Will We See Inflation or Deflation?

Will the future be inflationary or deflationary? The answer to that economic question is likely to be the most important variable in developing a profitable investment strategy to navigate the next few years. Some investors point to the recent drop in October’s Consumer Price Index, the slowing velocity of money given tighter credit, or the precipitous decline in asset values such as real estate and equities as support for the deflationary view.

I think one would be well served to look at this debate from a “cui bono” perspective - in other words, who benefits from the different outcomes? The goal of the US government with all of these interventions/bailouts is first and foremost to stay relevant, i.e. stave off a complete financial system melt-down because it is hard to collect taxes from a barter system, and second to keep this de-leveraging process orderly. Given the current state of affairs and the subsequent responses by the Treasury and Fed, it is becoming very clear that the only way out of this debacle is to inflate our way out.

To see this in action take a look at the example below. The exercise below measures nationwide indebtedness as household debt to household income. We assume that no new debt is incurred in either scenario and 1% of debt is paid down each year as a result of principal payments. In an inflationary scenario (i.e. wages increase +5% yr/yr), we see that the debt/income ratio becomes more manageable as a result of the increasing denominator. Conversely, in a deflationary scenario, declining wages will result in the debt level becoming even more onerous. From this analysis alone you can see that inflation is the preferential outcome because it makes the nation’s debt load more manageable.

The important thing to remember is that the Fed and the US Government control all of the necessary ingredients to prevent deflation. Deflation is simply too undesirable from a policy standpoint to allow and since the Government has the power to prevent deflation I think it is wise to assume they will act accordingly.

The most dangerous words in investing are “this time is different”. The truth always proves to not be “different”, in 2000 the internet bubble was no different than the tulip bubble and the same for the 2008 oil bubble. Deflationists argue that this time is different but I struggle to see how deflation could take hold given the certain increase in the money supply.

In August 2007, the Fed’s balance sheet was $850 billion, and as of last week that figure has ballooned to $2.2 trillion. The US government and their generous bailout shopping spree will result in them having to having to pay for these obligations at some point. The obvious conclusion is that they will simply print more money to cover these obligations. For the past 50 years (and all of human civilization for that matter), an increase in the money supply has led to an increase in inflation. Chart 1 shows the 48 year history of the year over year increase in the Consumer Price Index (proxy for inflation). Chart 2 shows the 48 year history of the year over year increase in M2 money supply.

As long as the government is willing to intervene with such blatant disregard for free markets and the citizens of the United State sit idly by in blissful ignorance, the Government will be able to prevent deflation. The old adage of “don’t fight the Fed” rings as true now as it has ever before.

Trading Implications: I expect the Government’s massive intervention will lead to a steep yield curve for the foreseeable future. A great way for investors to play this thesis safely and profitably is through Annaly Capital (NLY) and American Capital Agency Corp (AGNC). NLY and AGNC are REITs whose business objective is to generate net income for distribution to investors from the spread between the interest income earned on their mortgage-backed securities and the cost of borrowing to finance their purchases. Both companies own only AAA-rated, highly liquid GSE mortgage backed securities on their balance sheet which are now backed by the explicit guarantee of the US government so they are not subject to any credit risk.

The downside is limited as the stocks are trading near tangible book value, which should provide a floor for the stocks given the high quality, liquid, and transparent balance sheets. The historic average book value multiple is 1.4x so there is room for capital appreciation but the beauty of these stocks is that we do not need them to appreciate to still earn +17-20% which with no credit risk is an attractive return in this chaotic market environment.

Disclosure: Long NLY and AGNC.

Comments

[Toeser:]

Actually, the feds are trying hard to bring down the yield curve to make mortgages more affordable. In the short run, deflation remains the primary risk. I don't see inflation as a risk for at least three years given the massive asset value destruction that is occuring.

I hope for a "normal" economy, but as a retired person I fear inflation far more than deflation. Inflation gets me to a soup line much faster.

2008 Dec 04 07:16 AM

[investor88:]

The debate about deflation and inflation is still on with no conclusive answer.

2008 Dec 04 09:44 AM

[surgeon:]

We will have deflation with asset prices falling and inflation because of the falling dollar. Is it possible to have both deflation and inflaton simultaneously?

2008 Dec 04 10:15 AM

[Smarty_Pants:]

Your assumption of credit risk is incomplete. Anyone who relies on earning from the spread between short term borrowing and long term lending is at risk for changes in short term lending rates once the long term rates are locked in.

If foreigners holding US debt start selling in earnest, short term rates here might rise above their locked in current long term rates.

I'm not saying that's going to happen, but it is possible and therefore a credit risk. If they have bought GSE bonds at 5% and short term rates rise to 6% or higher they will start bleeding money at a time when the value of their GSE debt has dropped below what they paid for it.

2008 Dec 04 10:48 AM

[berloe:]

I love the high yields. That hasn't stopped these (NLY; AGNC) high yielders from falling 50% from their highs. That IS a risk!

2008 Dec 04 12:44 PM

[Alex Filonov:]

Unfortunately, government and Fed don't control all necessary ingredients to stop deflation. They don't and can't control money velocity.

