Inflation, Deflation or Stagflation?

Updated June 23, 2009

by LM Lupo

"Future events cast their shadows", as the saying goes, thus many argue that inflation is the rule of the day, or at least in the foreseeable future.  But honestly, when has an economy ever wiped out trillions of wealth and then promptly--or even slowly--experienced inflation?  It has never happened, save for the exceptional banana republic, (but we're not really talking trillions then.)

The reason is simple, the machine that created the credit bubble no longer exists and it is unlikely to return for several years, if at all. Thus, no jobs, contracting wages, downsizing, liquidation, and all things deflationary. How then could U.S. bonds fall in such an environment?  In a word, supply. Also, one needs to consider that stagflation is a very real possibility where there is a steady trickle of job losses, no growth, and high government spending and more bond sales, and more bond sales, and...you get the point.
 

But back to the deflation argument for just a moment, which, by the way,  I find to be the second most likely outcome.  In order for deflation to prevail most investment dollars would need to be outright saved rather than invested or capitalized.  You do not need an economics degree to argue that money withdrawn from the economy is deflationary.  But is that what we have? Wealth and credit destruction yes, but are funds running scared into the bank, under the mattress, and into government bonds?  No, not at all. 

The Shadow is Before You

Funds are chasing commodities right now and will continue to do so in the foreseeable future.  It is also worth noting that many of the large bond players are talking up TIPS as a safe way to play the potentially inflationary bond market.  TIPS are for grandmas not professional investors.  After all, if one is really concerned about inflation eroding ones bond investment why buy bonds at all?  The government will only cover a modest portion of the lost purchasing power with TIPS, anyway. And that's not an opinion, that's a matter of record.

Stagflation with higher interest rates and bull market pockets in instruments that are relatively easy to control is the most likely macro scenario.  We are seeing this now with Gold well above $900, oil still hanging on to $70 per barrel, and bonds yields trading up to long term resistance.  Also, consider that the ETF's in crude and natural gas are supporting prices that fundamentally would be unsustainable without these extra levers exploited by the new hot money.  Business is always one step ahead of the law and its clear that the trading business is playing a significant regulatory loop hole to create these pocket bull markets.  I remember when overzealous commodity players required  literally parking a train load of commodities on the tracks in order to avoid the 'cornering' rules of the CFTC, NFA etc. Still not convinced? Take a gander at the DBA ETF which represents the Deuthche liquid index of agricultural commodities. This 'deflationary' environment has brought prices back to the 2007 level when corn and beans were at all time highs!  Who let the dog and the air out?

So what to do with the bond in a stagflation environment?

1...All quant models are bearish
2...All technical models, save for the very short term, are bearish
3...All fundamental models are bearish
4...Pimco and Grandma are buying TIPS

5...Retail investors are loaded to the gills in Treasuries

The Treasury Bond ETF (TLT) closed at 93.67 today.  Lets revisit when it trades 81.00 within the next few months.

We make market order out of market chaos.©

updated: 09/22/2008 23:50:00

Fundamental Analysis Macro View   LM Lupo

U.S. Treasuries Downgraded to B+ with Credit Default Risk Now on Close Watch

In a 9/11-type panic move, the U.S. Treasury has moved to hyperinflate the money and bond supply (debt) of the US citizens with a request for unlimited purchasing power for any financial asset the Treasury deems necessary for economic stability, and that includes mortgage-backed securities, collateralized mortgage obligations (CMOs) equities, gold, or anything else it deems worthy to avoid a “financial meltdown.” 

The current price tag reveals a $700 billion sticker per Henry Paulson and U.S. Treasury officials, yet this is the same team and administration that brought us an $80 billion dollar Iraq war price tag that mushroomed to well over $2 trillion dollars, and an additional bailout of $1 trillion dollars for Fannie Mae (FNM,) Freddie Mac, (FRE), Bear Steans, and AIG.  Should bond holders and investors in the world’s

largest debt market really believe the Paulson number of roughly $700 billion? 
 
