first three “Great Inflations” come to Before we consider what’s in store during the remainder of the current “Great
an end? Inflation”, or price upwave, it’s worth reviewing how the first three came to an end.
The first two are depressing, to say the least. The third one is the exception since
Britain – then the global hegemon - got sound money “religion” and adopted the Gold
Standard.

How the first three Great Inflations came to an end

Price upwave Summary

First Great Inflation Bankiing collapse followed by "Black Death" (with world
population reduced by an estimated 20%)
Second Great Inflation Plague and wars - population reduction again – and decline in
silver supply (then the world's money)
Third Great Inflation "Great Re-coinage of 1816" and Britain adopted the Gold
Standard


Ain’t gonna happen, by the looks There is no evidence that sound money policies will be adopted by the US. Quite the
contrary, in fact. In 2011, the congressional “Super Committee” could not even agree
on modest cuts to the Federal budget. At this point, it seems that only a crisis will
precipitate change.

This price upwave is almost of the scale Look at the Y-axis of the first three inflations and then look at the current one – there
is no comparison. Here they are all on the same chart rebased to 100 – although I’ve
labelled the X-axis according to the current cycle. The first three are almost horizontal
in comparison.

Winter phase: CAGR in CPI – fourth long wave versus first three (rebased: year 1 = 100)

3,000

2,500

2,000

1,500

1,000

500

0
25

145
1

9

129
33

73

113

121
17

57

137
65

105
41

49

81

89

153
97

First Second Third Fourth

Sources: See the four charts above

There are two key points from the charts of these inflationary periods that I want to
highlight:

• You can see how the trajectory of inflation in the current cycle increased
significantly in the early 1970s – obviously this was when Bretton
Woods (see below) collapsed which severed any direct link between
gold and paper currencies; and



• It’s very noticeable how the rate of inflation accelerated sharply in the
latter stages of each of the first three great inflations. The timing of
the accelerated phase in each of the three and the CAGR of inflation in
each one versus the CAGR of the whole period is shown in the next
table:

CAGR in inflation during the first three Great Inflations

Great Inflation 1209-1317 1496-1650 1733-1813

Whole period 1.2% 1.2% 1.4%
Final phase 8.2% 2.7% 4.2%


With hindsight, it’s clear that the collapse of Bretton Woods had a very significant
impact on the rate of inflation. In the same way, I believe that the recent
announcements of OPEN-ENDED MONEY PRINTING ACROSS THE DEVELOPED
WORLD are equally significant. My view is that we are moving into the final phase of
this Great Inflation with the associated acceleration in inflation as seen in each of the
previous upwaves.

New era: post-QE3
Open-ended money printing On 13 September 2012, Bernanke announced QE3 – the programme to buy US$40bn
per month of MBS with newly created money by the Federal Reserve on an unlimited
time horizon. The QE3 announcement followed hot on the heels of the announcement
of a similar plan (termed OMT – Outright Monetary Transactions) for unlimited bond
buying by the ECB’s Draghi (subject to EU nations agreeing conditions). On 19
September 2012, the Bank of Japan, one of the worst offenders, announced yet
another round of QE. The Swiss National Bank has already pledged to print as many
Swiss francs as required to defend the 1.20 level against the crippled Euro.

And the cure for a financial bubble…. We have entered a NEW ERA in the destruction in the purchasing power of fiat
currencies and the creation of a bubble in money itself. Dr Kurt Richebacher,
publisher of “The Richebacher Letter” until his death in 2007, sagely remarked that:

“The only cure for a bubble is to prevent it from developing.”

Paul Volcker said of Kurt Richebacher:

"Sometimes I think that the job of central bankers is to prove Kurt Richebächer
wrong,"

I fear that it’s already too late and Kurt Richebacher is going to be proved right again.
Ironically, the title of his last newsletter from 22 March 2007 was “A speculative
bubble like no other.”

Long waves and monetisation The following quote (apologies to the author whose name I’ve lost) links the impact of
monetisation on the late stages of the long wave:

“Once the forces of a long wave decline are in motion, they will tend to persist even in
the face of substantial money supply injections – like a car skidding backward downhill
while its wheels continue to spin uselessly in an uphill direction. Eventually, the
inflationary forces catch fire again and the car, once again, lurches upward, but with
greater difficulty and a higher rate of inflationary friction. Sooner or later, additional
money printing produces no economic motion – only higher prices – and the economy
figures its inevitable economic decline.”

