INSIGHTS

On May 19, 2014

Viewpoints from AAM - A Penny Won’t Even Buy Your Thoughts

In the 1970s and ‘80s inflation was a dirty word. It was the enemy of consumers everywhere. Now, deflation is the dreaded evil with inflation now being desired. Global central banks are racing to devalue currencies with an eye toward fighting deflation pressures. These actions will certainly have an impact on the value of fiat currencies. The U.S. Federal Reserve (Fed) is now winding down their bond-buying program that took its balance sheet from roughly $800 billion to well over $4 trillion. Japan embarked on quantitative easing (QE) over a year ago and now the European Central Bank is openly considering the same effort. Flooding markets with additional currency combined with very low interest rates are a textbook method for fighting deflation pressures. However, the inflation that will certainly be created will punish holders of assets denominated in those currencies. Wealth that is housed in the most liquid currencies will seek other havens that are outside the reach of these central banks. Bitcoin is just one example being sought to provide a store of value outside the hands of the currency doctors.

Should we be concerned about the intentional devaluation of the world’s most liquid currencies? Is there a risk of “debasing” the currency? Well, if it is done in a slow manner, one might argue that a gradual increase in the currency supply can actually help sustain growth. The truth is, that with almost no exception, since the Federal Reserve Bank was created 100 years ago this year, we have been slowly debasing our dollar. The graph below shows that we have effectively devalued the purchasing power of the dollar over 95% during the life of the Federal Reserve.

*Bureau of Labor Statistics (BLS)

We know that there are many proponents of a weaker dollar. A weaker currency is good for exports, until it is not. When your export partners engage in weakening their currencies, then the game ceases to have winners and actually can penalize consumers. Sure, weaker dollars and low interest rates can spur consumption demand which accounts for nearly 70 percent of U.S. Gross Domestic Product. With a bloating record U.S. debt burden, inflation means paying back that debt with deflated dollars. That favors the debtor but penalizes the creditors. I can think of no examples in history where debtors that are suffering from decreased creditworthiness and inflation suffer any fate other than rising interest rates.

Most people fear the stagnation that deflation brings, with Japan’s last 25 years as the best example. Opponents of QE and easy money policies note that preserving the purchasing power of currency helps us maintain our world “reserve” currency status. Intentional devaluation of the currency, they argue, will destroy the confidence in the dollar and cause global commerce to seek out other solutions.

I am not here to debate the prudence of tilting the purchasing power of currency either stronger or weaker. Global central banks are intentionally sowing the seeds of inflation daily as they pump excess currency into the markets. I am only here to point out that there is only one place that this can lead, and that is inflation coupled with higher interest rates.

Our thesis first begins with our absolute rule that prudent investors should never fight the Fed. The Fed has unlimited tools to achieve their goals. They will continue to use them in order to achieve their goals. In this case they are very clear that higher inflation expectations are what they desire. Like it or not this is where we will end up, because that is where the driver of the “monetary bus” is taking us. We believe that interest rates and inflation are positively correlated over long periods of time. Higher inflation brings higher interest rates as lenders demand borrowers pay a rate of interest that covers the expected loss of the currency value during the term of the loan. Conversely, deflation rewards lenders with principal repayment currency that has a greater purchasing power than when lent, thus a lower interest rate is needed. The inflation risks, along with the credit risks, are the two main drivers of prevailing interest rates. Many argue that the Fed is artificially keeping rates low with the asset purchasing program, but that program will soon become history. Normally, using its traditional tools, the Fed can only affect changes to short-term rates.

The graph above shows the nearly perfect correlation of interest rates to inflation. We believe that the Fed is driving us to higher inflation and thus higher interest rates. In fact, the Fed wants to see higher long-term interest rates over time as economic activity elevates and the demand for credit rises. Banks, which are very heavy with reserves, stand ready to meet growing lending needs. In the first quarter of 2014, we have seen commercial and industrial loan demand grow by double digits in many regional bank earnings reports. This is healthy and should drive higher rates.

There are those who don’t agree with our thesis for higher inflation and higher rates. They aptly point out that the Fed has been engaged in record-setting easy monetary policy and that no inflation is visible. They point to the benign Consumer Price Index (CPI) as proof. To them I simply reply that the CPI has never been a good leading indicator of inflation. Until there is proof of inflation, central banks continue to sow seeds of inflation. We would argue that they will continue to be easy long after we see the inflation in the numbers. The U.S. economy is the largest in the world. It takes time to respond to stimulus. The Fed’s actions have never been applied in our history. We feel compelled to point out that commodity prices are picking up and it is showing up in the PPI (Producer Price Index) and CPI. Along with upward wage pressures, we note that rising commodity prices are very good leading indicators of inflation. We are seeing those pressures.

Some argue that the Fed will keep rates low for a long time as they have a huge amount of balance sheet risk which higher rates would complicate. There is also an argument that the Fed will attempt to keep rates low so that the United States can more easily afford their record debt payments. We would simply point those folks back to listening to what the Fed is trying to do and look at long-term correlated interest rates. The United States ended a 30-year secular bull market in bonds in 2012 with the 10-year Treasury bond basing at 1.38%. We have since embarked on a secular bear market for interest rates as they normalize and as inflation expectations become elevated. Economic recovery will add credit demand to the pressure.

The Fed’s balance sheet management is a serious concern. However, let’s remember that the Fed never has to sell any of its treasure trove of Treasuries. They have the luxury of holding the long-dated bonds and notes until maturity. They are not required to mark them to the market nor can they be forced to liquidate them. It is our postulation that the Fed will keep their trove intact rather than worry about finding a buyer large enough to buy, let alone at what price they might bring.

We don’t opine on the long-term efficacy of inflation or deflation. We simply believe that advisors should adequately prepare their client’s assets for the next 30 years. We suggest that duration will likely be the biggest challenge to bond portfolios. Advisors will need to look for rising streams on income that can offset the lost purchasing power of inflation. Tangible assets tend to do well in times of inflation. Finally, cash can be the worst enemy. It earns nothing and actually loses value during inflationary times.

CRN: 2014-0509-4197 R

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