TREASURY BONDS NOT BENEFICIARIES OF BAILOUT It is clear that the Wall Street investment banks such as Goldman Sachs, where Paulson was once CEO, and Morgan Stanley will benefit from the bailout plan, as will several other irresponsible banks and Wall Street investment houses.  However, U.S. Treasury Bond holders will see the supply of bonds increase vastly, with the end result of hyperinflation a near certainty.

In addition, given that the sovereign wealth funds of Japan, China, Russia, and the Middle East are the primary holders of US treasury bonds, but not the beneficiaries of the bailout plan, expect to see them unload their dollar denominated U.S.

Treasuries in large quantities, which will negatively impact the value of the U.S. Dollar.

TREASURY BAILOUT PLAN SPECIOUS LOGIC
(Sowing to the financial wind, reaping the financial whirlwind.)

Of course, the current argument by Bush administration officials, US Treasury officials, and the Federal Reserve board state that the result of not bailing out the few financial houses who are asking for their bad bets to be covered will create “dire consequences.” 

Yet, no details are forthcoming from the administration or any officials about what these “dire consequences” might be.  After all, what is the real risk?  More investment banks failing? Recklessly levered bankers losing their golden parachutes? Should they not fail anyway so as to clean up and purge the financial system from rogue investment banks and overly levered financial institutions? 

The only one risk that remains clear with this proposed bailout plan is hyperinflation impoverishing all U.S. citizens.

BOND NUTS AND BOLTS

We are witnessing hyperinflation right now as the market simply anticipates the U.S. uberinflation guaranteed by “Paulson’s Plan of Treason.” On Monday, September 22, the first day of trading after announcement of the plan, gold is trading “limit up,” meaning there are unlimited offers to buy, crude oil is also “limit up” – both indicators of hyperinflation hedging

Something is “limit down” though, which means no one is offering is buy: United States Treasury Bonds at their current interest rate. Buyers want a higher interest rate to take on a higher risk. In addition, they anticipate more bonds out there than ever before.

But even more is at work here to make you the poorer than you ever imagined.

To raise his “bailout” money, Paulson prints more U.S. Treasury Bonds, most likely long-term in this case because of the incredible sums of money involved, he offers it for sale, it is sold to other people, institutional investors such as pension plans, and sovereign nations, and the United States Government receives that money as cash – this cash goes to Paulson’s buddies.

These Treasury Bonds are priced in U.S. dollars. As more bonds are sold, more dollars hit the street. The dollar becomes worth much less – our hyperinflation becomes uberinflation. The prices U.S. citizens will pay for basic goods such as gas, loans, and food will triple in price, but your paycheck will remain the same.

For the mature investor out there, this is not your inflation of the 70s. This is more like Weimer Republic using a wheel barrel of currency to buy a loaf of bread. $700 billion on top of the last one trillion on top of a two trillion war debt on top of our standing debt obligations – and Paulson, by the way, has never indicated there’s an end in sight – in fact, to the contrary.

The debt that bankrupted Wall Street will bankrupt our government if Paulson has his way.

BOND FUNDAMENTALS VERY BEARISH
The U.S. Dollar has already collapsed over 50% in just the last decade, interest rates in the collateralized debt market required federal freezing in early 2008, gold and crude oil are trading as hyperinflationary currency hedges, and our debt markets stagger like a drunkard with the weight of the largest global debt default in written history hanging upon its shoulders. 
 

BAILOUT OR BAIL BOND?
It is treason to steal from the United States of America and significantly impoverish every person in the United States simply to bail out a few financial institutions – no matter how big or important they think they are. That’s why Financial Trader deems the Paulson Bailout the “Paulson Plan of Treason.  ”This is a serious act of disloyalty to his nation to benefit a small group of private interests and save himself.
 

Conclusion: Given these negative fundamentals, we downgrade the U.S. debt market from AAA to B+ and our financial computer model WatlooSoft© maintains a strong technical sell signal on treasuries with a forecast for a 30% decline in US Treasuries, with 10 year note yields above 6.00% in the coming months.  

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