An Investor's Guide to Hyperinflation 14 comments
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Recently there has been an increase in expectations of hyperinflation in the US in some schools of economic thought, as the notion that the ongoing stimulus packages, coupled with the declining tax base, could lead to a loss of confidence in the US dollar. In this post I'll attempt to provide a quick breakdown of hyperinflation -- what it is, how it can happen, and how to trade it.
What is hyperinflation?
Hyperinflation is when the rate of inflation is 40%+ per year. One of its most important characteristics is a breakdown in commerce; i.e. a return to barter, and a reluctance to take on financial assets.
What causes hyperinflation?
Hyperinflation is an economic AND political phenomenon. It is also characterized by both expansion of the money supply as well as a collapse in demand.
If it does happen, when will it occur?
Herein lies the key question, and one that is not easily answered, as psychology plays a critical factor. Amongst those who consider it likely, expectations range from 2010 to over a decade away.
What to watch for over the long-term
Recall our previous post on the five indicators of US dollar stability; they are still worth watching. Here is an update on some things to watch for in our current environment:
1. Credit Default Swaps. This can be thought of as an insurance policy on an underlying asset. If credit default swaps for the US sovereign debt is rising in price, it suggests concern about US Treasuries -- and if demand for Treasuries falls, the ability of the US government to finance itself without devaluing the dollar comes into jeopardy. And the cost of insuring Treasuries via credit default swaps is rising; See this article from Marketwatch.
2. Fed Funds Rate. Bernanke and company still have rates essentially at zero. This in and of itself will have little if any inflationary impact in our current environment, though it does reveal that the Fed wishes to create inflation. The psychology of the Fed is extremely important.
3. Public Debt/GDP Ratio. The bailout/stimulus frenzy has resulted in an increase in public debt. At the same time, the contraction in the economy is reducing the tax base. If this continues, it leads to greater and greater amounts of debt monetization -- i.e. printing money -- as well as increasing the likelihood that debt holders will run from the debt and sell their holdings, thus leading to a run on the dollar. Currently, the US debt/GDP ratio is over 180%. The median public debt-GDP ratio among countries that defaulted on their public debt during the last 30 years is about 50 percent.
4. Gold/Treasuries Trade. Long gold/short 20+ Treasury bonds is the trade for those who expect inflation in the long-term. If this trade continues to do well, it will be a signal of inflation expectations in the market's psyche. Long silver/short 20+ year Treasuries has done even better, and is also worth watching.
5. China. China is a massive buyer of US Treasury bonds, and has recently been griping publicly about concerns that the stimulus packages will result in dollar devaluation, thus weakening the value of their US Treasury bonds.
- China's PM Wen nervous over holding U.S. Treasury bonds - UPI.com
- China frets over the safety of its trillion-dollar investment in U.S. Treasury bonds - By Ben Whitford - Slate Magazine
6. Failed Treasury Auctions. The US is still addicted to debt and needs to raise more debt on a monthly basis. Should a Treasury auction fail, it would lead to monetization to make up the difference. More crucially, it could be the "black swan event" that creates a panic out of Treasuries.
Trading hyperinflation
As hyperinflation is extremely detrimental to an economy, it will create a few issues for traders, should it arise. Such as:
1. Trading may not be possible. Hyperinflation is associated with a breakdown of trading financial assets. The US stock markets, derivatives markets (including futures and options), and bond markets remain the most vulnerable.
2. Watch for government response. As we discussed in our series on trading in a centrally planned economy, playing defense against government policy is extremely important in hyperinflation. Thus far in the crisis, the Federal Reserve has taken the approach of addressing the symptom (breakdown of credit markets) rather than the cause (fiat, debt-based monetary system with unsound banking legislation that resulted in a credit bubble and a depletion of savings). If this continues, we can expect greater regulation of markets, as well as price controls (the symptom of hyperinflation). This will result in shortages of critical assets, and will result in the creation of black markets as well.
3. Decoupling is not dead. The more one expects hyperinflation, the more one is expecting decoupling -- the notion that the foreign countries will discontinue financing the US economy through the purchase of Treasury bonds.
4. Precious metals, foreign currencies commodities. They are the safe havens, and perhaps some in physical form as well, if you are particularly concerned.
5. Tradeable commodities. Hyperinflation is a currency crisis, and requires other commodities to barter with. Precious metals are the time-tested choice, though they are likely not to be as readily tradeable as other currencies. For this reason, having some non-US dollar currencies in physical possession -- i.e. euros, yen, Australian dollar, etc. -- may be worthwhile. Decoupling enthusiasts will prefer Eastern currencies, namely the renminbi, yen, Australian dollar, and New Zealand dollar. In terms of historical precedents, the currency crisis in Russia saw bottles of vodka become currency.
