How does one hedge against deflation?

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John3754
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How does one hedge against deflation?

Post by John3754 »

What could one do in order to hedge against the possibility of a period of deflation?
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SimpleGift
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Re: How does one hedge against deflation?

Post by SimpleGift »

High-quality bonds, preferably Treasuries. For a good discussion on deflation hedging, see this thread from 2012:

In Defense of (Some) Treasuries in the Portfolio

In a nutshell, in a deflationary environment with drastically falling prices, investors flee to the perceived safe haven of government debt. Also, the reliable, fixed income stream is worth more relative to the ongoing decline in prices. In the decade of the 1930s, when prices were falling 20%-30% in many countries, U.S. government bonds returned nearly 5% per year, during a time when most other asset class returns were markedly negative.
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Electron
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Re: How does one hedge against deflation?

Post by Electron »

Long term non-callable Government bonds do very well in periods of deflation.

Take a look at the holdings in the Yale University Lazy Portfolio.

http://www.marketwatch.com/lazyportfolio

The 15% position in Long Term Treasury bonds is their hedge against deflation.
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munemaker
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Re: How does one hedge against deflation?

Post by munemaker »

Has there ever been deflation in USA?

I worry about inflation, not deflation, especially considering the fed stimulus.
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Re: How does one hedge against deflation?

Post by bhsince87 »

munemaker wrote:Has there ever been deflation in USA?

I worry about inflation, not deflation, especially considering the fed stimulus.
Yes, absolutely. 2009 was the last bout, although it was minor. It also happened during the Great Depression.

But since the Fed was created, its been rare in the US. Deflation seems to be their number one enemy. Before that, it was actually fairly common.
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Re: How does one hedge against deflation?

Post by SimpleGift »

In their portfolio design, many investors discount the probability of deflation, perhaps because the U.S. hasn't had a significant deflation episode since the 1930s. However, the U.S. economy came close during the 2008-2009 financial crisis and we have the example of Japan's "lost decade" of sustained deflation in the early 2000s.

Most recently, we can look to Europe today, where 8 countries are already in outright deflation:

Image
Source: Zero Hedge

And many of the major European economies very near the brink of deflation:

Image
Source: New York Times
Last edited by SimpleGift on Sat Oct 18, 2014 5:13 pm, edited 5 times in total.
bhsince87
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Re: How does one hedge against deflation?

Post by bhsince87 »

Pay off debt! It's toxic during deflation.

As others have mentioned, government bonds are good. Longer term is usually best.

CDs and cash are good too.
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Re: How does one hedge against deflation?

Post by fredflinstone »

as others have noted, long-term treasury bonds are a great hedge against deflation. One could also, I suppose, rent rather than buy a home.
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Re: How does one hedge against deflation?

Post by arcticpineapplecorp. »

Doesn't cash help with deflation? If prices go down, you can buy more with the same dollars as before. This is the opposite of inflation where your dollars are buying less. If I remember correctly there was a small period of deflation, I think either around the end of 2008 or beginning of 2009 or experts were very afraid we would go into a deflationary spiral. I remember prices were going down because businesses were stuck with too much inventory they couldn't get rid of. People were staying on the sidelines because they wanted to get the item on an even deeper sale the following week. Remember hearing stories on NPR and marketplace. There were many "experts" telling people who still had secure jobs and money to shop or the job problem and possible deflation would continue to get worse.
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Louis Winthorpe III
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Re: How does one hedge against deflation?

Post by Louis Winthorpe III »

John3754 wrote:What could one do in order to hedge against the possibility of a period of deflation?
30 year Treasuries.
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Re: How does one hedge against deflation?

Post by john94549 »

Shed debt. Once you are debt-free, invest in federally-guaranteed instruments of debt (i.e., where you are the creditor).

An entirely different question is "should you."
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Re: How does one hedge against deflation?

Post by lee1026 »

You can also short commodities futures, buy interest rate futures, take highly leveraged positions in long term government bonds.
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Re: How does one hedge against deflation?

Post by Johno »

bhsince87 wrote:
munemaker wrote:Has there ever been deflation in USA?

I worry about inflation, not deflation, especially considering the fed stimulus.
Yes, absolutely. 2009 was the last bout, although it was minor. It also happened during the Great Depression.

But since the Fed was created, its been rare in the US. Deflation seems to be their number one enemy. Before that, it was actually fairly common.
Yes, the deflation rate in the US (geometrically) averaged over 2% in the 30 years or so after the Civil War, a cumulative decline in the price level of around 45%, which was why the call for easier money to help debtors, especially farmers, had become such a powerful political force by the mid 1890's.

