How to make the Fed "pay"
The U.S. Federal Reserve now sits atop $3.09 trillion in assets. It uses that money to control interest rates, Wall Street and our very economy. What you might not know is this... Every 30 days, a handful of lucky Americans are allowed to "raid" the Fed, legally. In January 2014, they walked away with more than $3 billion. Former Wall Street power broker Chris Matthai has uncovered a simple way to siphon some of these billions into your bank account next month. Go here for details. | |
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The Market's Biggest Threat Andrew Snyder, Editorial Director, The Oxford Club  It's the sort of thing that keeps economists up at night. It's perhaps the biggest threat to the markets - a threat to everyone that owns a stock. And yet it's something few investors prepare for.
Deflation is the sort of beast that can wreak havoc on an economy. It tosses conventional strategies on their heads and turns the immense power of time against investors.
In the last six months, it's become a growing threat to investors across the globe... including here in the United States.
First, let's make sure we're on the same page.
A Dangerous Spiral
Deflation is simply reverse inflation; it's a general fall in prices. What once cost $100 deflates to just $90. It sounds like good news... until your paycheck gets cut and your stocks fall because sales are slipping.
There are many factors that cause deflation. In the 19th century, it was technological improvement. We learned how to make things with less resources. Similarly, a rise in production or a drop in input costs (including energy) stirs deflation. And often, some sort of financial shock hammers demand, forcing prices lower.
That last cause is the worst case of deflation because it often leads to prices that spiral lower, with low demand lowering production, which lowers wages, which further lowers demand... the spiral continues.
Right now, Europe is ground zero in the fight against deflation.
On Friday, the European Union's statistics agency reported that consumer prices across the continent are now 0.6% lower than they were in January 2014 - the largest decline in prices since 2009. The "strongest" economy in the eurozone, Germany, saw prices rise by a mere 0.1% last month. Meanwhile prices in Spain dipped by 1.1%.
The gap between the two countries proves that, while a declining energy sector certainly plays a role in falling consumer prices, there are larger underlying economic issues. It's a reason to worry. It opens the door for that dangerous spiral.
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Folks realizing that the home or car they want to purchase will be worth less in six months are likely to hold off on buying... or they'll simply bid prices lower. This sort of buying slowdown can be difficult for central bankers to break.
Fortunately, the only sort of deflation we're seeing here at home comes thanks to falling energy prices.
With the price of crude getting slashed in half over the last six months, the cost to produce - and therefore buy - many goods is falling.
As long as this price-cutting stays moderate, we're fine. The extra savings in our pockets will overcome any negative effects. But if prices dip too low or the trend lasts too long, we could see something like we saw in the 19th century, when innovation and efficiency quickly drove down the price of many goods.
All of this begs a couple of questions.
Understand Your Options
First, why is deflation bad?
That answer is simple. There are two main reasons central bankers risk everything to beat deflation. Not only does it slash away at the value of all our assets, but it also boosts the price of our debt.
As we've written over the past few weeks (here and here), cheap long-term debt is an absolute wealth builder in times of healthy inflation. But when the price of goods is falling, taking your assets and income with it, the debt you owe is static. Deflation, in real dollars, makes your debt grow by the day.
So our most important question, with deflation taking hold in Europe and with it breathing down our necks in the States, is... what in the world do you do about it?
Let's be clear. You should not panic. Don't dump all your long-term debt. Don't sell your stocks. After all, even Europe's deflation is expected to be short-lived (thanks to incredible pressure from its central bank). But it's smart to understand your options.
Like we said, when deflation takes hold, the leverage debt provides can turn against you. That's why smart investors buy bonds when they expect falling prices. They realize that as deflation takes hold, yields drop and bond prices rise.
This chart of Uncle Sam's 10-year Treasury hints at what's happening...
In other words, if deflation takes hold, you'll be glad you have a proper allocation of bonds in your portfolio. It's those bonds - corporate and government - that will keep a short-term bout of deflation pain free.
If long-term deflation is a threat - we hate to say it - cash is king. Normally, a large stockpile of cash will lead to nothing but mediocrity. But when prices are falling, that $100 bill in your pocket will buy more tomorrow than it does today.
Finally, it's a bit contrarian, but gold should be considered a friend when prices start to fall. After all, we know how central banks across the globe are fighting deflation... by printing hordes of money.
If they do enough of that, gold will surge.
Too many folks think of gold as an inflation hedge. It's not. It's an insurance policy against monetary failure... the kind we see when deflation is rampant. The bottom line is deflation - while only a moderate threat today - is a threat, especially in international markets. It's a nasty force that puts the market on its head. Savers are rewarded... and risk-takers are punished.
When deflation truly digs in its heels, it's no doubt the most destructive force investors face. We don't see it on the horizon. Let's hope it stays that way.
Good investing,
Andrew Snyder
Editorial Director, The Oxford Club
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