Yielding to Deflation: Important Risk Factors to Consider

By Joshua Enomoto, Founder of and Contributor

It seems implausible, given the amount of media hype surrounding global quantitative easing, that the subject of deflation would actually be the front and center focus of current economic discourse, but it is: with Japan’s Nikkei 225 index down more than 19% from its 2013 peak, and the S&P 500 finally showing significant signs of weakness, deflation, and more specifically, the fear of deflation, may be the recurring theme of 2013, much like the fear of inflation was the previous year’s motif. And while it is certainly prudent to not go too overboard with any one particular theory, understanding the risks associated with deflation would be smart and practical, given how ill-prepared most investors are to this silent killer.

First, we must acknowledge that even from a conspiratorial mindset, deflation is a more likely reality than inflation or hyper-inflation. There’s a common saying that the rich get richer and the poor get poorer. The reason why is mostly obvious: the rich have access to the most resources, the best information, and the least (personal) exposure to risk. When it comes to financial investments, an obvious but underappreciated advantage the mega-rich employ is leverage: their trading activities move the markets. In other words, when they sell, the market has topped. When they buy, the market has bottomed. The reason the poor continue to be poor is that they often chase trends that no longer exist.

Inflation is yesterday’s news…that is, according to the mega-rich, the large financial institutions. The story now is about stability, interest rates and yields. Sure, inflation is very much a concern to the average, everyday investor who is rightfully apprehensive about central bank mismanagement. Nevertheless, it is not his opinion that matters, but the actions taken by the institutional players: wherever they go, the markets will follow.

Over the last 43 years, U.S. Treasury Notes 10-Year Yields have been fairly volatile, not only from a generational perspective, but annually as well. Specifically, within this time frame, there have only been three instances where a 4-year consecutive volatility band between peak and trough has been less than 20% (years 1971 thru 1974 ; 1988 thru 1991 ; 2003 thru 2006). Interestingly, however, interest rates appear to be stabilizing after the abolition of the gold standard, as indicated by the 47% reduction in volatility comparing the years 2003 – 2006 and 1971 – 1974). Also, the length of time between each 4-year period of consecutive stability has shortened, suggesting that something is fundamentally changing within the bond market.

Taken as a whole, the average 10-year yield over the last 143 years is 4.62%, fairly close to the average of the last 20 years of 4.82% (1993 – 2012). Historically, the United States has never seen the levels we are accustomed to today, with yields often going below 2%. A reversion to historical averages suggest that at some point, a 100% increase from current rates is more likely than not. And this could have “repercussions” in other sectors, namely, the greenback and the economy.

Higher yields in and of themselves are not necessarily a “bad” thing: true, they make existing debt loads more difficult to pay back, but if higher yields are accompanied by a growing economy (which they usually are), the increased output should theoretically balance out long-term obligations. On Friday, June 7, the Labor Department released their monthly jobs report, which indicated 175,000 jobs were created, a “just right” number that was above expectations but low enough to warrant continued quantitative easing. As expected, jubilation hit Wall Street, with the Dow Jones, NASDAQ, and S&P 500 closing up an average of 1.33% against their respective prior sessions.

While the equities market is the “sexy” side of investing, where the focus should have been was the 10-year yields, which rocketed up to 2.16, a 4.14% increase against prior. The US dollar index also closed up higher, albeit slightly, gaining 0.21% against the prior day’s massive sell-off. Gold, however, closed down -2.35%, eroding earlier efforts to build a support base for further price gains. Technically, gold has become so ugly that it is on a whisker’s edge of entering a prolonged bear market cycle. If there is inflation, the institutional money have pulled the greatest magic trick on Earth.

Compounding matters even more, currency crises are often resolved by the institutionalists moving to other currencies: only the individual investor moves to gold, if they choose to move at all. The rise in valuation of the Japanese Yen against the dollar gives you all the confirmation you need. Even a “sure-bet” like short USD/YEN can have a “hiccup,” throwing many traders off the saddle.

By watching the latest events unfold, it’s becoming clear that the financial sector will resolve fiat problems with fiat solutions, with hard assets playing an ever-decreasing role. And with higher yields and a generally downtrending Yen, the greenback is technically and fundamentally poised to become stronger. The question is, will the dollar rise with the economy or will there be a divergence between paper valuations and physical reality?

This quandary will be the base for near-term instability of the U.S. equities sector, as investors speculate the latest happenings around the world. On the technical side, a stronger dollar is a competitive disadvantage towards exports as foreign partners will have to pay larger net costs to utilize American goods. Fundamentally, a higher yielding dollar will attract safe-haven money, further spiking the dollar due to carry-trade dynamics. This should, and has, positively impacted Japan’s economy, incentivizing American institutionalists to invest in Japanese equities.

If the U.S. economy cannot improve in terms of real growth, higher dollar valuations would essentially subsidize growth in other countries, an ironic reversal to Japan’s lost decade. This would likely be a “worst case scenario” for America, who would have to pay debt obligations with higher valued currency units, which would lead to more and more investors looking abroad for opportunities. Circulation would cease, thus rendering inflationary policies ineffective at best.

However, there are signs that the economic recovery may be for real: the higher yields is just one of many factors. Improvement in the jobs market, though highly flawed, do show at least a positive trend. The easing of armed conflicts should lessen the burden placed by the military industrial complex. The shale gas revolution and other energy related projects could put more Americans to work and take us significant steps closer towards energy independence. And finally, a stronger dollar allows American consumers more leverage in choosing quality over quantity.

Regardless of your economic worldview, the institutional money have largely negated inflationary scenarios and therefore, it is critical that investors consider deflationary forces, either as a currency play or as a long-term contraction in the economy. In both circumstances, being cash-rich more than anything else would be the best course of action.