The famous money speech from Atlas Shrugged There should be more outrage regarding the obscene abuse of the monetary system
by the central banks and the Federal Reserve in particular as the “guardian” of the
world’s reserve currency, such as it is. Money represents much more than just a
medium of exchange, it represents THE CAPITALISATION OF HUMAN LABOUR. Here
is a short piece of the famous “money speech” from Ayn Rand’s classic “Atlas
Shrugged”, a book which is proving chillingly prophetic in terms of unfolding events:



“Money is the barometer of a society's virtue. When you see that trading is done,
not by consent, but by compulsion – when you see that in order to produce, you
need to obtain permission from men who produce nothing – when you see that
money is flowing to those who deal, not in goods, but in favors – when you see
that men get richer by graft and by pull than by work, and your laws don't
protect you against them, but protect them against you – when you see
corruption being rewarded and honesty becoming a self-sacrifice – you may
know that your society is doomed… Whenever destroyers appear among men,
they start by destroying money, for money is men's protection and the base of a
moral existence. Destroyers seize gold and leave to its owners a counterfeit pile
of paper.”

The impact of inflation One of the problems with inflation is that it acts as a REGRESSIVE FORM OF
TAXATION hurting low and middle income families the most. From Wikipedia:

“A regressive tax is a tax imposed in such a manner that the tax rate decreases as the
amount subject to taxation increases… In terms of individual income and wealth, a
regressive tax imposes a greater burden (relative to resources) on the poor than on
the rich”

Looking at the US, accelerating inflation will pose a serious economic challenge for
much of the population as the American Payroll Association reported last month that
68% of American are already living “paycheck to paycheck.”

Complacency and the velocity of money Velocity of money
I showed the chart for the velocity of money for the MZM aggregate above. Many
commentators who disagree with the likelihood of a sharp upturn in inflation point to
the comatose level of in this measure as proof that the chance of a pick-up in inflation
remains remote.

Tipping points…. They overlook two facts relating to the early stages of historic examples of inflationary
periods:

• The rise in prices tends to lag the growth in money supply; and
• The velocity of money can remain stable, or continue to fall, for some time.

You can see both during the inflationary Summer period (1967-80) of the current long
wave in terms of US data. Firstly, the three inflationary peaks in 1970, 1974 and 1980
were all preceded by peaks in money supply growth between 2-4 years earlier.

Money supply (M2) and inflation (CPI) during 1967-80
16.0%

14.0%

12.0%

10.0%

8.0%

6.0%

4.0%

2.0%

0.0%
1967 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1978 1979 1980

Money supply Inflation


Please note, I have used the M2 aggregate for money supply since the data for MZM
money supply is not available before 1980 (even though the MZM velocity is).



During this entire period, when inflation varied between 2-14%, the velocity of M2
remained VERY stable:

Velocity of money (M2) and inflation (CPI) during 1967-80
2.5 16.0%

14.0%

2.0 12.0%

10.0%

1.5 8.0%

6.0%

1.0 4.0%

2.0%

0.5 0.0%
1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980

M2 velocity Inflation


In severe, or hyperinflations, like Weimar, a tipping point is reached, when velocity
spikes upward and prices rise faster than the increase in the money supply, as
confidence in the value of the currency suddenly plummets. The chart below for the
Weimar period show the trend in the German wholesale price index and the velocity of
money from January 1921 to October 1923

Velocity of money in Germany: January 1920-October 1923

20
18
16
14
12
10
8
6
4
2
0
Jan-21

Apr-21

Jul-21

Oct-21
Jan-20

Apr-20

Jul-20

Oct-20

Jan-23

Apr-23

Jul-23

Oct-23
Jan-22

Apr-22

Jul-22

Oct-22

Source: The Economics of Inflation – A Study of Currency Depreciation in Post War Germany

It’s also interesting to note that the Weimar inflation was preceded by a boom in
the German equity market as Jens Parsson explained in his 1974 book “Dying of
Money: Lesson from the Great German and American Inflations.”

"Monetary inflation invariably makes itself felt first in the capital markets, most
conspicuously as a stock market boom. Prices of national product remain temporarily
steady while stock prices rise and interest rates fall. This (is what) happened at the
commencement of the German inflationary boom of the 1920... (then) velocity took an
almost right-angle turn upward in the summer of 1922, and that signaled the beginning
of the end.”

Determination to debase the dollar is under- Bernanke REALLY does want to devalue the dollar
estimated



Despite Bernanke pushing ahead with an indefinite version of QE3, most
commentators (surprisingly) do not view it as inflationary, or at least not for a
considerable length of time. While it should be abundantly clear that his entire
strategy has been inflationary since Lehman collapsed, I think the vast majority of
commentators still underestimate Bernanke’s determination to reduce the value of
the dollar through inflation. Bernanke’s claim to fame as an academic is for his study
of the Great Depression and how to combat deflation. I went back and re-read
Bernanke’s old essays and speeches on preventing deflation.

Bernanke’s emphasis on dollar devaluation gets What is very striking in two speeches is how he singles out dollar devaluation as
overlooked being the KEY policy which took the US out of the Great Depression. Here is a
segment from his famous “helicopter speech” in 2002, i.e. the one more formally
known as “Deflation: Making Sure “It” Doesn’t Happen Here.”

