Bond Bubble? Deflation? We're Self-Insured

06/22/2010 11:06 am EST

Focus: MARKETS

Knight Kiplinger

Editor-in-Chief, The Kiplinger Letter, Kiplinger's Personal Finance, and Kiplinger.com

Knight Kiplinger, editor-in-chief of The Kiplinger Letter, sees little cause to fear the worst, despite the unmistakable signs of economic hardship.

Are sharply higher prices for Treasuries and gold the start of a new bubble? It’s unlikely. Treasury prices soared as investors fled Europe’s debt woes, pushing interest rates on 10-year T-notes from 4% to 3% in the course of a month.

Gold’s rise comes on the back of inflation worries, sparked by spectacular debt levels of the US and other governments, plus jitters about economic and political turmoil. [But] other signals that speculation is getting out of hand—a narrowed spread between yields on junk bonds and 10-year Treasuries, for example—are missing.

Policymakers are hypersensitive to the possibility, though. With the economy still quite fragile and credit markets not yet functioning smoothly, the prospect of a broad asset bubble developing and then bursting sends shivers down their spines. That’s why some in Congress want new rules on mortgage down payments, requiring lenders to raise them in communities where house prices are galloping ahead of household incomes.

Had such a trigger been in place a few years ago, home buyers in super hot Miami and Phoenix, for example, would have needed 50% down payments. The plan probably won’t fly, however. Realtors, home builders, and lenders will object, viewing such a requirement as too much government intervention to bear.

[Other industries have also fallen on hard times.] The stalled stock market is bad news for venture capital companies, discouraging initial public offerings—the main exit strategy for investors in start-ups. A fifth or more of today’s 800 VC firms are headed to the dust heap before year-end—a wringing out from the past few years of lousy IPO activity.

This year had been looking better for venture capitalists. Recently, five private firms teed up IPOs in one week alone. In 2009, there were only 49 IPOs all year.

A tough year [also looms] ahead for insurers. Stubbornly high unemployment is spurring more drivers to drop their coverage, boosting the share of car owners who drive without a financial net to about 18% this year, up from 14% in December 2007. Also cutting into revenues: Increased business bankruptcies, paring the number of firms buying insurance. And the dearth of new homes being built, sold, and insured.

With consumer prices falling for the second consecutive month in May, the prospect of deflation is provoking angst. Persistently falling prices have a corrosive effect on the economy, since they tend to be accompanied by falling wages and incomes. That makes debt burdens, which don’t adjust down, increasingly onerous, stunting the ability of consumers and businesses to spend.

But deflation, in moderation, has an upside. One reason: Wages tend to adjust only gradually, so when prices dip for a short time and wages don’t, the effect is to increase, rather than decrease, spending power. Another benefit comes through interest rates. When there’s little chance of inflation, the need to compensate investors for potential erosion in the value of their money shrinks and interest rates fall, buoying spending on homes, cars, business equipment, etc.

Odds are inflation rates will continue to slide through year-end, as the weak housing market keeps pressuring rents and energy prices remain low. But [there’s] little chance of lasting deflation. Prices will firm up a bit next year. Meanwhile, enjoy it. As long as it’s just a sip, there’ll be no hangover.

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