Wall Street Anticipates Inflation, Should You?

by: Big Jake

According to recent news reports, the US Treasury Department will meet this Friday with the bond market primary dealers to hear their concerns about the need for “floating-rate” bonds, for which the coupon would track the Fed’s discount rate. This would be different from TIPS, for which the principal is adjusted according to the CPI.

Whether or not such a product is ever introduced, we can identify several important subtexts here. First, there is a clear expectation among the "Masters of the Universe" that interests rates are going way up in the near-medium term. Second, the Masters of the Universe do not trust the CPI, and moreover, they do not believe that the CPI will ever be allowed to approach real interest rates if inflation blasts off. If that was in the cards, then TIPS would be perfectly acceptable.

The latter point is pretty much beyond argument. Whatever the government statisticians may tell us, consumer price inflation is running much higher than three percent annually. Bank fees are going up by 50-100 percent each year while medical costs are rising 20-30 percent, not only due to higher premiums, but also due to insurance companies increasingly taking every opportunity to nickel-and-dime both patients and providers alike. And anyone who goes to the supermarket knows that the per-unit cost of food has risen 50% in the last five years or so, when smaller packaging is taken into consideration.

So when the BLS continues to insist that price inflation is running at an annualized three percent, you can see why holders of TIPS may not feel very safe in their investments. Naturally, they want something that would be more responsive to market rates, which—in a “normal” economy—tend to run closer to the true rate of price inflation.

So that brings us to the first point. The primary dealers feel that sometime in the near future, when we return to a more normal economy in which interest rates are “allowed” to rise, then they will rise, and rise significantly. In other words, Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS), et al. believe that the current liquidity trap can be overcome, that debt deflation will not consume the world, that people will soon be willing and able to borrow again, and that the exchequers will have to compete with private borrowing once more.

Now, without making any risky calls as to timelines, I think it is safe to say that hedging against the prevailing worldview on Wall Street is a sound investment strategy. Because, even while maintaining a balanced approach and not putting all your eggs in one basket, it is very important to stay ahead of the herd. For this reason, I think it is worth considering any investment that locks-in or guarantees as much return as possible, while keeping risk to an absolute (not relative) minimum.

It is quite possible that three, four, or more years from now, those who pursue such investments will have come out on top with their modest returns, relative to those who bet on higher rates and lost. So, relative to market rates rather than CPI, the effective yield on TIPS does not seem so bad after all. One may lose out on purchasing power, but one may also come out ahead relative to others in the event that this particular flavor of global debt deflation—with US rates near zero, incomes falling, but prices rising fast—continues its run.

Another great option for retail investors is to park money in a long-term bank CD with an FDIC-insured institution, through a 401k if necessary. This may provide less than two percent annually, but it would prove to be fantastic in the event that rates remain stuck near zero, five or six years from now.

My point is that there are options other than desperately plowing your money into the stock market casino, or keeping it uncommitted in a checking or savings account or money market fund that draws near-zero interest. One simply has to be willing to accept the possibility of continued debt deflation. Then one will be able to accept a safe return that may appear suboptimal, but that may very well put one ahead of others who chose to “keep the powder dry” for a more opportune moment that never came.

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