The Danger of Deflation in an Inflationary Environment

SUMMARY

In this episode of Milkshakes Markets and Madness, Santiago Capital's host analyzes deflation risks in an inflationary landscape, the debt-based monetary system's vulnerabilities, and gold's role as a protective asset.

STATEMENTS

The recent CPI release was lower than expected, sparking a stock market rise by signaling potential Federal Reserve rate cuts ahead.
Anticipated rate cuts could prove inflationary, undermining the disinflation indicated by the softer CPI data.
Debates center on whether inflation, deflation, or stagflation poses the greatest economic threat moving forward.
Many assume endless Federal Reserve money printing ensures persistent inflation, but this overlooks systemic deflationary risks.
Inflation involves rising prices; disinflation means slowing price increases; deflation entails falling prices, which the current system cannot sustain without collapse.
Central banks target mild inflation to maintain stability, as fiat currencies inherently depreciate over time.
The monetary system is debt-based, where the monetary base serves as collateral to loan additional money into existence.
Loans create money but also generate interest that must be serviced, requiring either money velocity or new liquidity to avoid defaults.
Without sufficient velocity—money circulating through economic activity—or fresh credit creation, defaults trigger credit contraction and deflationary spirals.
In severe cases, even reserves can erode, prompting central banks to expand the monetary base for recolateralization and restore confidence.
Central bank interventions like quantitative easing counteract credit destruction but often lag, allowing initial asset price declines during contractions.
Over the past 25 years, major events have caused S&P 500 drawdowns of 50% in the dot-com bust, 50% in 2008, 35% in COVID, 25% in 2022, and 20% earlier this year.
Crises wipe out overleveraged participants before interventions arrive, necessitating such losses to prompt Federal Reserve action.
Gold offers enduring value as it withstands inflation, deflation, and systemic shocks in all scenarios except a seamless full recovery.
The host joined Monetary Metals' advisory board to promote "gold with a yield," positioning it between static bullion and volatile miners for balanced portfolios.
Private credit markets have surged beyond traditional bank lending, introducing opacity and heightened systemic risks through unregulated lending.
Emerging private credit defaults and bankruptcies signal potential broader credit contractions, even as stock indices rise.
Diverging correlations between risk assets and private credit suggest impending market drawdowns if contractions intensify.
Regional banks are showing signs of rollover amid rising bankruptcies, echoing past rapid liquidity crises like 2020 and 2022.

IDEAS

Deflation remains a latent threat in inflationary times because the debt system's interest obligations demand perpetual credit expansion.
Money velocity acts like a shark needing constant motion; stagnation leads to defaults that evaporate liquidity and crash prices.
Central banks exist to bail out contractions but cannot prevent initial chaos if interventions arrive too late or insufficiently.
Stagflation emerges as the new normal, with trade wars and supply chain reshoring driving uneven price pressures across sectors.
Gold's true appeal is its indestructibility during collapses, preserving wealth when paper assets and credit vanish.
Yield-bearing gold bridges the gap between safe but idle bullion and high-risk miners, enhancing overall portfolio efficiency.
Shadow banking's explosive growth masks vulnerabilities, as opaque private credit amplifies risks without regulatory buffers.
Payment-in-kind interest structures provide short-term borrower relief but erode lender liquidity, priming systems for sudden freezes.
Tightening credit spreads amid rising bankruptcies reflect supply shortages, not diminishing risks, setting up sharp reversals.
Historical drawdowns demonstrate that even anticipated recoveries claim victims through speed and leverage amplification.
Market concentration in a few stocks, combined with passive investing, accelerates flash crashes during credit squeezes.
Regulatory oversight lags in non-bank lending, allowing crisis seeds to sprout in the shadows before mainstream contagion.

