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August 22, 2009

Prepare Yourself for the Inflation Invasion

Dian L. Chu, 09/07/09

The Treasury Department, responding to growing demand from China and other investors, will boost the sale of inflation protected bonds, i.e., TIPS. Chinese officials had indicated they want inflation-protected securities, especially as the U.S. economy starts to recover.

Inflation Expectation Eases

TIPS value fell after the announcement. The spread between TIPS and comparable Treasury Notes ended at around 1.93%, signaling that investors expect annualized inflation of 1.93% over the next decade. However, this is still below both the average 2.8% of the past 10 years, and the 2.1% at the end of last year.

Inflation’s Twin Tale

Most analysts are of two minds about inflation: One tends to argue that the Fed's printing of new money would lead to explosive inflation or even "hyperinflation.” The other group argues that there is too much "slack" in the economy for prices to rise, i.e., a stagnation scenario, due to high unemployment, falling wages, plunging home values, and damaged 401ks. So far, the latter view seems to have held up better.

Growth of Money supply

At the moment, both inflation and deflation are seemingly off the radar based on the latest consumer and producer prices. Realistically, we can’t ignore the inevitable inflationary effect from the government’s quantitative easing program.

Since the start of this global economic crisis, the U.S. government has been injecting massive amounts of new currency into the financial system to prevent deflation and stimulate economic growth. M2, a measure of money supply that includes checking accounts and money-market mutual funds, has grown about 16% over the last 12 months, or a colossal $1.12 trillion increase. All that money is going to find a home. This phenomenon will eventually devalue the dollar and push price inflation much higher, which is also referred to as reflation.

Betting on Inflation

Warren Buffett said on Aug. 18 that the U.S. must address the massive amount of “monetary medicine” that has been pumped into the financial system and now poses a threat to the economy and the dollar.

In reality, the Fed will likely be slow to act, in part because of the still high unemployment rate, which rose to 9.7% in July, from 7.2% in December. So the U.S. has got a lot of inflation or even hyperinflation issues to worry about in the future.

Meanwhile, Pictet Asset Management, which manages $60 billion in fixed-income assets, reportedly is buying U.S. inflation-protected bonds, betting that the government’s economic-stimulus measures will fuel price growth.

W-shaped vs. V-Shaped

Prominent Harvard economist Dr. Martin Feldstein indicated that the U.S. economy has improved, but he wondered "if the current recovery is really sustainable" or whether there could be "another slowdown or indeed downturn after the third or fourth quarter".

Judging from the recent commodities rally, we may have inflation, for example, in food and energy, while deflation in the rest of the economy. If this stagflation scenario emerges, we will likely experience a W-shaped recovery instead of a V-shaped one.

Commodities Rock & Rule

A large spike in prices for goods and services is expected once we finally emerge from this global economic crisis, which could be in a year or so. Hard assets such as oil, agricultural products and precious metals will experience substantial price appreciation in this future high inflationary environment. Therefore, commodities are well positioned as a sector with likely strong growth prospects over the next decade.

Investing Strategy

Based on this analysis regarding inflation and a likely W-shaped recovery scenario, here are some ideas of potentially profitable plays to consider:

Precious Metals ETF's: SPDR Gold Trust (GLD) & iShares Silver Trust (SLV)
Hard Assets ETF: Market Vectors RVE Hard Assets Producers ETF (HAP)
Agriculture Commodities ETF: PowerShares DB Agriculture Fund (DBA)
Metals Equity Play: Freeport McMoRan (FCX), BHP Billiton Ltd. (BHP)
Crude Oil Producer: Petroleo Brasileiro SA (PBR), ExxonMobil (XOM)

Disclosure: No Positions
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Item Reviewed: Prepare Yourself for the Inflation Invasion Rating: 5 Reviewed By: EconMatters