“Although a policy of intervening to affect the exchange value of the dollar is nowhere
on the horizon today, it's worth noting that there have been times when exchange rate
policy has been an effective weapon against deflation. A striking example from U.S.
history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in
1933-34, enforced by a program of gold purchases and domestic money creation. The
devaluation and the rapid increase in money supply it permitted ended the U.S.
deflation remarkably quickly. Indeed, consumer price inflation in the United States,
year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in
1934.”

Bernanke has been telling the same story since Here is a segment from a 1999 speech at Princeton, “Japanese Monetary Policy: A Case
the last century of Self-Induced Paralysis?”

“Franklin D. Roosevelt was elected President of the United States in 1932 with the
mandate to get the country out of the Depression. In the end, the most effective
actions he took were the same that Japan needs to take - namely, rehabilitation
of the banking system and devaluation of the currency to promote monetary
easing. But Roosevelt’s specific policy actions were, I think, less important than his
willingness to be aggressive and to experiment - in short, to do whatever was
necessary to get the country moving again. Many of his policies did not work as
intended, but in the end FDR deserves great credit for having the courage to abandon
failed paradigms and to do what needed to be done.”

In case you don’t think the Federal Reserve is serious in reducing the value of the
dollar, it’s worth remembering these comments from high-profile hedge fund manager,
Kyle Bass, speaking at the annual AmeriCatalyst event in late-2011:

“The government’s idea right now is we are going to export our way out of this and
when I asked a senior Obama administration official last week how are we going to
grow exports if we won’t allow nominal wage deflation? And he says, we are just
going to kill the dollar. I said okay…I mean, that’s the only answer.”

Robert Rubin is trying to tell us something Let’s also remember Robert Rubin’s comments regarding the dollar which appeared on
Bloomberg on 9 March 2012. Rubin is another consummate “insider” having been
Secretary of the Treasury during Clinton, ex-GS and Citi, Bilderberg and Co-Chair of
the Council on Foreign Relations.:

“Robert Rubin, who as U.S. Treasury secretary in the 1990s promoted a stronger dollar,
said he has too much of his personal investments in the currency. A ‘disproportionate
amount’ of his assets are in cash and he ‘should be more allocated away from the
dollar,’ Rubin, 73, said yesterday in a speech at the TradeTech conference in New
York. He said he also was “greatly overweighted…My overall conclusion is we should
all hope for the best, he said. ‘It is absolutely prudent to prepare for the worst.”



Crumbling foundations of the dollar’s reserve status
Two “sacred cows” under threat All paper currencies are devaluing relative to gold but, as the world’s reserve currency,
the US dollar stands at the centre of all this. The foundations of the dollar’s status
are being dismantled while relatively few commentators seem to be paying
attention. For example, let’s consider two issues which have been widely touted as
critical to preserving the dollar’s reserve currency status:

• China has to buy US Treasury debt; and

• The dollar has a monopoly on use in world trade.

Unfortunately, one of these has vanished and preparations are well advanced for the
demise of the second.

China has been a seller…. The consensus view for years has been that China HAS to keep buying US Treasuries
because the alternative was mutually assured economic destruction of the US dollar
and the Chinese economy. The chart below shows how July 2011 marked the peak in
Chinese holdings – since then the holdings have been reduced by about US$160bn,
i.e. about 12%.

Chinese holdings of US Treasuries since April 2011 (US$ bn)

1,350

1,300

1,250

1,200

1,150

1,100

1,050

Aug-12
Feb-12

May-12

Sep-12
May-11

Jul-11

Aug-11

Sep-11

Oct-11

Nov-11

Jan-12

Mar-12

Apr-12

Jun-12

Jul-12
Apr-11

Dec-11
Jun-11

Source: US Treasury

….since S&P downgraded the US AAA credit In my opinion, it’s not a coincidence that S&P downgraded the US AAA sovereign
rating credit rating on 5 August 2011 and Chinese holdings of US Treasury bonds peaked
at US$1.315 trn in July 2011. Indeed, China is showing a marked reluctance to continue
funding US deficits as its holdings of US Treasuries have fallen by approximately
US$160bn from the July 2011 peak. Meanwhile, the US Federal deficits remains above
US$ 1 trillion. In spite of this, nobody seems to care!

China and its trading partners preparing for Besides ready buyers of US debt, the foundation of the dollar’s reserve currency status
trade in local currencies (post Bretton Woods) has been its near-monopoly use for transacting world trade.
Preparations to dismantle the dollar’s monopoly on world trade are taking place in
front of our eyes, primarily by China in conjunction with its trading partners. Few
people seem to be worried about this issue either.

BRICS policy following March 2012 meeting The BRICS nations (including South Africa as the “S”) met in New Delhi on 29 March
2012 where they laid the groundwork for settling trade balances in their own
currencies. According to Wikipedia:

“To promote trade in local currencies, the BRICS countries signed the Master
Agreement on Extending Credit Facility in Local Currency and the Multilateral
Letter of Credit Confirmation Facility Agreement to replace the United States
dollar as the main unit of trade between them.”



