Today we are going to try and help you understand the strange action in the stock and bond markets. We are going to look into the future, and see if we can get a feel for what's around the curve in the road. Is it smooth driving, or are there some rocks in the road we need to avoid?

Last week I asked, "What if they gave a Dollar Devaluation Party and no one came?" After a quick review, I am going to follow up on the implications of this theme, as I believe this is going to have a big impact upon the economy and your investments.

1. Japan is at the epicenter of the deflationary forces that are sweeping the world. The Fed told (or suggested to) Japan at their Jackson Hole meeting that they could get out of their deflationary spiral by printing money and dramatically dropping the value of the yen. The Bank of Japan could care less what the Fed thinks. However, they have finally come to the end of their ability to do nothing, and being faced with a true crisis, will go about destroying their currency on the backs of the average consumer by reducing the overall standard of living for the little guy, all the while striving to save face. Given the massive incompetence demonstrated heretofore by Japanese banking authorities, there are those who question whether they can succeed in actually dropping the yen, but central banks can destroy value when they put their mind to it.

2. The Federal Reserve recently published a paper noting that the US could avoid Japanese style deflation by among other things, allowing the dollar to drop and providing a very easy money policy.

3. The rest of the world is addicted to the drug of American consumption. With the exception of Europe and a few smaller countries, they are engaged in "Competitive Currency Devalution." By that we mean they try and make their currency cheap against the dollar and against their neighbors so American consumers will find their products cheap and continue to buy.

4. Martin Barnes (of bcaresearch.com), Stephen Roach of Morgan Stanley, Bill Gross of Pimco and other major economic luminaries are openly telling us that deflation in the near future is a real concern. Even Andrew Kashdan of Apogee Research seems to grudgingly admit that deflation might be a problem in the short term before inflation comes roaring back. They all seem to think (or hope) the Fed can keep us out of a destructive deflation. A common theme is that as long as the housing market holds up, we should be able to avoid serious problems or "disaster" as normally sanguine Martin Barnes so states. This may prove to be a thin thread holding us back from the abyss.

5. One of the big bullets in the Federal Reserve gun to fight deflation is the currency bullet: the Fed can help the dollar drop in value. This is not supposed to be too hard, as the current account or trade deficit is approaching 6% of GDP. In every other historical instance of such a huge gap, the currency of the offending country has dropped, bringing things back into a balance. A drop in the value of the dollar would be inflationary, and is supposed to be able to offset the deflationary forces in the country. It also means we spend less on foreign goods, and helps bring the trade deficit back in line.

History versus the Fed, Part Two

Long time readers know I am a big fan of History. Central bankers, businessmen and investors continually try to beat History to a pulp, and often win a few early rounds. Like Mohammed Ali and his Rope-A-Dope strategy, History lets his opponents wear themselves out throwing ineffective jab after futile blow. In the end, my man History always wins in the final rounds. Betting against History can look good for the first few rounds, as History looks drugged, but the end is always the same.

History told us there would be a recession in the fall of 2001 because of the inverted yield curve in the fall of 2000, which I wrote about in August of 2000. An inverted yield curve is always followed a year later by recession. Greenspan and the Fed fought back by aggressively lowering rates. They lost. Hopefully they can do better fighting deflation.

I note the casual observation that the longer History allows his opponents to pummel away, the more vengeful his wakening. Putting off the Day of Reckoning is a natural human passion, often pursued with great gusto. History has a way of bringing things back to the mean, forcing us to reap what we sow.

Last week, I noted that every country cannot devalue their currency at the same time. If the United States decided to pursue a policy of weakening the dollar, it would not work if every country decided to pursue the same policy, in an effort to remain attractive to the American consumer. Everyone can't drop the value of their currency at the same time.

The Invisible Hand of Adam Smith suggests that the economy is driven as we each pursue our own best interests. That does not mean that what is in the best interests of the individual will result in the short term betterment of the economy. If everyone in the US decided to start saving 10% of their income, we would quickly go into recession. Long term, if this trend were to continue, the economy would be better off. However, we all pay our bills in the short-term.

The same is true for countries. Just as President Bush argues that the security interest of the United States is our responsibility and inherent right, and not subject to foreign approval, each country argues that its economic sovereignty and future is also within its sole prerogative.

