iShares Barclays TIPS Bond (TIP)

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Inflation Ahead: What's an Investor to Do?

by: Thomas J. Gordon May 18, 2009

http://seekingalpha.com/article/138132-inflation-ahead-what-s-an-investor-to-do?source=yahoo

This The hard bitten investor in you is having thoughts like this as regards our current economic situation. “In the U.S., the government is spending a lot of money it doesn’t have on stimulus, pork barrel projects, TARP/TALF rescue, etc.. That can’t be good. They must be either printing or borrowing money to do this. Interest rates on government bonds and inflation have to be going up in the future.” Two things fly in the face of this thinking. The 30 year Treasury had yields of less than 3% in January of 2009 (I would argue this was a flight to safety from other investments). During the Great Depression, a dollar in 1939 was worth a lot more than a dollar in 1928 (see chart) and bond rates fell from 1928 to 1939.

I generally don’t like to compare the current situation with the Great Depression but there are some parallels:

- There was a financial panic (troubles with Banks, extensive counter party risk).

- Stock Market values fell dramatically.

- There was excessive borrowing by consumers and businesses in the times leading up to the downturn.

- There was heavy government intervention by both Democratic and Republican regimes to try to turn the economy around.

So if we were to take the Great Depression as our standard of comparison, our conclusion would be that in 2019 a dollar will be worth at least what it is now and the 30 year bond yield will be under 5%. Some economists would tell you that severe economic downturns decrease the Velocity of Money, driving up the value of the currency and interest rates down.

I am going to argue that there are significant differences between the current situation and the Great Depression, and that we do have inflation and higher interest rates in our future. Here are those differences:

- Milton Friedman famously complained that the Federal Reserve reduced the money supply at the onset of the Depression and therefore made the situation much worse. The current Federal Reserve is expanding all Money Supply indicators (M1 is up 15.1% the last 12 months, M2 is up 9.8% the last 12 months) at more than adequate rates.

- The Depression situation was more constrained by a Gold Standard for the U.S. Dollar than is currently the case. Until Bretton Woods ended the gold convertibility of the U.S. dollar in 1971, at least lip service had to be paid to the gold convertibility of the U.S. dollar. Roosevelt famously outlawed private ownership of gold during the depression, so you can see the government chafing under the constraint of hard money.

- Government Spending was more restrained before and during the Great Depression and thus there was less pressure to monetize the national debt (print/create paper money). The Coolidge and Hoover administration ran surpluses up to the Great Depression and if you look at this graph, Roosevelt did a good job of matching government spending outlays to the tax take up to WWII (few would fault him for deficit spending in WWII).

So if we are in for unexpected inflation and corresponding higher interest rates (Nominal Interest Rate = Inflation + Real Interest Rate) what’s an investor to do? Lighten up on fixed rate long term bonds, obviously (I would argue both government and corporate). If you still think the government is a safe investment, two government TIP funds are TIP and IPE. If you are long the following vehicles it may be the time to sell: GKD, GKE, TLH, TLT, ITE, TLO. If you are ready to short government bonds, there are the hedge fund/smart money favorites: PST, TBT, and TYO. Concerning PST, TBT and TYO, many of us have been bitten by the index fatigue of the ultra short vehicles. It may be better to short TLT, TLO and GKE rather than be long PST, TBT and TYO.

I don’t recommend currency speculation as a response to unexpected inflation or higher interest rates. My guess is that all fiat currencies are going to lose purchasing power relative to real assets and perhaps not change in value much relative to each other. Maybe the Chinese have the only disciplined economy left in the world, but they are still ostensibly a totalitarian country and the government mostly fixes their exchange rate. Precious metals (GLD, SLV and others) is an obvious response to unexpected inflation. For some reason gold mining ETFs have not held value over the last year the way precious metal ETFs have. Hard assets such as real estate and commodities also prepare you for unexpected inflation

Disclosure: The author is long TBT. No position in the other ETFs mentioned.