Money Morning Mailbag: Investors Show Growing Concerns Over Deflation

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The threat of deflation has been making its rounds as inflationary measures like the consumer price index (CPI) fell for the first time in 13 months in April, dropping 0.1%. Core CPI - which excludes food and energy prices - rose only 0.9%, its smallest gain since 1966. The producer price index (PPI) also dipped 0.1%.

"The recent trend in inflation has been swiftly to the downside," Eric Green, chief U.S. rates strategist at TD Securities, told Reuters. "All measures of inflation are decelerating."

Investment behavior has shown an anxious but mixed sentiment of hedging against both inflation and deflation: Demand for gold metal is outstripping supply by more than 1% per year and has pushed gold prices to record highs, while others have sought out both corporate bonds and U.S. Treasuries for safety.

But a sign that deflationary concerns could be overtaking inflation fear is the popularity in growth of U.S. Treasuries and Treasury STRIPS. The market for STRIPS expanded 4.4% from December to April as worries increased that the Eurozone debt crisis would slow the global economy and prompt the Federal Reserve to keep rates low, supporting the value of STRIPS.

"With the austerity measures slowing growth and taking pressure off inflation, we're seeing a drifting back into Treasuries and into Strips," said Mark Fovinci of Ferguson Wellman Capital Management. "We are coming out of a recession and into recovery, which has been led by exports. The declining euro will take the edge off growth and pressure off inflation."

Despite Fed chairman Ben Bernanke's 2002 promise to fight deflation with an outlined action plan in his speech, "Deflation: Making Sure 'It' Doesn't Happen Here," analysts predicting deflation think the Fed is out of tactics and a decline in prices is inevitable.

But Money Morning Contributing Editor Martin Hutchinson isn't worried about deflation. He says inflation is heading our way and investors acting otherwise will be left unprepared.

"The inexorable gold-price rise is indicating inflation ahead, and rising commodities prices over the past year also indicate that the current inflation quiescence may not last much longer," he said in a recent article.

Hutchinson warns against turning to Treasuries as a "safe haven," despite investors and overseas central banks flocking to the investment.

"If inflation appears prominently, interest rates will rise, and long-term U.S. Treasury bond prices will fall," says Hutchinson. "Thus, long-term U.S. Treasury bonds, far from being a safe haven, are today one of the world's most dangerous investments - imbued, as they are, with both credit- and interest-rate risks. Not only should investors avoid them, they should also overweight their portfolios in assets such as gold, which can expect to benefit from Treasuries' inevitable decline in value."

Hutchinson's unflinching opinion on inflation's arrival prompted readers to write in with their contradicting views. The following is a letter received from a reader who questioned Hutchinson's position:


I (and others, I think) would very much like to have an article (perhaps by Martin Hutchinson) on the near to medium threats of deflation. Mr. Hutchinson's recent article on U.S. Treasuries not being a safe-haven prompted me to write a 'Reply' as follows:

"Excellent and timely article, thank you. But I am sticking with my U.S. Treasuries in the belief that as credit is increasingly withdrawn from the system, deflation will arrive rather than inflation, stocks will dive, gold (perhaps after one last hurrah) will fall back and the dollar rise on the back of outstanding IOU's worldwide being repaid, and because investors of the world's richest country will repatriate what funds they retain. The unwinding of credit may take time, and eventually, yes, inflation will return. Then and only then will it be time to move back into stocks, but the unwinding will take until 2012 or later - am I wrong?"

Another reader agreed, adding that:

"'Convergence' between U.S. accounting practices and international accounting practices is to be implemented in one year:  June 2011. As part of this convergence, U.S. banks must soon begin to revalue (lower) assets on their books at "fair value" (mark-to-market). In response, it is highly likely that banking institutions will be forced to build up additional reserve capital to meet Federal requirements. In the process, banks could be expected to tighten up some more on credit and issue even fewer loans. Any reduction in available credit is most probably going to be deflationary, not inflationary. More banks could fail. I believe higher inflation is coming, but it may very well be much farther out than Hutchinson currently believes. Remember, it took from 1967 to 1979 for fiscal and monetary policy to produce inflation [that] markets recognized. There can be quite a lag, in the meantime, gold may have a lid on its near-term price. Is Hutchinson a closet gold bug writing an infomercial?"

Your reaction would be of great interest - deflation (or the threat of it) isn't something discussed a great deal in Money Morning, I think. Is that because you are all in the inflationary camp?

- Martin

In response to continuing questions concerning whether investors should prepare for deflation or inflation, watch for an analysis by Hutchinson next week in Money Morning. 

(**) Money Morning editors reserve the right to edit responses for grammar, length and clarity when posting on our Web site. Please include your name and hometown with your email.

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