BRICS leaders at March 2012 summit

Source: bricsindia.in

Since then, preparations by the BRICS have taken a further step forward. The
following was from a Forbes report on 20 June 2012:

“Brazil, Russia, India and China, the BRIC countries, are back to talking about creating a
unified financial system where they can avoid euro and dollar volatility. This time, a
pooling of Central Bank dollars from the countries in case liquidity dried up as the
world tracks the West’s crisis momentum. Regardless of the amount of difficulty
involved, the big four emerging markets plus South Africa said earlier this week they
were considering setting up a foreign-exchange reserve pool and a currency-swap
arrangement in an effort to avoid any credit crisis stemming from the advanced
economies. China President Hu Jintao and other leaders met in Los Cabos, Mexico for
the G20 Summit. There, according to the Chinese Foreign Ministry, the leaders
discussed the currency swap and foreign-exchange reserve pool ideas with their
Russian, Indian and Brazilian peers. Hu asked the finance ministers and central bank
chiefs to implement these ideas, according to a story in China Daily on Wednesday
morning.”

China’s bilateral currency agreements with key Now let’s consider the raft of bilateral trade agreements between China and several of
trading partners its major trading partners:

• Russia – Vladamir Putin and Wen Jiabao announced an agreement to
conduct bilateral trade in their own currencies in November 2010. This
was followed up by the signing of a bilateral currency settlement
agreement between their central banks in June 2011.

• Japan – China and Japan announced plans to promote direct exchange
of their currencies in December 2011, negating the need to buy dollars.
On 1 June 2012, China and Japan began to directly trade their currencies
on the inter-bank foreign exchange markets in Shanghai and Tokyo for
the first time.

• Germany – following talks in late-August 2012, China and Germany
announced an accord to transact an increasing amount of their trade in
Euros and the Yuan. This was from a Reuters report on 30 August 2012:

“Germany and China plan to conduct an increasing amount of their trade
in euros and yuan, the two nations said in a joint statement after talks
between Chancellor Angela Merkel and Chinese Premier Wen Jiabao in
Beijing on Thursday. ‘Both sides intend to support financial institutions
and companies of both countries in the use of the renminbi and euro in
bilateral trade and investments,’ said the text of the statement. It also
said that both parties welcomed investments in China's interbank bond
market by German banks and supported the settlement of business in
the yuan by German and Chinese banks and the issuance of yuan-
denominated financial products in Germany.



• Australia – in late- March 2012, China and Australia agreed a currency
swap with Australia. The Reserve Bank of Australia commented:

“The main purposes of the swap agreement are to support trade and
investment between Australia and China, particularly in local-currency
terms, and to strengthen bilateral financial co-operation…(there were)
increasing opportunities available to settle trade between the two
countries in Chinese renminbi and to make renminbi-denominated
investments.”

Australia is obviously a major exporter of key commodities, like iron ore,
coal and agricultural products.;

• Brazil – which is the other major supplier of iron ore. Besides the BRICS
agreement (above), China and Brazil agreed a currency swap last month;

• Chile – with iron ore sorted out, what about copper? Last month,
Chinese Premier Wen Jiabao and Chilean President Sebastian Pinera
agreed to upgrade their bilateral ties to a strategic partnership and
double trade in three years. The agreement proposed the creation of
currency swaps, reportedly to expand settlement in Yuan;

• Taiwan – a currency clearing agreement was signed between China and
Taiwan In September 2012. Trade will be settled in local currencies at the
Bank of Taiwan in Shanghai; and

• UAE – an agreement was reached to settle oil trades between China and
the UAE in Yuan.

I’ve just covered three major ones, but there are many others, for example, China has
also agreed a currency swaps with other countries, including Thailand, Indonesia,
Malaysia, Indonesia, and Kazakhstan.

Yuan now accounts for 10% of China’s foreign It should be clear by now that preparations are well advanced for the replacement
trade of the US dollar’s monopoly on world trade. In fact, according to the latest data
from the Society for Worldwide Interbank Financial Telecommunication (SWIFT),
Yuan-denominated trade accounted for 10 percent of China's total foreign trade
in July 2012 compared with zero two years ago. As this process unfolds, the value of
the US dollar will erode – which will manifest itself in inflation.

Other preparations China has taken other steps made several other steps towards internationalising the
use of the Yuan:

• It was announced in early March 2012 that the China Development Bank
will make Yuan loans to development banks in the other BRICS nations;

• After a 5-year gap since the last relaxation of the trading band, China
announced in April this year that it would be increased from 0.5% to
1.0% versus the US dollar;

• Last September, China and Britain agreed to cooperate in establishing
London as a major offshore trading hub for the Yuan; and

• On 29 June 2012, China announced that it had set up a trial zone for
Yuan convertibility. This was from a BBC report:

“China is to set up a special business zone to experiment with the yuan's
convertibility, the latest step in its moves to open up its capital markets. The
Qianhai zone will be established in the southern city of Shenzhen, just across
the border from Hong Kong…It has also been pushing for a more global role
for its currency. Zhang Xiaoqiang, vice chairman of China's National
Development and Reform Commission, the state planning agency, said: ‘The
country's policy is to gradually open up its capital account and realise the full


convertibility of the yuan.’ Qianhai, as the first experimental zone of the
country's modern service industry, should be a pioneer of that.”