If the United States were to go into a deflationary recession, the rest of the world would quickly lurch into a far worse recession. Just as the US has been responsible for 64% of the world's growth in the last decade (Morgan Stanley), we would have a similar negative effect on a world slowdown.

If the rest of the world does not allow the dollar to drop in value, it would likely contribute to our going into deflation (or another outcome I address later). But just as each individual when saying to himself, "I need to save more money for retirement" is a reasonable thing, the collective outcome would be recession; the same holds true for countries.

The head of every central bank in the world would agree that it would be a terrible thing for the US to slip into real long-term deflation. But in the next breath they will do what they think is in the best interests of their country, or at least the best interests of the leadership and large businesses of their country.

Right now, the majority of the world's central bankers seem to think that means keeping their currency low against the dollar. Until their respective country's addiction to the American consumer is cured, that seems likely to be their future opinion. The market will cure their addiction if they do not. However, I can guarantee you no one will like the market's concept of drug withdrawal. Marine drill sergeants have more compassion than the market.

Long-term, we would all be better off saving more money. Long-term, they would all be better off building up their own consumer base. But we all live in the pressures of the short-term. It is the same for individuals and sovereign states.

Will the Trade Deficit Please Go to Work?

The US trade deficit is supposed to be the main mechanism by which the dollar is brought under pressure. Earlier this year, I wrote about the deficit, and suggested the dollar was at its top. Shortly thereafter, it began to drop.

Part of the reason I suggested the dollar would fall was that foreign buying of US companies was rapidly slowing down. This was a major contributor to the flow of dollars into the US for the past decade. "What could pick up the slack"? I asked, and thus predicted a drop in the dollar. The dollar did drop, especially against the euro and its associated currencies. But elsewhere, it has held its own fairly well. Why?

Our trade deficit is now at its largest ever. If the dollar is not dropping, it is because there are large inflows of dollars into the US. It is no longer European companies buying US businesses, or Japanese building US factories. Where is the money coming from? And why, seeing how weak the stock market is, hasn't the dollar dropped further? Surely the world sees we are a bad investment?

Well, not exactly. The rest of the world's stock markets are doing as bad as or worse than ours. The carnage world-wide is astounding. As an example, the German exchange opened the Neuer market, its answer to the NASDAQ just five years ago. There was much acclaim, as the market soared. At the time it was hailed as the engine for future European technology growth. It became the mechanism for corruption, fraud and large investment losses. Last week, they simply shut the new exchange down after losses of over 90%, and little action on the exchange.

If you were in Argentina or Brazil, the S&P 500 would look like a good investment. On a relative basis, the US markets are not that bad. So, US investors are fleeing foreign stock markets, and foreign investors are looking for safe havens.

"Due to large inflows as well as large net selling of foreign securities by US investors (roughly $20 billion in July alone), net aggregate portfolio inflows totaled $71 billion in July, the second-highest total on record. Keep in mind that foreign investors are not the only ones exporting cash to the US -- so too are US investors as they bail out of foreign markets." (Morgan Stanley)

Japanese investors have sent $40 billion to the US in just the first seven months of this year. They recognize that eventually the Bank of Japan is going to have to destroy their yen in order to save the country. (It calls to mind the old line, "The operation was a success, but the patient died anyway.") The smart money is leaving.

Coffee Cans in the Back Yard

If you are in Korea, it increasingly looks like they are in for a hard landing (recession). Plus, the central bank is determined to maintain a competitive posture for its currency. Latin America? The rest of Asia? Diversification seems like a good idea in most of the world.

Many of you write and ask, "Won't foreigners flee the dollar and go into the euro, thus driving the euro up and the dollar down?"

Maybe, but not as much as you might think.

If you held a gun to my head and asked me which one fund should you put your money into, if I thought you might pull the trigger, I would give you one name. But in the absence of physical coercion, I would strongly tell you that you need to diversify. And 99.9% of you would agree. For some of you, diversification means two coffee cans in the back yard, but at least you understand the principle.

Why would foreign investors be any different? Why put everything into a euro basket, especially when Europe may be slipping into recession? Having traveled in 40 countries, I can tell you that Americans are one of the few peoples who are comfortable with all their eggs in one currency basket.

