Negative Yields, Inflation, And the Bernanke Put

Includes: DBA, DBC, SGG
by: Ari and Arun

We’ve had mixed economic data for the last couple months, early hints of inflation, severely negative real yields, and a promise from Ben Bernanke to do whatever it takes to keep the US growing.

Mea Culpa and an Agro Bull

My call for an immediate stock market downturn was wrong. The stock market has rallied moderately on the pledge by Bernanke to support the economy and mixed economic data (more on this later). Fortunately, my bullishness in agriculture has offset my mistake in equities. The one commodity I’ve consistently held (and recommended that you hold) is sugar, which is up 40% since July. I still like the agricultural commodities as long-term fundamental bets and as medium-term inflation hedges. I’m not an agricultural specialist though and I have no idea how much gas sugar may have left in the tank. Any asset that rockets up 40% in a short period is at risk of a significant pullback, so it’d be safer to wait for weakness to buy.

Data Revisions:

Last quarter’s (annualized) GDP number was revised down from 2.6% to 1.6%. This huge change helps explain disagreements between bulls and bears. Six months ago the bulls were pointing at a string of seemingly bullish economic data to support their case for a V-shaped recovery. Bears like me had to question the validity of the data (most of which has since been revised lower) and point out that all the “growth” is just a result of deficit spending and fed monetization. The moral of the story is you can’t trust current economic releases.

Unlimited Support and First Hints of Inflation:

In response to a string of weak economic data in July and early August, Bernanke announced a new round of quantitative easing. He said he will do whatever it takes to keep the economy growing. “Whatever it takes” could include purchasing more treasuries, corporate bonds, or possibly even stocks. There is no limit to how much money Bernanke can print, but excessive printing will eventually lead to severe inflation. We have begun seeing the first signs of moderate inflation. Prices are rising at a pace of about 2% a year. This is not meaningful in itself, but has significant policy implications. When the country was experiencing deflation, Bernanke could print money with impunity. Now that we have low inflation, more printing could quickly lead to high inflation. To be clear, without a significant negative shock to the economy, significant inflation is a high likelihood within the next year or two. A negative shock like a debt crisis or severe double dip recession would likely postpone the inflationary pressure for at least a few more years.

Negative Yields:

The Federal Reserve has been buying treasury securities, which forces yields lower. 2 year treasury notes currently yield a little over 0.5%. Compared to the 2% inflation rate, this means that holding a 2-year treasury is equivalent is having 1.5% of your cash confiscated every year. This encourages even prudent investors to seek higher yielding securities even if that means higher risk. In other words, the negative 1.5% yield is a tremendous incentive to gamble, since the alternative is a sure loss of purchasing power. If you’re told that 2% of any money you hold in a bank or in short-term treasury securities will be confiscated each year, you’re very likely to “discover” attractive high yielding investments somewhere. I put “discover” in quotes, because if you look hard enough, you can always find an excuse to buy an asset as a gamble and call it an investment.

Double Dip or Not?

Economic data for July and early August was generally bad but the data of the last few weeks have been positive. Specifically, manufacturing and housing data were significantly better than expected. The current evidence suggests that we are not yet experiencing a double dip recession, but maybe a “new normal.” “New normal” is a term popularized by Bill Gross at Pimco, the world’s largest bond fund. Gross argues that the next 5-10 years will be characterized by very weak GDP growth and sustained high unemployment. He is predicting a weak recovery. The stock market is currently pricing in something slightly more optimistic, but not far off.


The world is engaging in an unprecedented experiment in economics. Is it possible to print our way out of a credit collapse? No country has ever succeeded before, but every situation is unique. I remain convinced that the government will be unable to “thread the needle” and we’ll either get a deflationary collapse or severe stagflation, with the former being more likely. To position myself to profit in either scenario, I remain short US equities and long specific commodities as an inflation hedge. I remain a gold agnostic, but with inflation beginning to rear its ugly head, I have taken on a tiny long gold position as a hedge to my short equity position.