The big question in finance is whether we are heading for deflation or inflation.

In order to become a better investor, one must occasionally push aside all the heat and noise of today’s financial markets and plot out alternate courses for the future. But before we push it away, let’s look at what the bond market is telling us. Today’s bond markets are definitely pricing in deflation which appears to be a safe bet if you look at the GDP numbers in the US.

US GDP since WWII

Price source: http://www.bea.gov/national/xls/gdpchg.xls

Actual GDP growth in current dollars turned negative for the first time since 1949. Why is that important to the bond market? Because bond investors are paid in current dollars. The great fear of a bond buyer is that inflation will eat up returns and principal. US Treasury yields are below 3% (see Bloomberg chart) and almost any inflation above 2% would be detrimental to bondholders financial health. These investors are not writing editorials in the New York Times, they are risking real money.

Why are bond investors so confident now?

Because there is lots of money but no chasing. Milton Friedman and Anna Schwartz proposed that “Inflation is always and everywhere a monetary phenomenon.” In simple terms, inflation is caused by too much money chasing too few goods and services. The problem with Friedman’s dictum is that it has been mis-sold by Fed and Treasury officials of late. They sold the country on the idea that since inflation is a monetary phenomenon, one need only double the Fed Balance sheet (print money) and the threat of deflation will disappear with a few months lag.

So now there is too much money but still no inflation. Inflation is not kicking in because retail sales are telling us that there is certainly no chasing of goods or services going on in the United States. Consumption makes up almost 70% of GDP so one needn’t look too far for the answer. What about the Government stepping in? With all due respect to Nobel Prize economists like Paul Krugman, the Federal Government is good for a bit more than 20% of GDP and most of that is transfer payments (taking money from one group and giving it to another). However stimulus programs are packaged, the government will not get dollars to chase goods and services on its own.

The Road from Deflation to Inflation

So that is a wrap. The smart money in the bond market has figured out that all the noise coming out of Washington will not trump the bruised and battered consumer whose credit lines have been euthanized over the last two years.

But the road to inflation is not totally blocked. The money is still there. With corporates building cash piles, real estate mired in the foreclosure work out dumps, and some version of the Volker Rule likely to constrain the amount of money banks can punt in the markets, there are not many profitable places for a bank to turn. Once bank lobbyists have figured out how to gut the financial reform legislation, mailboxes should start filling up with credit card applications once again.

And once the credit taps are opened, we will see the excess money start to chase goods and services. Will the Fed step in to raise interest rates and preserve “sound money”? Perhaps when inflation gets into the high single digits but by then it will be too late. Current GDP will be growing at 10% or better, government coffers will be filling up as taxpayers are pushed into higher brackets and the Debt to GDP ratio will stabilize and then start to fall.

Who wins?

No one really. Bond investors are hit first and pay the most but inflation is a stealth tax on everybody and it tends to be a very regressive tax. The political will for cutting spending or raising taxes is almost non-existent so developed economy governments will fall back on inflation to get the job done quietly. Does that amount to a default? If one reads “This Time Is Different”, one might feel that way.

What should investors do?

Nothing today. With the weight of money on the deflation side of the trade, there are no points awarded for being early. This is a trade to watch out for and the indicators are retail sales and M2/M3. Once these turn, there are a number of funds and ETFs that can give you inverse exposure to bonds. But be careful about the tracking errors that can build with time. With inverse and leveraged products, it is easy to be right on the idea and get it wrong on the execution.

A simple way to hedge against inflation is to borrow as much as you can service at today’s low “deflation inspired” rates. A 30 year mortgage below 5% (check rates here) may not sound too sexy today but if inflation rises to 3-5% and hard assets start to appreciate, it could be a cocktail party bragging point for years to come.


Filed under: Fixed IncomeInflation/DeflationInterest RatesMarket CommentUncategorized

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