The psychology of hyperinflation
One of the most challenging aspects of hyperinflation, and perhaps a reason why many do not discuss the likelihood of it, is because it is psychologically uncomfortable to do so. Those who seek psychological comfort should avoid financial markets, as the entire thing is a psychological game, from my perspective. With that said, the importance of maintaining a sound psyche -- not succumbing to fear, greed, or rage that will distort one's thinking -- is extremely important to preserving one's wealth. With that in mind, I recommend the following to preserve psychological health:
1. Ignorance is NOT bliss. One would think that those who ignored the warnings of the collapse of 2008 would have learned their lesson that ignorance is not bliss, but for many, this does not appear to be the case. In any event, Honest pursuit of the truth is essential to maintaining psychological health, and thus one's wealth, in all times -- but especially during hyperinflation.
2. Seek psychological security. Those who are interested in the psychology of trading often note the importance of overcoming fear and greed. Indeed, I could not agree more with this timeless advice. In addition, though, I personally recommend finding that which provides psychological security -- and making sure you have that firmly secured. Perhaps this is spending time with your friends and family. Perhaps it is making sure have you the time and place to meditate or engage in art therapy. Whatever it is that provides psychological security will become more important in the face of hyperinflation -- not only in terms of preserving your happiness, but also in terms of preserving your ability to rationally analyze opportunities in managing and growing your wealth.
Leading voices on hyperinflation
To learn more about this topic, I recommend the following economists:
- John Williams
- Jim Sinclair
- Eric Janszen (particularly the hyperinflation commentary for subscribers)
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This article has 14 comments:
Yours is an informative and provocative article. I commend you.
Hyperinflation (like that which destroyed the Weimar Republic in Germany), is not that likely today, but your comment, "Those who are interested in the psychology of trading often note the importance of overcoming fear and greed. Indeed, I could not agree more with this timeless advice. In addition, though, I personally recommend finding that which provides psychological security -- and making sure you have that firmly secured," comprises sound intelligence.
Fear and greed are our greatest enemies. Ignorance is our greatest shortcoming. Family is our foundation. Confidence and integrity are the tools that me must build with to create trust. With trust, the economy will run smoothly once again.
I have a couple of basic remarks.
hyperinflation in modern times (i.e. within the past 120 years) has never occurred froma boom but always from depressions and the measures that were applied to fight deflation and depression. The current situation is a necessary precondition, but it may not be a sufficient one.
second, of coúrse the Fed will never adress the cause ('fiat money and fractional reserve banking') because both are the very mission and business of the Fed. Certainly, the Fed will not aboslish itself - but that would be required to adress the cause of the problem.
Third, foreign paper currencies are definitely no place to hide. If the dollar breaks, so break the fractional reserve banking systems of Europe and Japan and the global economy. Which means that hyperinflation, when it occurs again, will almost certainly be a global phenomenon.
Fourth, the author writes 'Precious metals are the safe havens, and perhaps some in physical form as well, if you are particularly concerned.' This sentence reveals that the author has absolutely NO real understanding of the problem and its dimension and its implications in the first place. PM in physical form - and only in physical form are probably the only safe havens. Forget about ETFs and paper gold. They all are just guaranteed by someone else - so essentially paper. Gold's and silver's and platinum's strength are precisely that they are assets that are no other man's liability.
Fifth, real estate, if it is used by you, if possible including farmland ranks a close second to gold. However, it can be much easier taxed or taken away from you by the govt.
Sixth, it is my understanding that you can try to prepare (=insure yourself) for a period of hyperinflation. But to talk about 'trading it' is, well, ridiculous. And the short-treasuries trade is a tad too obvious and too crowded right now. being early in this trade will likely mean being wrong and getting killed by the markets. The economy will tank a lot more, deleveraging will continue a lot longer than many think and that is precisely the environment that can and probably will catapult the longdated Treasury bonds to new highs. When a very smart guy like Jim Rogers abandons and covers his short Treasury position for the time being even though he continues to view it as the greatest short of the century at some point, then this should make you think about your timing.
As with anything timing is the issue and you state that. Our current policies, if they progress on the path they are on, could lead to a hyperinflation scenario but when? I general it takes a long time. The National Intelligence Council 2025 report has the US as still the largest but no longer the dominant player on the world scene. So a collapse in the dollar and hyperinflation in that 2025 scenario would not be the globally destabilizing event it would be if it happened tomorrow. Point being that one cannot look at the current world situation and simply add US hyperinflation to it, many things will change on the way.