A Yuan-based regional bloc is forming On 31 October 2012, China Daily commented on the conclusions of a report from the
Peterson Institute for International Economics that a China based currency bloc is
forming in Asia:

“The report agreed that the renminbi has been moving closer to becoming a global
reserve currency. It noted that seven out of 10 major economies surrounding the
Chinese mainland were tracking the yuan more closely than they do the US dollar,
including South Korea, Indonesia, Malaysia, Singapore and Thailand. Only three
economies, Hong Kong, Vietnam, and Mongolia, still have their currencies following the
US dollar more closely than the yuan”

Similarities with events prior to the last change in the monetary system
Bretton Woods quasi-Gold Standard collapsed in I am struck by the similarities between the events which preceded the demise of
1971 the world’s last monetary system - the post World War II Bretton Woods (BW)
monetary system in 1971 and what’s happening today.

President Nixon meets President de Gaulle in 1969 prior to the collapse of Bretton Woods

Source: Jotzet / Foter / Public Domain Mark 1.0

Space prevents a detailed analysis of the demise of BW, but here is a brief summary:

• In the early 1960s, the US began running trade and budget deficits which
putting pressure on the dollar’s peg to gold at US$35/oz. In 1961, the US
and UK together with Germany, France, Switzerland, Italy, Belgium,
Netherlands and Luxembourg formed the London Gold Pool. These
countries agreed to pool their gold reserves and sell gold to maintain the
dollar peg;

• The escalation of the Vietnam War and LBJ’s social programmes in the
mid-1960s increased the deficits and put even further downward
pressure on the dollar. The London Gold Pool began losing large
quantities of gold as the US exported its inflation (and Treasury
securities) to the rest of the world.

• One major trading partner, in particular, took exception to US monetary
and fiscal policy and that was France. Speaking in 1965, French President



Charles de Gaulle described the dollar as “America’s exorbitant
privilege”, stopped buying US Treasuries and began converting US dollar
reserves into gold bullion at an increasing rate. Other countries began to
follow suit.

• In March 1968, France pulled out of the London Gold Pool, the Fed
Chairman threatened to defend the $35/oz gold price down to the “last
ingot” and the day after 225 tonnes disappeared in a single day, the
London Gold Pool collapsed and the gold’s dollar peg was broken.

• In 1971, as US inflation hit 5.8% and Switzerland and France made large
redemptions of dollars for US gold reserves, President Nixon finally
closed the “Gold window” and the direct convertibility of the dollar into
gold. So ended Bretton Woods, setting the scene for the acceleration in
inflation and surge in the gold price during the 1970s.

• The inability of the US to pursue prudent fiscal and monetary policies
opened up the structural flaws in Bretton Woods which were eventually
overwhelmed by markets. The demise of BW prompted the transition to
the current system of un-backed floating currencies whose shelf life is
running out.

If we fast forward to today, it’s abundantly clear that China is taking a similar role to
that of France in the mid-1960s, i.e. acting as the main protagonist shepherding
the world towards a new system.

High-level Chinese criticism of today’s dollar- In the same way that President de Gaulle was a vocal critic of BW, senior Chinese
denominated system officials have criticised the current system. For example, outgoing President Hu Jintao
described the US dollar-dominated system as a “product of the past” in January 2011.

Zhou Xiaochuan, Governor of the People’s Bank of China (PBOC), has been a
particularly high profile critic of our current system. On 23 March 2009, the PBOC
released a statement (also published on the Bank for International Settlements
website) by Zhou “Reform the International Monetary System” in which he called for
the replacement of the dollar as the world’s reserve currency:

“The outbreak of the current crisis and its spillover in the world have confronted
us with a long-existing but still unanswered question, i.e., what kind of
international reserve currency do we need to secure global financial stability and
facilitate world economic growth, which was one of the purposes for establishing
the IMF?”

Un-backed systems like today’s are the Zhou made the valid point that the current un-backed monetary system is the
exception EXCEPTION and, by implication, unsustainable:

“Acceptance of credit-based national currencies as major international reserve
currencies…is a rare special case in history”

Triffin’s Dilemma recycled Referring to the dollar, Zhou highlighted the problem of “Triffin’s Dilemma”, i.e. the
conflict of interest between a national currency and its use as the reserve currency,
which had been the essence of French dissatisfaction:

“On the one hand, the monetary authorities cannot simply focus on domestic goals
without carrying out their international responsibilities; on the other hand, they cannot
pursue different domestic and international objectives at the same time. They may
either fail to adequately meet the demand of a growing global economy for liquidity as
they try to ease inflation pressures at home, or create excess liquidity in the global
markets by overly stimulating domestic demand. The Triffin Dilemma, i.e., the issuing
countries of reserve currencies cannot maintain the value of the reserve currencies
while providing liquidity to the world, still exists.”