INSIGHTS

The debt-based monetary framework inherently breeds fragility, as interest on created money necessitates endless growth or deflationary implosion.
Even bullish inflationary narratives overlook how rapid credit defaults can outpace Fed printing, triggering asset plunges.
Central interventions restore equilibrium only after sacrificial market pain, underscoring the need for personal resilience over reliance on saviors.
Stagflation's complexity demands flexible portfolios that hedge mixed dynamics rather than betting on uniform trends.
Productive gold investments not only safeguard against extremes but actively improve risk-adjusted returns through yield.
Opaque private credit's ascent signals a shadow crisis brewing, where hidden defaults could unravel broader financial webs.
Awareness of systemic symbols—velocity and supply—equips investors to foresee contractions invisible to the untrained eye.
Preparation transforms potential victims into survivors, allowing participation in post-crisis rebounds without forced exits.

QUOTES

"These two symbols are the two most important symbols to understand how the system works."
"The shark has to swim and it has to move. If it doesn't, it sinks to the bottom of the ocean and it dies."
"Don't confuse new money with more money."
"Gold has a permanency to it um where it can't get inflated away it can't be destroyed in a deflationary collapse and it would have value on the other side of whatever environment this was."
"If you believe gold is money then you should be putting gold to work as money and that's what they offer at Monetary Metals."
"The urgency for regulatory bodies to address their systemic risk grows before another financial crisis emerges from the shadows."
"You can either be a victim or my point is if you're not ready, you can be one of the victims that is a necessary sacrifice to bring them in to save everybody else."

HABITS

Regularly evaluate economic scenarios ranging from full recovery to collapse to inform asset allocation decisions.
Maintain a core holding in gold as an insurance policy against inflation, deflation, and systemic disruptions.
Incorporate yield-generating gold options to make holdings productive rather than idle.
Track developments in private credit and shadow banking for early warnings of credit contractions.
Avoid excessive leverage or margin trading to ensure survival through potential 20-50% market drawdowns.
Review historical crisis patterns annually to calibrate portfolio resilience against rapid liquidity shifts.

FACTS

The U.S. M2 money supply currently stands around 22 trillion dollars.
The S&P 500 experienced a 50% drawdown during the dot-com bust and another 50% in the 2008 financial crisis.
Private credit outstanding has grown faster than traditional bank lending over the past few years.
Gold prices pulled back 8-9% last week after an exponential yearly rise, now down 6-7% from recent highs.
Five major asset price drawdowns have occurred in the last 25 years, ranging from 20% to 50%.
U.S. bankruptcies are rising while corporate credit spreads continue to tighten due to reduced issuance supply.

REFERENCES

Monetary Metals advisory board and platform (monetary-metals.com/santiago).
Santiago Capital Research reports and Substack (research.santiagocapital.com).
October 2023 report on shadow banks and private markets (originally under Macro Alchemist).
Federal Reserve slides on monetary base, M2, and debt-based system mechanics.
Mike Green's chart from Simplify Asset Management on bankruptcies versus credit spreads.
Santiago Capital paid research access (santiagocapital.com).
Historical S&P 500 drawdown data from dot-com, 2008, COVID, 2022, and 2024 events.

HOW TO APPLY

Grasp the debt-based system's core: Recognize that the monetary base is collateralized to create loans with interest, requiring velocity (circulation) or new supply to service debts without defaults.
Monitor velocity indicators: Track economic activity metrics like consumer spending and business lending to detect stagnation that could halt money movement and spark contractions.
Prepare for lags in intervention: Build cash reserves or low-leverage positions to weather initial credit crunches, as central bank actions often follow rather than prevent asset declines.
Integrate protective assets: Allocate to gold holdings, including yield-bearing options, to maintain value across inflation, deflation, or stagflation scenarios without relying on credit recovery.
Watch private credit signals: Regularly review reports on non-bank lending, bankruptcies, and spreads for opacity-driven risks, adjusting exposure to correlated assets like stocks and regional banks early.
Simulate crisis scenarios: Annually stress-test your portfolio against historical drawdowns (e.g., 35-50% drops) to ensure it withstands forced liquidations and positions for post-crisis gains.

