Inflation v. Deflation and the Yield Curve: Jesse's Lifetime Trading Plan

More on the inflation v. deflation debate. There is a divergence among the pros as you can see from this article in Bloomberg which is worth reading.

Our 'model' is deflation now, at least in prices, with a nasty inflation of probably double digits at least to follow.

There is little advantage in trying to anticipate the progression of these events unless you are looking at the slow accumulation of precious metals and key investments with very long time horizons. Timing will be difficult until things become obvious, which leaves sufficient time to move among relatively liquid assets.

The Fed will be slow to drain, and it is not unlikely that we could see short term rates spike up to 15 to 20 percent with much of the longer yield curve at 12+%. The Fed will feel the need to crush a burgeoning inflationary cycle, especially if there are any exogenous shocks in key commodities.

That will set up a once-more-in-our-lifetime buying opportunity in zero coupons and annuitiies, and very high quality dividend paying utilities with DRIPS. We made that play in the early 1980's and it was a long term winner.

You now have our investment gameplan for what is likely to be the rest of Jesse's life. Let's see how it plays out and allow the market to inform us of the timing, and surprise twists. We see little advantage in anticipating these markets and the preservation of capital is paramount.


Bloomberg
Treasury Real Yield at 16-Month High on Inflation Bet
By Dakin Campbell

Feb. 2 (Bloomberg) -- For the first time since 2007, Treasury investors are betting that inflation will accelerate.

The yield on 10-year notes exceeds the consumer price index by 2.72 percentage points, the most since December 2006. The gap between two- and 10-year rates widened at the fastest pace in a year last month as traders demanded more compensation for longer-term debt. Treasury Inflation Protected Securities that signaled falling prices as recently as Nov. 20 show they will increase in the U.S. this year.

Deflation was the growing concern for investors in 2008 as government bond yields fell to historic lows in December, the Reuters/Jefferies CRB Index of commodities tumbled 53 percent since July and home prices plunged 18 percent amid a deepening recession. Now, the bond market is saying Federal Reserve interest rates at zero percent, President Barack Obama’s $819 billion planned stimulus package and $8.5 trillion of U.S. initiatives to revive credit markets will reignite inflation.

“When the Fed gets finished here they will have an inflation nightmare on their hands,” said Mark MacQueen, who helps oversee $7 billion as co-founder of Sage Advisor Services Ltd. in Austin, Texas. “There is a lot of downside in conservative government bonds.”

MacQueen is selling 30-year Treasuries, which are more sensitive to inflation expectations than shorter-maturity debt.

Rising Yields

The yield on 30-year Treasury bonds climbed 29 basis points, or 0.29 percentage point, to 3.61 percent last week, according to BGCantor Market Data. The price of the 4.5 percent security due in May 2038 declined 5 29/32, or $59.06 per $1,000 face amount, to 116 2/32. For the month, the yield rose 93 basis points, the most since climbing 100 basis points in April 1981.

The yield fell three basis points to 3.57 percent at 8:08 a.m. in New York.

Yields are rising so fast they are already higher than where economists just three weeks ago expected they’d be at year-end. The median estimate of 44 economists, investors and strategists surveyed by Bloomberg News from Jan. 5 to Jan. 12 was for 3.45 percent by 2010.

Investors in 30-year bonds lost 14.6 percent last month, according to Merrill Lynch & Co. index data. January was the worst month for government securities since Merrill Lynch began tracking returns on the securities in 1988. (That was a drop from a record spike high however - Jesse)

Yields on 10-year notes fell to the lowest on record in December as the cost of living dropped 0.7 percent, trimming the annual advance to 0.1 percent, the smallest rise in half a century, according to the Labor Department in Washington.

Crude Oil

Consumer prices fell as crude oil dropped 78 percent to $32.40 a barrel on Dec. 19 after rising to a record $147.27 in July. House prices in 20 cities plunged by more than 18 percent in November from a year earlier, according to the S&P/Case- Shiller index.

At the current sales rate, it would take a record 12.9 months to absorb all the unsold homes on the market. That’s more than twice as much as the five to six months that the National Association of Realtors in Washington says is consistent with a stable market.

