Lurking around the corner: Deflation
By Jeff Petty, MBA, Investment Banker, Texas, April 11 2014
I think people are underestimating the risk of deflation. The Fed is tapering in a dis-inflationary environment, which is only exacerbating it. I’m targeting 200-210 basis points on US 10Yr Treasuries at the end of 2014. I still believe that we’ll see a 100bp 10Yr and a 200bp 30 Yr eventually. There is a shortage of high quality paper and a stock market drop would put an even stronger bid in Treasuries. The market is (as usual) over-estimating forward inflation & the yield curve. I think Fed is going to push out raising rates until 2016 or 2017. Equities are fairly-priced, at best. More like slightly overpriced at these levels. There isn’t a single value area in the US except for coal stocks (and that’s only for regulatory headwinds). We’ll have poor 10 year forward returns at these levels, in low-to-mid single digits. If asset bubble finally pops, Fed can’t lower rates any lower. They’ll be forced to do QE, but that hasn’t helped the real economy so far, just asset prices.
The Fed is doing QE, but not fast enough to keep up with underlying debt payback/destruction, which is why we have very little inflation. If asset prices pop, we’re going to outright deflation, thereby making a 100bps 10Yr Note look like a good investment in real terms. The Treasuries will look like the JGB market. If we’re creating loads of new tech companies, big data, cloud services and software & robotic automation, then that means that the cost of inputs is dropping. Per Moore’s Law, that is inherently deflationary. The cost of starting a new business is plummeting, putting downward pressure on labour markets. If inputs are dropping, then note prices should climb in response to falling inflation, which they are. However the Fed is trying to fight the trend in the economy and force inflation into the system with a symmetrical 2% target.
It’s the same flawed logic of pushing on a string, like when they talk about how they need to force loan demand. You can’t tell the economy to decide it needs to apply for a business loan just because it suits a Fed model. Volatility will pop, giving gold a fear trade, but if deflation does happen, gold is going to slaughtered. People like Peter Schiff love to scream about how the Fed is printing tons of money and the US is about to experience hyper-inflation. However gold is the canary in coal mine showing us that the inflationary pressure is in the opposite direction. As always, I want to point out that I believe the Fed is engaged in Soviet-style pricing, so this is not a defense of the Fed’s wildly inappropriate policy responses.