Loss of US AAA rating was a turning point In my opinion, preparations for the transition to a new monetary began to speed
up following S&P’s downgrade of the US sovereign credit rating from AAA to AA+
on the evening of 5 August 2011. I see this as a VERY significant event. While the US
“establishment” (Obama, Geithner and Buffet) lashed out at S&P, China lashed out at
the US. The following was from a BBC report on 6 August 2011, which quoted China’s
state-owned news agency repeating Zhou’s call for a new reserve currency:

“China has scolded the US over its ‘addiction to debt’ after rating agency Standard &
Poor's downgraded the US top-notch AAA rating to AA+. State news agency Xinhua
said unless the US cut its ‘gigantic military expenditure and bloated welfare costs,’
another downgrade would be inevitable. Xinhua called for the printing of US dollars to
be supervised internationally and repeated China's contention that a new global
reserve currency might be needed.”

China acting like France pre-BW demise Besides criticism of the existing system, there are two other ways that China (in
modern times) is behaving like France in the 1960s/beginning of the 1970s:

• We’ve already seen (above) how China has become a net seller of US
Treasuries; and

• China has also been accumulating gold. In April 2009, China surprised
the gold market with the announcement that it had increased its gold
reserves by 454 tonnes, to 1,054 tonnes (still a long way below the 8,132
tonnes of gold reserves which the US alleges to possess), since the last it
had provided an update on its gold reserves in 2003.

Ssshhh….,China is quietly adding to its gold Anecdotal evidence is strongly supportive of the view that China is once again
reserves increasing its gold reserves even though it has yet to make a formal announcement. I
highlighted the significance of the downgrade of the US AAA credit rating on 5 August
2011 earlier. Only two months later, reports of heightened demand for physical gold
from Asia – and especially China - in the London market began to filter through.
Here are several examples from various sources:

21 October 2011 – King World News’ “London Trader”:

“We had a major, major physical buy order today. The Chinese bought a massive
amount of physical today at the lows.”

17 January 2012 – King World News’ “London Trader”:

“They (the Chinese) have recently taken another roughly 150 tons away from the
Western central banks.”

18 March 2012 - Jim Willie of the Hat Trick Letter:

“My best gold trader source…The Chinese are the principal buyers, but he swears that
China is not alone… The battle is being won in the vaults, where the gold cartel is being
depleted”

19 June 2012 - TF Metals Report:

“London Good Delivery bars are being delivered to Eastern buyers. Instead of being
vaulted inside the LBMA system, these bars are being sent directly to refiners. The bars
are then being melted and recast in 1 kilogram sizes.”

Surging Chinese gold imports via Hong Kong There is other evidence of strong Chinese gold demand in the data for Chinese gold
imports via Hong Kong. During the July-September quarter of 2012, they rose 52% to
199 tonnes compared with 131 tonnes a year earlier. On an annualised basis, this is
about 800 tonnes compared with annual world mine production of c. 2,700 tonnes.
The next chart aggregates Chinese gold production and imports via Hong Kong:



Output of China gold mines plus imports via Hong Kong

Source:: Chartsrus

Chinese officials confirming pro-gold policy On 8 November 2012, Zhang Jianhua, an official of the Peoples Bank of China stated:

"The Chinese government should not only be cautious of the imported risk caused
by rising global inflation, but also further optimize its foreign exchange portfolio
and purchase gold assets when the gold price shows a favorable fluctuation."

I think it already is, but will (undoubtedly) continue adding to its reserves. Just to
emphasise the point, a few days later Gao Wei, an official from the Department of
International Economic Affairs of Ministry of Foreign Affairs, writing a commentary in
the China Securities Journal argued that China’s gold reserves were “too small.”

Like France in the 1960s, China is the main protagonist, but other central banks are
also increasing their gold reserves, just as they did in the final days of BW. These
institutions have had an almost Damascene conversion in recent years as they have
changed from sizeable net sellers to sizeable net buyers. We probably shouldn’t be
surprised that a) they were late joining the party and b) the inflection point was in
2008 – when the Great Financial Crisis hit - 7 years into the gold bull market.

Central bank gold holdings since 2000 (tonnes)

Source: World Gold Council


Transition to a new monetary system Thunder Road Report | December 2012

Transition to a new monetary system

New reserve currency will be an expanded SDR Careful examination the writings of elite level central bankers, like the PBOC’s Zhou,
and western banking/political “insiders”, it becomes clear that the basic plan for the
new reserve currency has already been worked out. Replacing the dollar will be a
new global reserve currency based on a basket of leading currencies - an EXPANDED
VERSION OF THE IMF’S SPECIAL DRAWING RIGHT (SDR).

