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Time to Hedge

|Includes: GG, SPDR Gold Trust ETF (GLD), IEF

All the talking heads predict inflation for 2010. But if you consult the numbers, it becomes clear that inflation is hardly the primary threat to the US economy this year.

The US government has $2.5 trillion of debt due to be rolled over in 2010, approximately 35 percent of its total outstanding liabilities. How can the US raise rates this year with this kind of debt turnover looming?

What’s more, the US economy isn’t out of the woods yet, and the eventual turnaround will take time to unfold. The problems are relatively easy to spot. Troubled Asset Relief Program funds will be extended until October of 2010, and the administration wants to use around $200 billion of it to pay for a “jobs initiative,” an approach that hasn’t worked well in the past.

At the same time, non-financial private-sector borrowing has continued to decline, falling to $635 billion in the third quarter of 2009. We haven’t seen declines of this magnitude since 1952.

These measures suggest the velocity of money circulating in the economy is extremely low--a clear sign of weak economic growth. Making matters worse, America’s debt is now 369 percent of its gross domestic product (NYSEMKT:GDP).

Wages remain stagnant, and unemployment is still high. Without jobs and more money in consumers’ wallets, a developed economy can’t experience meaningful inflation.

The inflation indicator the Federal Reserve is watching is the personal consumption expenditure (PCE) deflator, which measures the prices of goods and services purchased by consumers.

In this index housing-related services receive a 16 percent weighting, half the weighting it does in the Consumer Price Index, which offers a more representative picture of economic activity.

The core PCE deflator measured 1.4 percent at the end of November, suggesting that the US economy will face continued deflationary pressures.

Ongoing weakness, say for the next four quarters, would be an enormous impediment to financial authorities’ re-leveraging efforts.

When it comes to jobs, one of the Federal Reserve’s favorite numbers is what the US Dept of Labor’s Bureau of Labor Statistics calls “U-6.” This broad unemployment indicator stood at 17.2 percent in November 2009.

Finally, the housing market remains weak. According to the Fed’s own numbers, homeowners’ equity as a percentage of real estate value is at a 58-year low of 38 percent.

The housing market is one sector of the economy where the US government is truly running the show. The feds now underwrite 98 percent of mortgage-backed securities issuance in the country.

Hence, the securitized loans underwritten by the Federal Housing Administration (FHA) are now explicitly guaranteed by the Government National Mortgage Association (Ginnie Mae), itself a government-sponsored entity.

This state of affairs could prove temporary, especially for some sectors. But it’s certain that the government will have a much bigger footprint in the US economy, altering America’s economic fabric.

The Best Bargain Hedges

US Treasuries have underperformed the market this year and can be bought at good prices for the purpose of insuring your portfolio.

The situation in the bond market was very interesting in 2009; the Chinese showed less enthusiasm about buying huge amounts of US government paper. And the Japanese increased their purchases, buying $751.5 billion in the first three quarters of the year.

The Japanese, having experienced the “lost decades,” know a thing or two about deflation and liquidity traps. Although the final outcome for the US economy is unknown, this experience should be taken seriously. The Japanese, for what it’s worth, seem to be find current yields attractive.

The easiest way to gain exposure to the US Treasury market is through iShares Barclays 7-10 Year Treasury Bond (NYSE: IEF). This exchange-traded fund (ETF) is a buy up to 95.

Gold also offers portfolio protection, and we’ve been bullish on it for a long time. We still view Goldcorp (NYSE: GG) as the best option among the major producers.

The stock, which outperformed the S&P 500 by about 5 percent in 2009, is a more leveraged play on the gold story. Goldcorp is a buy up to 45.

Finally, bullion is the best way to own gold, though the popular ETF alternative is a close second. SPDR Gold Trust (NYSE: GLD) is a buy at current prices.

Yiannis G. Mostrous is associate editor of Personal Finance and editor of The Silk Road Investor.

Disclosure: "No Positions"