As for the TBT trade. Jim Rogers exited his short treasury positions last fall when it was clear that they were going against him. If the Fed announces they are starting to buy treasuries the shorts will get killed. Personally, I don't believe they will do that. I think instead they will step up their efforts directly in the other credit markets they are playing in and that will add fuel temporarily to the bear market rally. Most of the talk about the Fed stepping in is from bond fund managers who seem to me to be dreaming of a savior. They know rates are headed up with the supply coming to market and they are hoping for a savior. Anyway we'll see. I remain nervously long TBT, short gold and long oil.
The only thing this article lacked was the now common cautionary tale, "Well, just look at Zimbabwe" . As if.
On Mar 18 05:02 AM Dean M wrote:
> You have been so off the mark on everything up to now but you keep
> beating the same drum. Weren't you touting oil, commodities and shorting
> the dollar a year ago. Yeah ok, decoupling - so Chinese consumers
> are going to buy all those flat screen tvs they produce at a cost
> of double their annual income. I know I'm not schooled in Austrian
> economics but if I go to yahoo finance and overlay various global
> indexes it sure doesn't look like decoupling to me. I do agree on
> shorting 20 year bonds right now and I bought some gld when gold
> touched $900 recently but I'm keeping a very tight leash on those
> investments.
Price controls (as well as regulation) will make a bad situation worse. With price controls it becomes even less profitable to stay in business. That's when you will start to see shortages in goods. I've heard that the New York City real estate market is a good example of this.
Regulation on the other hand, makes "mom 'n pop" businesses suffer, because they cannot afford the army of accountants and lawyers necessary to remain in compliance. That's why you see Exxon Mobil advertising about their efforts at "greening the planet," etc. Not only is it "good" PR, but these large corporations are driving increasing regulations so the smaller companies go out of business.
Ironically, the Brazilian economy, which was for some time seen as a weak third world status economy, is set to emerge stronger from the current economic gloom: Strong Manufacturing and Production Base, Energy independence (Brazil is the biggest producer of Bio fuels in the world and is an emerging global oil producer), Huge Agricultural self sufficience and plenty of farmland and Commodities on their rich land.
So NO, Hyperinflation is not inevitable in our MODERN times, if modern goes further than 20 years ago. Yet, spectacular recovery is even more possible from such a disease through fiscal and debt discipline, none of which our sad America is willing to get through right now...
1. CDS spreads. The takeaway from the referenced article is: "Nassim Taleb described CDS purchases as tantamount to buying insurance on the Titanic from someone on the Titanic." This is NOT a rational market. I'd love to see all of the transaction data on U.S. CDS in the last 6 months. This market is so thinly traded, I'd bet it would fit on a few sheets of paper. Anybody have a source?
2. "[T]he Fed wishes to create inflation."
Nonsense. Every statement by the Fed includes words indicating that it is cognizant of the longer-term inflationary impacts of its recent actions, and that it expects quick action to be required to prevent inflation at the end of the current crisis.
3. The author wrote: "Currently, the US debt/GDP ratio is over 180%."
Nonsense. The future liabilities of Medicare/Medicaid and Social Security are not debt. They're not even liabilities yet, and are subject to modification by a number of Congresses even before the current regimes no longer break even.
By the logic behind this, should I include in a calculation of my personal debt the payments I currently expect to make on all of my expected future purchases? My personal debt number would look pretty bad. Additionally, including the maximum liability of AIG "nationalized policies" is specious. Why not also include the expansion in liabilities on the Fed's balance sheet without considering the corresponding assets? You'd get a bigger number that way, which appears to be the goal.
The real foreseeable number within a couple of years is scary enough - I think 80-90%. Why not just use that?
"The median public debt-GDP ratio among countries that defaulted on their public debt during the last 30 years is about 50 percent."
Please name all of the countries to allow readers to assess their relevance. By the way, what's Japan's debt/GDP?
4. Long Gold/Short Treasuries. This is a great paired trade - if it works. But it could be doubly bad if things go the other way. What happens if the Fed starts buying Treasurys and takes deft actions to unwind its balance sheet at the end of the credit crisis? Treasury rates could fall, fear of inflation could go lower, which could cause gold to fall and Treasurys to rise. As a strict inflation trade, TIPS are far less risky. Unless of course you think the government is going to default.
"5. China..."
How is this data point something to watch for in the long term? By the way, you do know that China holds less than 7% of the national debt, right?