Here is Wikipedia describing the SDR in its current form:

“Special drawing rights (SDRs) are supplementary foreign exchange reserve assets
defined and maintained by the International Monetary Fund (IMF). Not a currency,
SDRs instead represent a claim to currency held by IMF member countries for which
they may be exchanged…While they may appear to have a far more important part to
play, or, perhaps, an important future role, being the unit of account for the IMF has
long been the main function of the SDR. Created in 1969 to supplement a shortfall of
preferred foreign exchange reserve assets, namely gold….the value of a SDR is defined
by a weighted currency basket of four major currencies: the US dollar, the euro, the
British pound, and the Japanese yen.”

Current composition of SDR In its current form, the SDR is composed of the following:

Current composition of the Special Drawing Right (SDR)

Currency % of SDR

US dollar 43.9%
Euro 34.4%
Sterling 11.5%
Yen 10.2%

Source: Wikipedia

Yuan and possibly other BRICS currencies will be In its expanded form it is likely to include the Chinese Yuan (Renminbi) and
added potentially the currencies of other BRICS nations. Let me explain.

Key speech by PBOC Governor In his landmark 2009 essay, “Reform the international monetary system”, the PBOC’s
Zhou advocated a super-sovereign reserve currency based on the SDR concept:

“The IMF also created the SDR in 1969, when the defects of the Bretton Woods system
initially emerged, to mitigate the inherent risks sovereign reserve currencies caused.
Yet, the role of the SDR has not been put into full play due to limitations on its
allocation and the scope of its uses. However, it serves as the light in the tunnel for
the reform of the international monetary system.”

He calls for the SDR to be used in international trade, for the pricing of commodities
and financial instruments and as the standard accounting unit:

“The scope of using the SDR should be broadened, so as to enable it to fully
satisfy the member countries’ demand for a reserve currency. Set up a settlement
system between the SDR and other currencies. Therefore, the SDR, which is now
only used between governments and international institutions, could become a
widely accepted means of payment in international trade and financial
transactions. Actively promote the use of the SDR in international trade,
commodities pricing, investment and corporate book-keeping. This will help
enhance the role of the SDR, and will effectively reduce the fluctuation of prices
of assets denominated in national currencies and related risks.”

Not surprisingly, Zhou recommends that the currencies of other large economies
should be included:


Thunder Road Report | December 2012 Transition to a new monetary system

“The basket of currencies forming the basis for SDR valuation should be
expanded to include currencies of all major economies, and the GDP may also be
included as a weight.”

No doubt, he has the Yuan and some of the other BRICS currencies in mind.

SDR plan backed in official Chinese media Now let’s review an article from the “China Daily” newspaper on 16 June 2012. It has
the largest circulation of any newspaper in China and, as Wikipedia explains, is a
mouthpiece for Chinese policy:

“it is regarded as the English-language ‘window into China’ and is often used as a
guide to official policies… It specifically targets an international audience… For the
most part, the paper portrays the official policy of the PRC. The editor of the paper has
told foreign editors that the paper's editorial policy was to back the Party line and
criticize the authorities only if there was deviation from party policy.”

The article argued that:

“The IMF should fully exercise its role and turn the Special Drawing Rights into a
new international reserve currency.”

It goes on to call for the diversification of international reserves within the SDR
structure which would:

“permit the US dollar to continue to play an important role in the long term, but other
currencies such as the euro, sterling, the yen, and the renminbi (Yuan) would play a
greater role as international reserve currencies. It is also imperative to include the
currencies of emerging economies in the currency basket of the Special Drawing
Rights and reform their adjustment and distribution. The IMF should make the
currency basket of the Special Drawing Rights reflect the state of the world's economy
accurately, and make the Special Drawing Rights play an important role in
international clearing, commodity and asset pricing, as well as in international
reserve assets.”

World Bank President hinted at expanded SDR Ironically, it’s not just China – even consummate US “insiders” are preparing for a
post-dollar reserve currency and have said so publicly. The President of the World
Bank, Robert Zoellick, is a consummate western “insider.” He is ex-US Treasury,
Deputy Chief of Staff, Deputy Secretary of State, PNAC, Council on Foreign Relations
and Bilderberg. Writing in the FT in November 2010, Zoellick argued that a successor
is needed to what he termed the “Bretton Woods II” system of floating currencies.
That was stating the obvious, but what was more interesting is that he also called for
an expanded SDR to be part of the new monetary system:

“Mr Zoellick, a former US Treasury official, calls for a system that ‘is likely to need
to involve the dollar, the euro, the yen, the pound and a renminbi that moves
towards internationalisation.”

