This Is What Deflation Looks Like

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Includes: VXX, VXZ, XVIX
by: David Goldman

Gold is up, but everything else is down. Gold is not -- not -- an inflation hedge; it is a hedge against the end of the dollar’s status as a reserve currency, a deep out-of-the-money put against the US currency.

The marginal cost of production of gold at the world’s most expensive mine is well under $1,000, and the metal is trading at a 50% premium to marginal production cost. If the US emulates the UK’s drastic budget cuts of last year and tightens monetary policy even marginally (not an inconceivable outcome), gold should fall to $1,000 an ounce. As I’ve said before, gold and government debt both are bubbles and you don’t know which one will pop first. You need to own some of both, unless your crystal ball is in better working order than mine.

Governments have been inflating, in some cases at an unprecedented pace, for several years. S&P’s downgrade (outlook, not rating) of US government debt is symbolic, not material, and it would be less of a weight on the market if not for the simultaneous unraveling of Europe’s debt. Finland’s election and the sudden rise to prominence of the nationalist “True Finn” party may be a harbinger of the future. (For the record, “Huck Finn” in Finnish means “stranded Finn,” which somehow seems appropriate.)

At some point, the taxpayers of Germany (who abhor the bailout of the PIIGS by huge majorities in all polls) will go in the same direction, and Greece will look rather like the bankrupt banana republics of Latin America during the 1980s.

We’ve had the inflation, and the financial system’s capacity to sustain inflation is coming to an end.

  • Lower banking profits are a symptom of deflation.
  • Political movements demanding budget cuts are a symptom of deflation.
  • Falling home prices are a symptom of deflation.
  • Governments restructuring debt is a symptom of deflation.

But the trouble is that rising bond prices are not necessarily a symptom of deflation – not, that is, when the credit of the issuer is sketchy.

We’re not quite there yet, but investors who have given 99% of their attention to hedging portfolios against inflation need to think hard about what to do if the wind suddenly reverses. In this case, cash will be king -- particularly yen and dollar cash. But who can afford to give up all the carry-on-earning investments?

My favorite hedge remains VIX futures. Granted that short-term movements in the VIX are quite arbitrary, equity market volatility nonetheless is a pretty good bet in the case of a regime shift.

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