Inflation and Deflation Slug It Out

11/09/2009 3:16 pm EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

Call it the great inflation versus deflation fight.

In this corner is the US TIPS market. In the last few months, demand for Treasury Inflation-Protected securities from investors worried about a resurgence of inflation has reduced supplies of the bonds at Wall Street dealers to a three-year low.

In that corner are Japanese investors. Japan bought a net $105 billion of US government debt in the year to August—even more than China bought. The 17% increase in Japanese holdings in 2009 will pay off only if the US experiences a prolonged period of deflation that drives down the yield and drives up the price of ten-year and longer US Treasury debt.

(The rising price of gold would seem to be another vote on the side of inflation. For why it’s got more to do with the weak dollar than with inflation, see my November 3 post .)

One of these opinions has to be right, eventually, but it’s dangerous to assume that either will win in the short term. Investors always tend to see the future through lenses tinted by their experience of the past and that’s exactly what’s going on here.

Japanese investors who are snapping up US Treasuries, for example, are looking backward at deflation in Japan during the country’s lost decade of the 1990s. That’s when Japan’s economy grew by an average of 1% a year and the price of everything—including financial assets—fell. So far, this decade hasn’t been much better, with the economy expanding an average 0.2% annually and consumer prices falling by the same 0.2% a year.

Not surprisingly, Japanese stocks tanked: The Nikkei 225 stock index fell 67% between January 1990 and October 1998. But because long-term interest rates fell as deflation went on and on, Japanese bond prices rose. An index compiled by Merrill Lynch shows that Japanese bonds returned 90% during the same period.

And you were wondering why Japanese investors are buying US Treasuries? If the yield on a ten-year US Treasury were to fall from 3.5% (the yield on November 9) to, say, 2.75%, an investor would see a total return of 7.2%, Bloomberg has calculated. A Japanese investor who was expecting US deflation and lower interest rates would also expect to see some further gains as the US dollar dropped against the Japanese yen.

US investors, on the other hand, have almost no experience with deflation. Absent personal experience, it feels like an abstract and rather theoretical danger. But inflation ravaged the US economy as recently as the late 1970s and 1980s.

Older baby boomers might have even invested during that period. One of my first—and still best—personal investments was in zero-coupon US Treasury bonds paying 12% or so as a result of the Federal Reserve ratcheting up interest rates to kill the double-digit inflation that prevailed.

So, when US investors look in the rear-view mirror to see what’s gaining on them, they see not deflation but inflation. Comparing the yield on a straight ten-year US Treasury with the yield on a ten-year TIP is a pretty good gauge of the expectations for inflation. That spread has reached its highest level in 15 months showing increased expectations for future inflation.

I think we’re going to travel a very winding road, with rallies and slumps in Treasury prices before we get a decision between these two camps. An interview in the Financial Times with James Bullard, head of the Federal Reserve Bank of St. Louis, gives a pretty good road map for that trip. Bullard expects the economy to grow by 3.5% to 4% in 2010. That level of growth, he told the FT, will gradually convince the Federal Reserve that the recovery is sustainable.

Historically, the Federal Reserve has begun raising interest rates about two-and-a-half to three years after a recession has ended. That would put the first interest rate increases in the first half of 2012.
If inflation is showing signs of kicking up, as the TIPS buyers now fear, the Fed will raise interest rates before that. If deflation seems to be the danger, as Japanese buyers of Treasuries now believe, the Fed will delay raising rates to pump up growth.

In either case, the key period to watch for some decision in this battle is, right now, about three years away.

Full disclosure: Jim Jubak does not own or control shares in any stock mentioned in this post.

Related Articles on MARKETS