Jan 3, 2009: Ich Bin Ein Deflationist

Highlights:
  • Inflation? Not any time soon
  • The current state in the U.S. economy
  • What to expect in the coming months
  • The good news

    • Inflation? Not any time soon

    I'm a deflationist.

    I see the strength in Gold on one hand, and in long-term treasuries on the other hand, at the same time, and wonder what are all these investors thinking. I think the best explanation is the simplest. Most have gotten the timing wrong.

    Sure, with the Fed getting interest rates to 0.25% and the relentless "quantitative easing" (read: printing more fiat dollars) eventually, something has to give. Once growth returns, inflation will take over. Probably hyper inflation, even.

    But now? Not even close.

    In order to understand what causes inflation one needs to realize that it is not enough to have a lot of money supply. One also needs demand. It takes two to tango.

    The current state in the U.S. economy

    So what do we have right now?
    U.S. banks teetering on the point of collapse, are sucking all the cash they can from the government TARP, and hoarding it to improve their capital ratios. Vast amounts of dollars are sitting there and not moving. Economic activity is a product of both the money in the system, and the rate this money is changing hands, also known as the velocity of money. The velocity of money is missing. In fact, it is dropping sharply as we speak.

    The TARP money, so far about half of the 700 billion allocated, has gone into a black-hole. Very few are now qualified to get loans to buy houses. Even the few qualified ones, have no interest in getting more loans, or in refinancing until mortgage rates get more competitive.

    Despite all the talk of mortgage rates being at historic lows, the current rates are still higher than what I'm already paying. Banks are scared to death to lend at cheaper rates even when they can get money for almost free.

    Personally, I'd refinance only when 15-years fixed mortgage rates go down to 3.5% or thereabout. I'm almost certain, they will get there this year.

    [Aug 2009 update: Well, we're down about 1% since I wrote this. However. it looks like rates won't get to as low as 3.5% after all. I modified my mortgage to 15-year fixed, at 4.5%. The best rates I've seen are online from ING Direct (ingdirect.com). They're offering 5-year ARM slightly below 4% (!) as I write this. But since they aren't offering 15-years fixed, and I want to lock the rate ahead of the plausible future long-term, rising inflation, I decided to go with my own bank instead]

    What to expect in the coming months

    I'm a die-in-the-wool deflationist, and will continue to be one, until I see real signs of things turning. As long as precious metals rise against all other commodities, I'd be skeptical of that rise. If anything, this move in precious metals and gold, is coming way to soon. I expect some corrections along the way.

    The daily news is filled with more announced layoffs. The biggest and "safest" companies aren't immune. Most of those that haven't yet laid off, probably will. As long as this strong trend continues, prices of goods and housing will keep dropping. There's really not much difference in what we're seeing now that what happened in Japan in the infamous lost decade (or two). Sorry to be bearer of bad "news."

    Obama: he's great. I like him. He's the best man for the job. But even a 1 trillion dollars stimulus package is nothing compared to the tens of trillions of household wealth lost between the markets and home values in 2008. Not to mention the big drop in GDP that's still ahead. The best hope we can have is for the stimulus package to somewhat slow down the contraction. I see the recession continuing for the better part of 2009, at least.

    The state of California might get a lower credit rating. This would make the interest rates it pays on its bonds, go up even more. Even higher than what I personally pay on my current mortgage!

    A few months back I was considering investing in California bonds for their nice yield. I no longer think it is a good idea. [Summer 2009 update: California is broke, they give IOUs to suppliers, selling assets in a bug "garage sale" and aggressively pushing their bonds. I'm not buying. Thanks.]

    The good news

    Now to the bright side of things. As I mentioned back in December I've been making progress on my short-term trading strategy and I'm seeing the first real (actual trading) signs of a great promise.

    Even better: I am not alone. Adi has moved from the east coast to the Bay Area after accepting a position at Google. So I now have a very valuable partner to brainstorm with, share code with, and our weekend productivity together has been rising fast.

    I think 2009 is shaping up to be one of my best, if not the best ever, years in the markets. I'm a deflationist all right for the foreseeable future, but I am actually pretty optimistic about the overall personal future.

    As always, this isn't intended as investment advice. It merely reflects my own thinking and actions at the time of writing. In the immortal words of John Maynard Keynes "When the facts change, I change my mind. What do you do, sir?"

    Every investor should make up his own decisions based on his risk tolerance, comfort-zones, convictions, and understanding.

    Any feedback is welcome.

    -- ariel