starbucks4ever (99.53)

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Inflation: now and futures

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October 02, 2010 – Comments (5)

Starting from tomorrow I will be making some changes in the real life portfolio.

Though most of it is focused on equities, some low-rated bonds did sneak in early this year. They had a good run but now is the time to slaughter these pigs. They have considerable upside left but the downside is greater.

I said it many times before and repeat it again: until the New Year at least we don't have to worry about inflation. But it may be smart to start worrying about inflation expectations, and these will be on the rise as the Krugmans fill up the media with "print, baby, print" sound bites.

I am a big fan of Rothschild and I like his idea of skipping the first and the last 20% of a price move.

Now, what about the real inflation that we should price in, and the chance for market inefficiencies?

Upon some thought, I come to the conclusion that Armageddon is not the cards, at least for now. We will not have double-digit inflation. John Paulson is wrong. Even 9% a year is far-fetched.

But if Paulson is wrong, that doesn't make Roubini right. Betting on deflation is even worse than betting on the double-digit horrors. My own educated guess, which will surely change as events unfold, is that for the next 5 years, we are most likely to see annualized 7% CPI increase in real life, and 5.5% CPI increase as reported officially.

That will be enough to wipe out the Treasuries crowd, but also to burst the gold bubble and teach commodity speculators a painful lesson.

If we accept my 7% estimate, then 10% yield on junk bonds will be reasonable. If investors choose to believe official inflation (or, to put it more accurately, if they choose to pretend they believe it), then 8.5% yield will be acceptable. If so, then most fixed-income ETFs must take a 20-25% haircut.

When the reality of inflation sips in, bond vigilantes will surely overreact. Then are now pricing in 3% inflation when they should be preparing for 5-7%. At the other extreme, they will brace for 10% when they should be preparing for 3-4%. At it is then when fixed income will become a good investment again. Will "Bernanke put" be offered to junk bond investors as it is now being offered for Treasuries only? In that case, I will not gain anything by selling now to buy back later, but I will not lose much either.

As Krugman is screaming that it's different this time, remember that while some things are different, others are not. The Fed's balance sheet is a coiled spring, ready to go at any moment. When the Blankfeins and the Dimons let it go as Bernanke chooses to look the other way, watch out.

5 Comments – Post Your Own

#1) On October 02, 2010 at 5:35 PM, tomlongrpv (79.61) wrote:

+1 rec

I assume you will be parking most of your portfolio in equities? Most of mine has been there for some time in part based on thinking like that in this comment.

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#2) On October 02, 2010 at 5:58 PM, starbucks4ever (99.53) wrote:

I really don't know, tomlongrpv. The portfolio has just about enough equities already. Perhaps I will let the money stay on sidelines waiting for better opportunities. But if I were just starting, then yes, I would put it all in a blue chips index like DIA.

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#3) On October 02, 2010 at 8:08 PM, MoneyWorksforMe (< 20) wrote:

zloj

You are not considering the implications of your moderate to high inflation predictions. If we do get a 7% increase CPI by as early as next year, confidence in USD will rapidly deteriorate as housing and unemployment will still be in the dumps, causing even more inflation. Other sectors of the economy, such as manufacturing will still undoubtedly be very weak. Right now the fed claims it is okay to continue to introduce QE and other forms of stimulus while the economy is decelerating and inflation remains a non-issue. But how does the fed continue the status quo with inflation as high as you anticipate? The answer is: they can't. And when it becomes clear they can't equities will suffer as well.

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#4) On October 02, 2010 at 9:32 PM, starbucks4ever (99.53) wrote:

MoneyWorksforMe ,

Your point is well taken. But I think confidence will not be totally ruined, it will just take a hit. The people will reluctantly accept anything below 10%. The administration has an excellent propaganda machine and the myth of democracy is still very much alive so it won't be too hard to convince the people that any problems are temporary or in the worst case they will be solved by the next president. Besides, it won't be 7% inflation officially. The headlines will only say 5.5%. The real numbers will be quoted in economics blogs but they will never reach the wide audience. And then, after a few years inflation will moderate somewhat, first to 6%, then to 5% and then to 4%...until the next round of QE.

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#5) On October 02, 2010 at 10:48 PM, MoneyWorksforMe (< 20) wrote:

zloj

I understand what you are getting at, but you make three very big assumptions:

1.) The fed knows precisely how much QE to introduce so as to not allow inflation to go too high or too low.

The fed doesn't have a clue really. Bernanke even admits himself that the fed does not know the direct and indirect impacts asset purchases will have on the overall economy. To think that they can maintain such a perfect balance in such a large and dynamic system is naive. This is a massive experiment, and the specific consequences are largely unknown.

2.) Other nations will continue to finance our debt as the fed issues QE ad infinitum.

Concern over the U.S. national debt and the rapid increase of its balance sheet have already been raising real concerns and undermining confidence. Each new issuance of QE threatens the viability of the USD and the credibility of our government. Large creditors, most namely, China have been divesting themselves of U.S. assets in an attempt to avoid serious losses. What fool will take China's place?

3.) QE works!

There is no evidence that QE works in the sense that it leads to the creation of organic growth, eventually resulting in an economy that can sustain itself devoid of government influence in capital markets. I believe each time the fed implements QE the economy becomes weaker, and confidence is undermined. It will reach a point where our economy is so weak and confidence so low that QE will be completely ineffective.

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