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If you’re in the same camp as David Rosenberg and Gary Shilling, you believe that the economy is in the throes of a deflationary cycle.

Whether or not I agree is irrelevant to this article. However, I’d like to point a critical flaw in the deflationist’s investment strategy.

A deflationary economy will cause bonds to rally. This is because the present value of future payments rises with the purchasing power of a dollar. The purchasing power of a dollar rises if prices fall. This is true of the first effects of a deflationary spiral, and at this point, the logical strategy is to own long-term government bonds.

It’s the second round effects that most deflationists fail to fathom – this is where the long term government bond strategy fails. If the economy was truly gripped by deflation, the banking system would collapse, risk assets would plummet, businesses would fail and millions would be added to the unemployment lines. (Debating whether these are the causes or effects of deflation is as fruitful as tracing the egg-to-chicken-to-egg.) The point is that if deflation grips the economy, business activity will plummet.

As business activity falls, government tax revenues drop and spending (to stimulate the economy) rises. Consequently, one might find that a deflationary episode increases budget deficits and, for an already indebted country like the United States, the risk of default. As default risk rises, interest rates rise to compensate bond investors for the additional risk. As interest rates rise, bond prices fall.

So you can see how the typical deflationist strategy of investing in long-term goverment bonds could become an investing nightmare. Always watch for the secondary and tertiary effects of a trend, particularly when an economy, like the US today, is operating somewhere outside of its ‘normal’ state.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: A Deflationist's Nightmare