It is in the short term, and by short term I mean NOW, that the Fed must begin to fight inflation. It is not altogether clear to me that the Fed can count on the normal market mechanism of a large trade deficit to ratchet down the dollar within a short-term time frame. It should happen. I think it will. But the appetite of the rest of the world for dollars is still strong. Currencies are a relative value game. You put your money into another currency because you think that when you bring it back into your local currency, you will have improved your buying power over simply leaving it in your local currency.

If the rest of the world perceives that competitive currency devaluation is going to prop up the dollar in terms of their local currency, and their goal is to maintain value in their local currency, it could be harder to drive the dollar down than one might think. If central banks are intent upon keeping their currencies low, it could become very hard.

A little deflation is not the end of the world, if the Fed can "reflate" the economy. Prolonged, systemic deflation will not be good, however. It will lead to lower home values, which will hurt the housing market, which will hurt jobs, which will hurt consumption and trigger a serious recession.

The Fed increasingly understands this. Dallas Fed Research Director Harvey Rosenebluem notes that "there is a distinct possibility inflation could morph into deflation. GregWeldon notes a recent strange comment by the Richmond Fed president, "The Fed knows what to do, if the Feds fund rate has been pushed to zero, and prices were falling." As Weldon points out, that must mean that at least a few people in the Fed system think this is a distinct possibility.

There is a huge discussion on this issue going on inside the walls of the Fed. At least some of the leadership understands the problem. They need to act NOW. If Greenspan lets deflation get away from him, the next sword at his neck will not be the Queen knighting him.

If the Fed has to forestall deflation by printing even more money, we are clearly told it will do so. But eventually, History will weigh in. Inflation will come back much stronger than it would have if the dollar could be one of the main mechanisms to fight deflation. This is the true implication of the problem with devaluing the dollar, as when inflation does come back, the Fed will raise rates to stop it, and thus bring on a serious recession. Think Volker and 1980. We are between the proverbial rock and the hard place.

A World of Hurt

Bill Gross may be the most influential and astute man in the country when it comes to bonds. His recent article and that of his associate Paul McCulley, are absolute must-read, in my opinion. (www.pimco.com) I wish I had the time and space to address them in depth this week.

This is what he says: "Well, here's what those same astute observers whisper, but are afraid to believe will happen. If the American [mortgage] refinancing boom ends before a new investment boom begins, we are in a world of hurt. Consumption withers, investment rejuvenation will not have begun, and the U.S. global economic locomotive, such as it is, will grind to a halt. How long do we have? Twelve months at the most, even if Greenspan drives rates toward zero."

The list of problem "bubbles" is long: a consumer debt bubble, a dollar bubble, a bond bubble, a trade deficit bubble, the boomer retirement bubble, housing bubble and so on. Each of these will eventually come back to trend. The forces of Economic History will see to that.

What we would hope is that not all of these bubbles burst at the same time. It would be even nicer if they would deflate slowly. We have seen the stock market bubble burst as well as the bubble in capital spending. While this caused a recession, it has been very mild as recessions go.

There are those who rightly maintain the US had a significant recession in the 80's. But it was a rolling recession. Each region went into its own recession, while the rest of the country was strong. I can assure you, we had a recession in Texas. Each of you can remember a downturn in your own area. But collectively, we did ok.

The hope seems to be in upper economic circles that we can have a gentle and rolling bursting of the various bubbles.

But to get this period of sequential bursting bubbles, the housing and mortgage refinancing boom must not go before the rest of them do. If the housing market goes flat, as Gross says, we are in a world of hurt. Barnes calls it a disaster. I would call it a serious recession, at a minimum.

The Fed has no choice. They will lower Fed rates. They must keep interest rates low to spur the refinance market. Lower mortgage rates act like a tax cut. It makes more money available each month for spending and saving. They hope this will stimulate the economy and thus create more investment.

Lower interest rates will also act to push the dollar down, without actually announcing a "weak dollar" policy.

It is for this reason -- massive stimulation by the Fed and lower rates-- that I maintain my view we will remain in a Muddle Through Economy for the next few quarters, at least. We might even continue the slow growth dance for a year or more.

We will find that the third quarter was an improvement over the second quarter, but that the 4th quarter will be weaker. Overall, growth will be slow. It is precisely when you are in a slow growth environment, with very low inflation, that deflation can creep in.

The Fed, which is being urged from numerous quarters to act preemptively, will soon do so. Stimulus can have an effect for a short time. As foreigners continue to buy our bonds, rates will continue to drop. I wrote about 5% mortgages in 1998. Thus, I still think mortgages have a small way to go, but I agree with Gross, that much below 5% is very unlikely.

