Inflation vs. Deflation

In a continuous effort to try and understand what the world will look like in the next several months (and therefore our investments as well), the dynamic between inflation and deflation should be understood on at least a basic level.
 
First, let’s understand what both of these really are.

Inflation – too much money chasing too few goods/services.  So if there’s lots of money in the economy and the individuals who have it are buying stuff (there’s that technical term again), there will be higher competition for the stuff, which results in higher prices.

Deflation – too much debt and difficulty making the interest payments.  Need to sell stuff to reduce debt exposure.

With the issues in Europe and even here in the US regarding the need to reduce debt, it appears to me deflation is in control, which would mean lower prices for stuff (stocks).

I would offer the more interesting question is how will we know when the economy switches from a deflationary stance to an inflationary stance as this will have a significant impact on the prices of food, gas, and other consumable items.  During a high inflationary period, you will see the prices you pay for goods and services go up and potentially faster than you see the value of your paycheck increase each year.

Inflation is made up of two parts.  The first is an increasing money supply.  This is how many dollars are in the economy.  The second is how fast each of theses dollars are turned over (or said a bit different, once someone spends a dollar, how quickly does the person receiving the dollar turn around and spend that same dollar).

Let’s look at a chart showing how many dollars are in the economy and see if it has been increasing:

Looks to me like we definitely have an increasing money supply.  It even looks as though it’s been increasing at a higher rate since 2000 (have to print money to fund these bailouts).

Next, let’s look at the velocity these dollars to see quickly they’re changing hands:

Looks to me as though anytime someone gets their hands on some money, they’re not doing anything with it.  Since we need both for inflation, as long as the velocity points down, deflation will be in control.

 

So, once velocity turns up (people start spending all of this money, which they will at some point), we will begin to see inflationary pressures.  The outcome of this will be the Federal Reserve raising interest rates (think in terms of the interest you can get for a mortgage, if you have a variable rate you will start to see your monthly payment rise as your rate adjusts) to slow down the pace of inflation by selling securities to collect some of the dollars you see in the first chart.  The simple way this works is the Federal Reserve sells securities and when someone buys these, it takes this money out of the system.  Also by “flooding” the market with securities, it will drive the prices down, which has an increasing affect on interest rates (ex. you own a bond, which you paid $1000 for and it pays $50/year, if someone paid you only $500 for this bond because there are a lot more of them in the market, they would still collect the $50 and so their interest rate received would be higher than what you were receiving; or $50/$1000 equals 5% whereas $50/$500 equals 10%).  If you recall from a previous post, interest rates are at historical lows with nowhere to ultimately go, but up.

Over the next several months, look for deflation to persist as countries and banks look to unload assets to clean up their finances.  Then watch the velocity of money for a signal when times may be changing.

I still get an eerie feeling the stock market is teetering on the edge of a cliff.  The euro has be accelerating its move lower, which I can’t help but think this means we will soon be hearing some negative news come from our friends across the pond.

Cheers,

Joel Fink
joel.fink@yahoo.com

Interesting Interest Rates

After some relaxing time visiting family and friends over the holidays, it’s time to get back to sorting through this mess of economics and investments.  I’ve mentioned previously about sharing what I believe will be one of the best investments of the next several years, but before I dive in I want to quickly review my general position on investing.

Great investments for me are areas such as markets that are so severely shunned by others that they are selling at crazy levels or stocks for example that are sold relentlessly, but really still have a sound financial structure and a relevant business model.  These are the types of situations, which get me excited about opening up my wallet and purchasing an investment.

So with this fresh in our minds, let’s move on to discuss interest rates.  There are very few guarantees in life, but one guarantee is that people will not lend money (at least for very long) to others for less than 0%.  Why would anyone give someone else money to use and not get paid something in return for giving them the money.  So from my point of view, this puts a worst case scenario for interest rates at 0% (the downside risk).  I happen to think the actual worst case is something higher than 0%, but let’s stick with the zero.

The following is a historical chart of interest rates the US government has paid to borrow money for ten years going back to the late 1800’s.

In the past 100+ years, the interest rate for a 10 year bond has been at its lowest around 2%.  The current rate for a 10-year bond is 1.87%.  So, if we place odds on whether rates will be lower or higher over the next several years, my money is easily on higher.

Just to be clear, I couldn’t tell you exactly when interest rates will be higher because markets tend to stay at extreme levels for longer than anyone typically estimates (anyone who says they know is guessing and don’t let them convince you otherwise). But I am willing to bet (put my money into an investment) they will be higher in 5-10 years from now as opposed to lower. 

The big question now is how to take advantage of this as part of an overall portfolio.  TBF and TBT (leveraged – uses debt to juice the returns) are exchange traded funds (ETF), which purchase securities designed to allow an investor to position themselves for higher interest rates.  Since I still believe the economic environment is weak for at least a good part of 2012, I do not believe we see a whole lot of upside pressure on interest rates in the near term.  However, I will be looking to begin making purchases of these ETF’s throughout 2012.  From my point of view the odds are stacked in our favor here, low risk with high potential opportunity.

Should you find this interesting and intriguing, contact your financial advisor and ask them their recommendation for how to best take advantage of a long term, higher interest rate environment.  Let them earn their money in 2012.

I plan on keeping a close eye on the market over the next few months with everything that’s been going on.  Some pretty bearish positions have been executed in some different areas (actual investments made as opposed to someone simply talking about different investments on the news, but not really putting their own money behind it), so I’m not the only one who thinks 2012 could be a rather bumpy ride and willing to put their money behind it by buying some protection.

Happy New Year!

Joel Fink
Joel.fink@yahoo.com