"6. Failed Treasury Auctions.... Should a Treasury auction fail, it... could be the "black swan event" that creates a panic out of Treasuries."
But what are the chances? Even if demand dried up (unlikely), the stage has been set for the Fed to purchase Treasuries. So if an auction was failing, wouldn't the Fed just step in? How exactly would we know anything was amiss?
"Thus far in the crisis, the Federal Reserve has taken the approach of addressing the symptom (breakdown of credit markets) rather than the cause (fiat, debt-based monetary system..."
Again with the common anti-fiat currency, anti-reserve banking nuttiness - as if there's another viable alternative. Exactly how was the fiat-based monetary system the cause of this crisis? No, better question: how did we avoid crisis for so long with the same monetary system? Or do you think the current crisis took oh, 50 years to build?
"If this continues, we can expect greater regulation of markets, as well as price controls (the symptom of hyperinflation)."
The sky is falling! The sky is falling! If the temperature keeps dropping as it will between 3pm and 9pm, we'll all be popsicles by the weekend!
Wait, Nixon implemented price controls - did we have hyperinflation in the mid-1970s? Of course not. In fairness, these policies went a long way towards the inflationary environment of the late 1970s-1982. But hyperinflation? Forty percent inflation? We had 40% inflation - over the worst three years, 1979-1981.
4. "Hyperinflation is a currency crisis, and requires other commodities to barter with... having some non-US dollar currencies in physical possession may be worthwhile."
Do you really think that, if the US currency broke down, that society would hold together well enough for foreign currencies to be useful? Really? I sure don't. And how much of people's wealth do you think they should hold physically, risking theft and loss while earning no return?
Really?
"In terms of historical precedents, the currency crisis in Russia saw bottles of vodka become currency."
Now that's a useful tip. At least we can all get sauced.
"...perhaps a reason why many do not discuss the likelihood of it, is because it is psychologically uncomfortable to do so."
No. It's because the likelihood of it is statistically insignificant. Disagree? Then why didn't you describe any scenario that might result in hyperinflation? Here, let me give you a tip: hyperinflation can only occur if the government massively and continually increases the money supply. Now, go ahead and explain why that might happen. By the way, M1's increase over the last 7 months, which all the fraidy-cats point to in horror, is less than 13%.
"1. Ignorance is NOT bliss... In any event, Honest pursuit of the truth is essential... especially during hyperinflation."
It's very likely that there is life elsewhere in the universe - shall I start worrying about the space aliens? Honestly, the truth is out there.
"2. Seek psychological security."
Always good advice. But then...
"Whatever it is that provides psychological security will become more important in the face of hyperinflation..."
Oh for the love of Pete. What are the odds of hyperinflation? Come on, put a number on it.
1. Yes, I have made wrong calls before. I have never claimed to be perfect and in my opinion, any trader who expects to be right 100% of the time has a poor strategy.
2. With that said, you can see my trade record here: www.informedtrades.com... . I have posted double digit returns since 2006. While there is always room for improvement, my track record has outperformed most, and has beat the rate of inflation as well, thus generating net positive returns.
3. To say I have been dead wrong on all my calls, and that I am the ultimate contrarian indicator, is simply false. The primary call I have made since the beginning of this year is long gold/short 20+ year Treasuries. GLD is up 8.16% for the year with TLT down 12.92% this year. I have also been a big advocate of silver, which is up 21.52% this year. These have been my primary calls. Though I would not play Treasuries due to Fed intervention, I am confident that these trends will continue.
I post all my trades as I make them, and I note all my stop-losses, on my site at the link provided above. You can see my long-term calls on gold, silver, and Treasuries in my commentary on SeekingAlpha and on InformedTrades.com.
Thanks again for all the comments.
5 Steps to Hyperinflation in the United States
I'VE READ OTHER ECONOMIST SAYING 50+%.
UP TO NOW THERE IS NO FIXED RULE ON DEFINING "HYPERINFLATION"/
UNDER SFAS-52 A COUNTRY'S ECONOMY IS CLASSIFIED AS "HYPER INFLATIONARY" WHEN ITS CPI IN 3 CONSECUTIVE YEARS, COMPOUNDED, BECOMES 100%, I.E. AN AVERAGE OF 26% PER YEAR.
IN THAT CASE THE COUNTRY'S "FUNCTIONAL CURRENCY" IS NOT CONSIDERED ITS OWN LOCAL CURRENCY. ITS "FUNCTIONAL CURRENCY" BECOMES THE U.S. DOLLAR FOR A U.S. MNC. OR THE EURO FOR A EUROPEAN MNC.
CHECK IT OUT !!