2008 Dec 04 01:16 PM

[america_f_yeah:]

Smarty Pants,
What you’re referring to is interest rate risk, credit risk is generally thought of as the risk of default. Certainly if the yield curve inverts (short term rates higher than long term rates) NLY and AGNC would not do well but the thesis in this article is based on the yield curve remaining steep.

2008 Dec 04 01:17 PM

[america_f_yeah:]

Smarty Pants,
What you’re referring to is interest rate risk, credit risk is generally thought of as the risk of default. Certainly if the yield curve inverts (short term rates higher than long term rates) NLY and AGNC would not do well but the thesis in this article is based on the yield curve remaining steep.

2008 Dec 04 01:18 PM

[Kinabalu:]

The inverted yield curve would definitely be a problem for NLY & AGNC, but the hazard Smarty Pants describes ("If foreigners holding US debt start selling in earnest") has other complicated results. It will increase long term rates as well as short term rates thus driving down the value of the in-place portfolio of GSE securities at both those companies. That decrease would be particularly negative for the value of the collateral behind the short term repos used by both to finance their leveraged assets. Margin calls on those repos could be a much more severe problem than just reduced net interest margin.

Inverted yield curves happen for lots of reasons but are not likely right now. Sovereign Wealth Funds selling US securities...maybe more likely.


On Dec 04 01:18 PM america_f_yeah wrote:

> Smarty Pants,
> What you’re referring to is interest rate risk, credit risk is generally
> thought of as the risk of default. Certainly if the yield curve inverts
> (short term rates higher than long term rates) NLY and AGNC would
> not do well but the thesis in this article is based on the yield
> curve remaining steep.

2008 Dec 04 03:33 PM

[Chris B:]

They can certainly control the 20% or so of the economy that is government spending. Even if the banks refuse to lend, an infrastructure blitz or more checks sent directly to consumers would certainly shake things up.


On Dec 04 01:16 PM Alex Filonov wrote:

> Unfortunately, government and Fed don't control all necessary ingredients
> to stop deflation. They don't and can't control money velocity.

2008 Dec 04 05:44 PM

[jepittman:]

Inflation and Deflation refer to rising and falling prices IN GENERAL or in the aggregate. Prices of individual goods and services are constantly in flux. Some up some down. So yes, you could say we always have both in individual goods and services but these comments are referring to prices in general. Hope this helps.


On Dec 04 10:15 AM surgeon wrote:

> We will have deflation with asset prices falling and inflation because
> of the falling dollar. Is it possible to have both deflation and
> inflaton simultaneously?

2008 Dec 04 08:03 PM

[jepittman:]

While it is true the answer is inconclusive for the moment, it appears clear that the Federal Reserve is on a mission to reflate the economy with the full political support of both the executive and legislative branches of government. Do you REALLY have doubts about the eventual outcome of this market conflict?


On Dec 04 09:44 AM investor88 wrote:

> The debate about deflation and inflation is still on with no conclusive
> answer.

2008 Dec 04 08:09 PM

[ozcutty2:]

If we are going to get inflation (seems likely, as its really the only way to pay off our debts) surely companies like the Credit card companies will do best, after all they take a small percent of each transaction in fees.

Commodoties boom is dead and buried, won't be back for 10 years.

2008 Dec 04 11:07 PM

[elwind45:]

Why worry about the bond market? Paulson must do everything in his power to hold bond market together. There is no way Treasury can allow higher rates for the distant future. Paulson turning his back on Treasury Bonds would be suicide! Hasn't anyone wondered who the fool is to be a long bond (any Treasury note) buyer at these levels? The rub comes from the yield curve. The steepness of curve is very positive for banks. A no-brainer? Except sugar daddy is buying up Treasuries to drive down yields to protect mortgages, and cutting into bank profits. Treasury is fighting banks. I believe that the Fed must view any future growth as inflationary and move to stop it. Will Treasury end up fighting the Fed and its member banks to keep rates artifically low?

2008 Dec 05 04:18 AM

[JohnP:]

Excellent. You pinpoint the key long term issue. You should also note, as is seen clearly in your charts, that bubbles are caused by Fed easing too long, and they burst when the Fed tightens too long.The Fed always overacts, because they can't stand the political pressure when they act and the results of their actions don't show up for 18 months. So they keep acting, and 18 months later, they've overshot. The problem goes back at least to Volker's term.

2008 Dec 05 01:55 PM

[grishick:]

We are in deflation right now. Gov-t only way out is reflating the economy with money supply. Don't forget that this year, more money "disappeared" than has yet been infused back into the market. By "disappeared" I mean the disappearing values of assets against which consumers and companies have been borrowing.

2008 Dec 11 08:27 PM

[Pup:]

All I can truly hang onto is the Bible reference to it taking a wheelbarrow full of gold to buy a loaf of bread. So eventually, or sooner, inflation.

Jan 01 04:50 PM

[Makarand Ko...:]

Thanks Benjamin for the data! By providing the accurate data supporting your viewpoint has made your point very clear. I agree with most of what you say. Fundamentally, looking at the enormous national debt, bailout policies, quantum of treasuries and municipals being issued, it seems that we should see inflation and hyperinflation. But as long as fear continues to dominate, deflation will rule To support what I'm saying, Please visit mkokane.blogspot.com/2...

Jan 29 02:43 AM