But until there is some evidence that deflation is in check, interest rates will continue to fall. Dennis Gartman recently noted the eerie comparison between the charts of the Japanese bond market and the US ten year note.

Can the Fed reflate the economy, lower mortgage rates and ratchet down the dollar in the next 12 months? Can we slowly let one bubble burst before we have to deal with another? Will the market be so kind?

Maybe. Maybe Not. History is on the side of Maybe Not. History says one or more of these bubbles run into a pin at the same time, and then we get a recession. Only this time, the Fed cannot cut rates 475 basis points.

This is why secular bear markets take years to fully run their course. It takes more than one recession to convince investors that stocks are too risky, and to look for more stable climes. It often takes three or four.

However, just because I think History will probably win, doesn't mean the Fed won't try like Hades to last just one more round. Maybe, the thinking goes, with a little more of the right stimulation, this time things will be different. Avoiding pain is great motivator. I personally would like to put off any real pain for another 5 decades or so.

Because of the stimulation we will be getting, we could see a bear market rally. But the stimulus will not overcome History, in my opinion, and sooner or later we get another recession and a resumption of the bear market. I just hope the next recession is as mild as the last.

On a side note, I agree with Gross, Kashdan et al that eventually we will see inflation again. I am just not so sure we will see it in 3 years.

There are just too many things that can happen on the way to the Dollar Devaluation Party. We will have to watch the developments in the world currency and bond markets with a close eye. I will be writing frequently about these markets in future letters.

I must admit, I find myself late at night succumbing to the all too human thoughts of the common pursuit of mankind: hoping we can put off the Day of Reckoning just a little longer while we get our house in order. Maybe the Fed will be successful. Unlike some of the more stoic analysts, I hope we can avoid "the world of hurt."

Employment Improvement?

Greg Weldon did a detailed analysis of today's employment figures. What he came away with was that the numbers just don't add up. According to the Household survey, the economy created 1.14 million jobs in the last two months, over 700,000 in September. Yet, in the non-farm survey 70% of various sectors reported job losses. Only government and real estate have posted consistent growth. Yet we are told the economy created 1.14 million jobs even as total hours worked and overtime hours both fell. This just does not add up.

Retail sales are quite soft. Housing starts are slowing down. 1.5 million people have been out of work longer than 27 weeks, and 27% of unemployed have been out of work for longer than 27 weeks, both cycle highs. Nothing in any economic indicator shows a boom in labor that could suggest the creation of 1,000,000+ jobs. Something is wrong with some of these Labor Department numbers.

Part of the answer to this conundrum lies in the fact that the 1,000,000 jobs statistic comes from a survey. This is not any different than political opinion polls. Being a little simplistic, they call households and ask if they are working. If the sample gets skewed, or the wrong assumptions are made, the numbers can come out very wrong, just like political polls.

The strong numbers caused the markets to surge this morning, and long bonds to plummet. By the end of the day, as the numbers went under the knife, and as more traders read the widely followed (by insiders) Weldon analysis, they came to the same conclusion: the numbers are bogus.

I do not doubt that there were new jobs added last month. I just do not believe there were 1,000,000 jobs added. The numbers will be revised, and revised downward.

One More Year, and Counting

Today is birthday number 53. Tonight I will spend it with family, but today it is my pleasure to write this letter, and I hope you enjoy my birthday gift to you.

The New Orleans Investment Conference is close to filling up. If you are thinking about attending (and meeting me there) then you should register quickly. The conference is November 7-10 and features Richard Russell and John Templeton, along with a host of excellent speakers. They allow yours truly to tag along. (See www.neworleansconference.com)

In the next 10 days, I am in La Jolla, back to Fort Worth, Pittsburgh, New York and Washington, DC. Too much travel, but all for a good cause - finding investment opportunities for clients, and maybe a little golf. (You can find out more about those investments by going to www.johnmauldin.com) Fortunately, I have a saint of a wife who lets me go so long and keeps everything working at home.

Your already wishing he was back home before he left analyst,

John Mauldin

P.S. If you like my letters, you'll love reading Over My Shoulder with serious economic analysis from my global network, at a surprisingly affordable price. Click here to learn more.

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• The Fed
• Trade Deficit

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