So it seems fairly clear that the plan is for continued use of the US dollar and Euro,
British pound, etc, albeit in what will (then) be depreciated forms. However,
international trade and accounting will be conducted in the new SDR’s. It’s certainly
noteworthy that US customs forms already have a box for inputting the SDR value
of the transaction:


Transition to a new monetary system Thunder Road Report | December 2012

US customs form

Source: US Postal Service

The new reserve currency will need some kind of It should be glaringly obvious where we are heading, but as the purchasing power of
“backing” the dollar and other currencies declines, I think that there will be an aversion by
exporting nations to continue accepting payment in un-backed currency, even one
which is broader in construction. On that note, let’s consider other remarks made by
Zhou Xiaochuan and Robert Zoellick regarding the coming new reserve currency. Zhou
argued that it:

“should first be anchored to a stable benchmark.”

Robert Zoellick talked about an:

“international reference point.”

Now what could act as the “benchmark” or What could fulfil such a critical role in the world’s monetary system? There’s only one
“reference point” possibility with a track record of several thousand years as Zoellick stated (leaked) in
the FT article:

“The system should also consider employing gold as an international reference
point of market expectations about inflation, deflation and future currency
values.”

One thing comes to mind Here is Philip Barton of the Gold Standard Institute writing in “The Dawn of Gold”:

“A stock of anything has to be started at a moment in time. A stock of 170,000 tonnes
does not just suddenly appear. At some point, long ago, the decision was made to
begin to hoard gold. No one hoards something that will not hold its value over time.
No one would put a dozen eggs or an iron bar in the back shed and expect it to have
value fifty years later. The crucial point to understand is that when the original decision
was made to begin to acquire and hoard gold, it must have already been regarded as a
store of stable value over time, otherwise the decision to store it would not have been
made.”

Besides central bank buying:

Remonetisation of gold There are other signs that gold is set to play a bigger role in the monetary system –
what I would characterise as the “remonetisation of gold”. The Bank for International
Settlements (BIS) is proposing to upgrade gold to a Tier 1, zero risk weighted asset
(RWA) in line with sovereign debt as part of Basel III regulations on banking
supervision. In its “Progress report on Basel III implementation” from April 2012, it
noted:


Thunder Road Report | December 2012 Transition to a new monetary system

“at national discretion, gold bullion held in own vaults or on an allocated basis to the
extent backed by bullion liabilities can be treated as cash and therefore risk-weighted
at 0%.”

It was previously risk weighted as a Tier 3 asset at 50%.

In the US, the Office of the Comptroller of the Currency (OCC), Federal Deposit
Insurance Corporation (FDIC), in conjunction with the Federal Reserve Board of
Governors, US Treasury have also drawn up provisional plans to include gold in risk
weighted assets (RWA) at 0% as part of a review of banks’ regulatory capital rules.
Currently, however, this proposal would only apply to financial institutions with less
than $1bn in assets.

With gold returning to the system, the question is how will it perform in its role as
the “stable benchmark” (Zhou) or “international reference point” (Zoellick)?

Zoellick even mentioned gold Following the article, which received a lot of coverage at the time, Zoellick was asked
to clarify his comments on gold in a subsequent interview. Firstly, let me pick out a
couple of the points he made:

“What I suggested is that gold serves as a key reference point to allow people to
assess the relations between different currencies… The system should also
consider employing gold as an international reference point of market
expectations about inflation, deflation and future currency values.”

Zoellick is not suggesting a return to a gold standards or gold exchange standard of
the past, but something new it seems.

Jim Sinclair suggests a link between gold and M3 On 13 February 2012, Jim Sinclair published some cryptic clues as to how the new
money supply system might work, although he seems to separate western currencies from the
developing world/BRICS:

“I see the new system utilizing a western world M3, which all member
governments will agree to as 100 on the Index of Standard Currency Equilibrium.
As this measure rises and falls, governments will agree that the value of their
Treasury gold will move in the same direction and percentage according to their
GDP ranking.”

Bascially a “fudge” without direct convertibility He likens the new system to the creation of the Rentenmark, which was created in the
wake of the monetary breakdown in Weimar Germany, and backed by mortgaged
land.

“There will be many variations and tweaks to this concept, but once again a new
Rentenmark will be invented as a virtual reserve currency unit tied to a standard
(gold) with a shadow of control on western global money supply. A function of
control will be by exposure (M3), but not convertibility. Like the Rentenmark, it
will be a bit of a farce, but it will work due to the demand for a fix that sits in the
shadow of gold but is not convertible.”

A final thought from former broker, Peter Baxter:

“I do believe one of the single greatest tragedies of the 20th century was the
calculated repression of the burgeoning Austrian School in favour of the flawed
Keynesian model of fiscal monetarism that has proven since inception to be the
source of so much systemic dysfunction… These wonderful bandits, Kondratieff,
Schumpeter, Cayce, von Mises, Dewey, et al, did lose out to the elitist sponsored
Keynesian model at that time, but the veracity of their theorems never died. Their
time has arrived now.”


Have you seen this man? Thunder Road Report | December 2012

Have you seen this man?

WANTED

FOR CRIMES
AGAINST THE
LONG WAVE

Source::Bloomberg


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