Friday, December 26, 2008


The Risk of Hyperinflation 2

I love when I am ahead of the curve, in this case, the yield curve. Right now everyone is in a race to the lowest interest rates since the...wait for it...Great Depression. Investors just want to get their money back so they are willingly lending the Federal gov't money for 30 years at 2 1/4 %. Does that make much sense? Well no it doesn't. But fear is driving most investment decisions today.

The Fed has a very specific strategy. A strategy they have used in the past. Lower interest rates and force investors out of safe instruments like U.S. treasuries and into stocks, corporate bonds, and real estate. The problem is no one wants to borrow money to buy a depreciating asset. So the investing class will sit on its hands until prices stop falling. That is where we are now. Waiting for the bottom and all the Fed's efforts will do little but prolong the inevitable deleveraging.

For any doubters out there, please note the last paragraph of the committee's communiqué: "The Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities . . . and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. . . . The committee is also evaluating the potential benefits of purchasing longer-term Treasury securities."

In other words, the Fed went for it, corroborating the view that many of us have held for some time: that when push came to shove, the central bank would let nothing stand in the way of printing any amount of money and monetizing anything required to fend off the ill effects of the collapsing bubble.

What will happen after asset prices are cheap relative to income? This is where my fear of hyperinflation comes in. All that liquidity that the Fed is pushing into the economy could be the fuel for a massive inflation a few years from now.

By convincing investors interest rates will remain ultra low for a long period, the Fed has made them willing to lend to the U.S. government for up to ten years for what is a paltry return.

There are two risks. First, the massive rise in bond prices and compression of yields has come in the secondary market. The U.S. Treasury has not yet succeeded in placing much of its massively expanded debt and new requirements for next year at such low levels. But given the panic-driven demand for default-free assets, officials should not have too much difficulty.

The bigger one is that the Fed is misleading investors into the biggest bubble of all time. Bernanke is making what learned economists call a "time-inconsistent" promise to hold interest rates at ultra low levels for an extended period.

As I have said, the dollar and long term treasury rates will signal this inflation first. This will not happen until asset prices have bottomed but the Fed better stay on the ball.

There's an unwritten sequel to this story: The Fed will be exceedingly slow to remove that liquidity. Thus, whenever the economy stabilizes, at whatever level, the rate of inflation seen shortly thereafter will be quite substantial, I would guess.

If the Obama administration begins its massive public works projects at the end of 2009 that will be just about when they are not needed. Massive gov't spending and massive monetary stimulus will be the fuel for massive inflation. We would be better off letting home prices fall another 10-15% and being done with it in 2010. Of course, letting markets work out of this problem on their own has not been Washington's modus operandi for a long time.

P.S. Bill Fleckenstein is offering free access to his main website over the hollidays. He is also decided to close his short focused hedge fund. Again, I like being ahead of the curve, I just hope that I am not too far ahead.

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