mamboni
11th August 2010, 05:22 PM
Fed Preview - Between the Rock of Deflation and the Hard Place of Hyperinflation
By James G. Rickards
http://kingworldnews.com/kingworldnews/KWN_DailyWeb/Entries/2010/8/9_Jim_Rickards_-_Portfolio_Recommendations.html
August 9 (King World News) - Here's the best way to understand the dilemma and choices confronting the Fed at the FOMC meetings this week.
We are experiencing a "natural" bout of deflation from the Depression and deleveraging.
We are also experiencing "artificial" inflation from fiscal and monetary policy, ZIRP and QE.
The natural deflation and artificial inflation are offsetting each other (so far) so that price indices are well behaved. But this is not price stability; it's a mask for the temporary stasis of the offsetting forces. Just because California is not shaking right now does not mean enormous stresses are not building below the surface and along the fault lines.
The problem for the Fed is that the deflation is accelerating; this is what the bond market is telling us.
The conventional reaction is more QE; this is what President Bullard was getting at in his recent paper and what Bernanke said was possible in his 2002 "Helicopter Ben" paper.
But massive QE is not a free lunch. It can be as dynamically unstable as deflation. In particular, neither the Fed nor anyone else has a rigorous understanding of the volatility of velocity. Recall that if you double velocity, you double nominal GDP ceteris paribus. However, real GDP cannot grow annually at more than about 3-4% (i.e. population growth + productivity growth). This means that if velocity doubles and nominal GDP doubles, there will be, at best 3% real growth and 97% inflation which definitely qualifies as hyperinflation.
A massive increase in velocity, or the volatility of velocity, can cause a phase transition in the macroeconomy from mild deflation to hyperinflation; exactly what happened in 1922 in Weimar Germany.
So the policy question is how much QE can the Fed implement before there is a loss of confidence in the value of paper money of the kind which causes velocity to spike?
Expectationally, the Fed will fight deflation but will fear hyperinflation. As a practical matter, this means they will rollover investment in maturing assets, extend duration, and engage in some new QE but not that much. In the short run this will slow but not stop the deflation process. So there is more room to rally in bonds. But as nominal yields on bonds shrink, stocks will start to look overpriced relative to earnings and dividends.
A portfolio that works in this environment consists of:
Long intermediate and longer maturity Treasuries and high grade corporates.
Neutral on junk
Short or neutral on equities
Long gold
But this strategy needs to be watched carefully and reviewed weekly. The most likely near term macroecnomic scenario right now is a long period of little or no growth and mild deflation; i.e. exactly like Japan in the 1990's. But we are not as homogeneous as Japan and the U.S. might have a very low tolerance for this, so political necessity might require that the Fed "do something." At that point, extreme QE could push the economy toward hyperinflation; in that event all paper debt assets begin to go to zero although equities might get interesting again. Gold is still a winner.
By James G. Rickards
http://kingworldnews.com/kingworldnews/KWN_DailyWeb/Entries/2010/8/9_Jim_Rickards_-_Portfolio_Recommendations.html
August 9 (King World News) - Here's the best way to understand the dilemma and choices confronting the Fed at the FOMC meetings this week.
We are experiencing a "natural" bout of deflation from the Depression and deleveraging.
We are also experiencing "artificial" inflation from fiscal and monetary policy, ZIRP and QE.
The natural deflation and artificial inflation are offsetting each other (so far) so that price indices are well behaved. But this is not price stability; it's a mask for the temporary stasis of the offsetting forces. Just because California is not shaking right now does not mean enormous stresses are not building below the surface and along the fault lines.
The problem for the Fed is that the deflation is accelerating; this is what the bond market is telling us.
The conventional reaction is more QE; this is what President Bullard was getting at in his recent paper and what Bernanke said was possible in his 2002 "Helicopter Ben" paper.
But massive QE is not a free lunch. It can be as dynamically unstable as deflation. In particular, neither the Fed nor anyone else has a rigorous understanding of the volatility of velocity. Recall that if you double velocity, you double nominal GDP ceteris paribus. However, real GDP cannot grow annually at more than about 3-4% (i.e. population growth + productivity growth). This means that if velocity doubles and nominal GDP doubles, there will be, at best 3% real growth and 97% inflation which definitely qualifies as hyperinflation.
A massive increase in velocity, or the volatility of velocity, can cause a phase transition in the macroeconomy from mild deflation to hyperinflation; exactly what happened in 1922 in Weimar Germany.
So the policy question is how much QE can the Fed implement before there is a loss of confidence in the value of paper money of the kind which causes velocity to spike?
Expectationally, the Fed will fight deflation but will fear hyperinflation. As a practical matter, this means they will rollover investment in maturing assets, extend duration, and engage in some new QE but not that much. In the short run this will slow but not stop the deflation process. So there is more room to rally in bonds. But as nominal yields on bonds shrink, stocks will start to look overpriced relative to earnings and dividends.
A portfolio that works in this environment consists of:
Long intermediate and longer maturity Treasuries and high grade corporates.
Neutral on junk
Short or neutral on equities
Long gold
But this strategy needs to be watched carefully and reviewed weekly. The most likely near term macroecnomic scenario right now is a long period of little or no growth and mild deflation; i.e. exactly like Japan in the 1990's. But we are not as homogeneous as Japan and the U.S. might have a very low tolerance for this, so political necessity might require that the Fed "do something." At that point, extreme QE could push the economy toward hyperinflation; in that event all paper debt assets begin to go to zero although equities might get interesting again. Gold is still a winner.