ONE-SENTENCE TAKEAWAY

Even in inflationary times, deflationary shocks lurk in the debt system—hold resilient assets like gold to survive and thrive.

RECOMMENDATIONS

Prioritize gold ownership for its unassailable permanency amid uncertain economic paths.
Explore yield on gold through platforms like Monetary Metals to boost portfolio Sharpe ratios without added volatility.
Scrutinize private credit trends as leading indicators of broader contractions, reducing exposure proactively.
Shun overborrowing to avoid becoming collateral damage in rapid drawdowns preceding Fed rescues.
Embrace stagflation preparedness by diversifying beyond stocks into assets hedging supply disruptions.
Study monetary mechanics—velocity and supply—to outthink 90% of investors on systemic risks.
Revisit historical crises quarterly to harden portfolios against sudden 20-50% plunges.
Advocate for shadow banking regulation to mitigate hidden threats before they cascade systemically.

MEMO

In a world fixated on taming inflation, a Santiago Capital analyst warns of an underappreciated peril: deflation's stealthy return, even as prices broadly climb. The recent Consumer Price Index reading, softer than anticipated, ignited a stock market surge by hinting at imminent Federal Reserve rate cuts. Yet this optimism masks deeper fragilities in America's debt-fueled economy. As correlations fray between soaring equities and faltering private credit markets, the host of Milkshakes Markets and Madness urges listeners to confront the system's baked-in vulnerabilities. Deflation, he argues, isn't a relic of the Great Depression but a perpetual risk, poised to strike if credit extensions falter.

At the heart of this tension lies a debt-based monetary architecture, where the Federal Reserve's base—currency and reserves—serves merely as collateral for loans that conjure the broader money supply into being. This M2, hovering near $22 trillion, bears interest that demands repayment, sourced only through money's velocity—its ceaseless circulation—or fresh credit infusions. Stagnation invites defaults, evaporating liquidity and spiraling prices downward. Central banks, designed as firefighters, rush in with quantitative easing to recolateralize and revive lending. But interventions lag: During the 2008 crisis, the S&P 500 plunged 50% before aid flowed; COVID saw a 35% drop in weeks. "Don't confuse new money with more money," the analyst cautions, likening it to plugging a leaking pool—outflows from defaults often outpace inflows initially, hammering assets.

Stagflation, once dismissed as analytical fence-sitting, now feels prescient amid trade wars and supply chain reshoring. Prices for essentials may soar due to national security-driven sourcing from allies, while other sectors deflate under credit squeezes. Private credit, ballooning beyond traditional banking with scant oversight, exemplifies the peril: Opaque funds fuel risky buyouts via payment-in-kind interest, deferring cash but amplifying liquidity traps. Recent bankruptcies are climbing, yet credit spreads tighten—not from safety, but issuance scarcity—echoing pre-2008 blindness. Regional banks, too, teeter, their charts mirroring 2022's swift collapses at Silicon Valley Bank.

Gold emerges as the analyst's anchor, prized not for speculative gains but indestructibility. It endures inflation's erosion and deflation's destruction, retaining value across all but flawless recoveries. Beyond inert bullion or volatile miners, he spotlights Monetary Metals, where gold earns yield by functioning as money—lending to businesses for returns that enhance portfolios. Having joined its board, the host embodies this shift, urging investors to "put your money where your mouth is" if they view gold as currency. Studies affirm: Such holdings sharpen risk-adjusted performance, bridging safety and productivity.

Ultimately, awareness breeds survival. The analyst, shaped by 2008's chaos, refuses to dismiss any scenario—from boom to bust—insisting on readiness without panic. Sell-all shorts or doomsday prepping? Unnecessary. Instead, shun leverage, track shadows like private credit, and fortify with permanents like gold. As correlations splinter and drawdowns loom from concentrated markets, the message rings clear: In a system demanding endless motion, complacency invites sacrifice. Investors who grasp these mechanics, he promises, join an enlightened minority poised for the rebound.