“We are in the midst of a deflationary freefall,” said John Brynjolfsson, the chief investment officer at hedge fund Armored Wolf LLC in Aliso Viejo, California. “I don’t anticipate there is anything the Fed can do to prevent that from continuing for the next six to 12 months.”

So-called real yields that measure the difference between Treasuries and the inflation rate turned negative in November 2007 and stayed there until October, dropping as low as negative 1.79 percent in August.

Real Yields

Except for one month in 2005, the last time real yields were negative was 1980, when the Fed raised interest rates to 20 percent to fight inflation that exceeded 14 percent. During that time, real yields were below zero for 23 of 24 months ending December 1980. (The Fed will do this at some point AFTER inflation has become apparent. There will be a significant opportunity to lock in high yields on annuitites, utilities with DRIPS, and the purchase of zero coupons. But that is some years away. It sticks in my mind because I made my parents retirement very comfortable using this strategy in 1980. Timing wil be important.- Jesse)

Policy makers led by Chairman Ben S. Bernanke cut the target rate for overnight loans between banks to a range of zero to 0.25 percent in December to revive lending and stem deflation. Obama’s stimulus plan passed the U.S. House Jan. 28 and went to the Senate for approval.

The current real yield is in line with the average 2.71 percentage points in the past 20 years, showing investors see an increasing threat in inflation. By the fourth quarter, consumer prices will accelerate at a 1.75 percent annual rate, according to the median estimate of 56 economists surveyed by Bloomberg.

Yield Curve

The difference in rates on two- and 10-year notes, known as the yield curve, has steepened from a six-month low of 125 basis points on Dec. 26 to 189 basis points on Jan. 30. That’s more than double the average of 91 basis points over the last two decades. Investors usually demand more compensation on longer- maturity debt when inflation is accelerating, causing the curve to steepen.

“We see the Fed and all the policy action gaining traction and reflating the economy,” said Mihir Worah, who oversees $65 billion in inflation-linked securities for Newport Beach, California-based Pacific Investment Management Co., the manager of the world’s biggest bond fund.

Treasury Inflation Protected Securities, or TIPS, due in 10 years yield 1 percentage point less than notes that aren’t linked to consumer prices. The so-called break-even rate, which reflects traders’ outlook for consumer prices, is up from negative 0.08 percent on Nov. 20.

TIPS pay interest on a principal amount that rises with the Labor Department’s consumer price index. TIPS ended last week at 103 13/32 to yield 1.75 percent.

Inflation concerns are also rising outside the U.S. Charteris Portfolio Managers bought inflation-protected bonds for the first time for its top-performing U.K. gilt fund.

Fed Assets

The City Financial Strategic Gilt Fund started investing in index-linked bonds in November and now holds 65 percent of its assets in the securities, Ian Williams, chief executive officer of Charteris, said in an interview last week in London.

“Government attempts to reflate the economy, especially in the U.S., will ultimately work,” Williams said. “It’s too pessimistic a view to see all this money being pumped into the system and still assume it’s all going to fail.”

The Fed’s assets have grown by $1 trillion over the past year under credit programs ranging from $416 billion in term loans to banks to purchases of $350 billion in commercial paper issued by U.S. corporations. Cash that banks can lend to consumers and business, known as excess reserves, rose to almost $844 billion in the week ended Jan. 14, central bank data shows.

Debt Sales

“We are already seeing a huge expansion of the Fed balance sheet and the multipliers that are implicit there are extraordinary,” said Brynjolfsson at Armored Wolf. “Double- digit inflation is not out of the question in the following decade.”

The corporate bond market offers one sign that the efforts by the Fed to unfreeze credit markets may be working. Companies sold $138 billion of debt last month in the U.S., the most since May, according to data compiled by Bloomberg.

Fed officials suggested that prices are increasing too slowly at last week’s meeting of the Federal Open Market Committee. “The committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term,” the FOMC said in a Jan. 28 statement.

“The Fed and Treasury will do whatever they can to get the economy going and that is ultimately what will stop deflation,” said Ethan Harris, co-head of U.S. economic research at Barclays Capital Inc. in New York. “It’s clear they will keep their foot on the accelerator until you get real growth.”