Inflation, Deflation, Or Something More Devastating In Between

For years, we have been listening to analysts and pundits arguing about two diametrically opposing perspectives for various market troubles; we have the inflation camp and the deflation camp.  But, could there be a hybrid of the two which causes more damage than either perspective and leaves both camps out in the cold?

On one side of the longstanding argument, we have the analysts who believe that all the quantitative easing will cause inflation, destroy the value of the dollar, and cause relative asset prices to skyrocket.  These folks believe that all the government and Fed action to stimulate the economy will have a dire impact upon the dollar and will cause interest rates to rise sharply.

On the other side of the argument are the analysts who believe that we are heading into a deflationary spiral wherein all asset prices will crater, as the dollar rises, and interest rates continue to drop to zero, or even go negative, as suggested by Janet Yellen of late.

What is simply incredible is that each side is completely entrenched in their polar opposite perspectives, and are equally convinced of their conclusions.  Moreover, most of the market has segregated themselves into one of these two camps. But, the one main lesson we all should have learned from our non-linear financial market is that it will likely inflict the most pain on the most market participants when a major paradigm shift occurs.  So, I am going to propose a hybrid scenario which would hurt both the inflation and deflation camps, and potentially leave very few standing once the next major storm passes.

First, let’s focus on what the inflation camp is doing to prepare for their “end-of-the-world” scenario.  Since they believe the value of the dollar is going to drop significantly, they are clearly selling dollars.  Furthermore, they are likely buying gold and any other assets they can get their hands on so they are able to retain the relative value of their net worth.  Lastly, since they see interest rates rising, they are selling bonds, since they expect bonds to implode in an inflationary environment.

Now, let’s focus on what the deflation camp is doing to prepare for their “end-of-the-world” scenario.  Since they believe that asset prices are going to significantly drop, along with interest rates, they are buying bonds and selling all hard assets.  Furthermore, they are buying dollars, since deflationists expect the value of the dollar to rise during a deflationary spiral.

But, what if we see a hybrid situation which has each camp right and wrong about different aspects of their preparations?  And, I am speaking of a rising yield deflation.  This is something with which, historically, the world has not had much experience in dealing.  In fact, the closest we have seen to this scenario was what we experienced in Europe during the Greek debt fiasco several years ago.  We saw interest rates rising due to fear of the government’s inability to repay its debts, while significant deflationary pressures were causing asset prices to spiral downward.

As we have seen, in a rising yield deflationary environment, neither of the traditional camps come out unscathed.  Rather, both camps will take their financial lumps, and much will depend upon the allocation of their money as to how they come out on the other side. But, neither side will be prepared properly for this type of environment. They will both be right and both be wrong.  Yes, this is a rising yield deflation, and no one seems to be discussing it.

So, the question one needs to ask themselves is what type of long term allocation will be advisable if we enter into a rising yield deflationary period? 

Well, in this environment, risk assets will surely take it on the chin, thereby hurting those in the inflationary camp.  Furthermore, interest rates will be rising due to the fear of government’s inability to repay their loans. So, bonds will also be taking it on the chin in this environment, thereby hurting those in the deflationary camp.  As for the dollar, it will likely be soaring due to the expected debt destruction increasing the relative value of the greenback, which clearly hurts those in the inflationary camp.  Lastly, I believe that gold will likely be soaring, since fear is what drives precious metals.  And, the fear of a government’s inability to repay its debts will clearly be a driver for gold, as we witnessed during gold’s parabolic ascent back in 2011.

Moreover, has anyone considered the potential that the US Dollar could be a safe haven at the same time as gold – at least for a period of time?  Has anyone ever considered that bonds could crash at the same time as gold rises?  And, has anyone considered that we see bonds and equities tanking together?  This is a perspective which will confound the most market participants.

I know many of you cannot even consider the potential that the dollar can rise along with gold.  But, many could not consider that the dollar was going to rise in the face of unprecedented QE, even though we were predicting a multi-year bull market about to begin in the dollar back in 2011.  From a fundamental perspective, remember that when debt is destroyed in a deflationary event, the relative value of the greenback (that is, relative to the value of overall “money,” which includes outstanding debt) will increase, since the amount of debt will be reduced by mass defaults as interest rates rise.  So, it is not hard to view the value of the greenback going up at the same time that fear is driving gold up as well.

In conclusion, I think that a rising yield deflationary event is the more likely situation we can face down the road, just as we did in Europe.  The amount of additional debt that has been added to the system will eventually have to be dealt with, and lack of confidence will likely cause leaks in the dam. I cannot say what event will trigger this mass shake-up in confidence, but when it does occur, it will have significant repercussions throughout the world.  But, take note that it does not necessarily have to start in the United States for the repercussions to be felt here.

And, when the event occurs, we will likely see fear cause interest rates and precious metals to soar, along with the US Dollar.  Now, with the precious metals being one of the most oversold areas of our financial markets, this may seem like the best investment to navigate the coming storm.  Moreover, I can assure you that all those that have pigeon-holed themselves within either the inflationary or deflationary camps will be flummoxed by a rising yield deflation, as that is the scenario for which the majority of the market remains unprepared.

So, while I am not claiming that this is the scenario which must occur, it is one for which the great majority of the market seems to be unprepared.  Therefore, you must remain vigilant and maintain an open mind to this possibility as we move forward into this potential storm in the coming years.  But, do not despair.  I am not expecting to see signs of the coming storm until at least around 2020.  However, do not say you have not been warned, as this is something which at least needs to be considered. 

"By failing to prepare, you are preparing to fail."
Bejaminn Franklin

Avi Gilburt is founder of ElliottWaveTrader.net.