However while a deep societal divide emerged between debtors and creditors, among assets stocks outperformed govt bonds in the US in that period. Stocks aren't necessarily a worse asset than bonds in deflation, depends. The late 19th century 'long depression' period globally was characterized by slower growth than before and after, and generally falling prices, but still pretty high growth in places like the US. Though it's a long time ago and much has changed, it's not implausible IMO that a period somewhat like this might be shaping up now, except for example the slowing but still relatively fast growing large economy might be China rather than the US. Deflationary pressure now seems to be global, not comparable in that respect to the situation where Japan's long deflation afflicted just that country, immediately followed a huge stock bubble burst, and where even low interest government bonds long outran the return of stocks bought near the top of the bubble.
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Re: How does one hedge against deflation?

Post by galeno »

30 yr USA T-bonds. The problem is that yields are already so low that there's not a lot of "bounce" in them.
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Re: How does one hedge against deflation?

Post by jdb »

Investment grade non callable muni bonds for taxable accounts.
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Re: How does one hedge against deflation?

Post by SimpleGift »

On the consumer level, deflation might seem attractive, since wages go farther as prices get lower — but on the macro-economic scale, prolonged deflation in today's global economy could have devastating effects, such as:
  • • The smothering of demand and GDP growth, leading to the kind of decades-long slump seen in the U.S. in the 1930s and Japan in the 2000s;

    • Central banks today seem to have mostly exhausted their fiscal arsenals, so they'll find it harder to launch the kind of full-scale monetary operation needed to reverse persistent deflation; and

    • Deflation greatly increases the value of a country's debt — which could tip a wide swath of countries, including nearly all of southern Europe, into depression and even default.
While the probability of a global "deflation contagion" is still small, I believe, the consequences of such a development would be quite severe for equity-heavy portfolios. Therefore an allocation to Treasuries in one's portfolio can serve as a good "deep risk" insurance policy, despite their current low yields.
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Re: How does one hedge against deflation?

Post by TX_TURTLE »

Simplegift wrote:On the consumer level, deflation might seem attractive, since wages go farther as prices get lower...
Problem is, when there is deflation many people lose their jobs. When prices are going down people try very hard to postpone consumption. And this doesn't help a single bit. For example, you are ready to buy a new car, but you wait because next month it will be cheaper. So does mostly everybody else. So the dealer lays off most of his sales force. The newly unemployed reduce consumption, which in turn pushes local businesses to lay off some of their workforce... It is a catastrophe. I've witnessed this scenario when I was a teenager (obviously outside the US) and I still remember.
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Re: How does one hedge against deflation?

Post by Johno »

Simplegift wrote:
• Deflation greatly increases the value of a country's debt — which could tip a wide swath of countries, including nearly all of southern Europe, into depression and even default.
I can think of another country outside Europe with huge debt which a long period of deflation and slower growth might tip into default. :wink:
Earlier I mentioned the 'Long Depression' of the 1870's-90's (though in US there was deflation right from the end of the Civil War). It seems a bit more like what the threat might be now, rather than single country deflation like Japan in 1990's-2000's. Stocks did better than bonds then, but OTOH US debt to GDP was low and deflation eroding the creditworthiness of govt bonds was not much of an issue, so govt bonds also had a healthy real return in that period. Now with high debt loads by governments around the developed world, perhaps more thought is required before immediately answering 'govt bonds!' as the answer to deflation. Imagine the graph of future US debt to GDP under current taxes and entitlements if, on the plus side, Social Security cola's dropped to zero (can't be negative under current law) and medical inflation dropped to say 0% in a general 2% deflation...but OTOH the existing debt grew in real terms 2% a year rather than shrinking 2% a year and trend real growth was say 1% (population growth) rather than low 2's. The numbers really don't work now, would work a lot less well then. Perhaps one might counter this by simply saying a prolonged USD deflation is impossible *because* of the US long term fiscal problem, but maybe not if there was a powerful enough global force, again thinking Long Depression, not Japan 1990's.

But just taking as given there could be prolonged USD deflation, I don't see US govt bonds as necessarily the right hedge for it, since eventually deflation would seriously erode their credit quality. If the US had issued 30yrs in 1865, it would have required the same taxes on nearly twice the real economic activity to pay the principal back in 1895. If that happened from now with today's prospective growth rates and debt load, it's pretty certain you wouldn't get all your nominal money back, there'd be a restructuring at some point.
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Re: How does one hedge against deflation?

Post by Cosmo »

John3754 wrote:What could one do in order to hedge against the possibility of a period of deflation?
Zero mortgage is a good start. How about renting versus purchasing a home?
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Re: How does one hedge against deflation?

Post by garlandwhizzer »

If deflation is limited to one country (Japan 1990 - now) the obvious way to beat it is to diversify internationally. If deflation is global as in the Great Depression, there are few places to hide (Treasuries, and T-bills, the latter yielding nothing but nothing theoretically zero return gets more valuable as time passes. The problem with Treasuries and T-bills is that prices of these "safe" instruments get bid up by the market in these circumstances until negative interest rates are achieved, i.e. you pay the issuer rather than the other way around. Germany and Japan are almost there now with interest rates on 10 year bonds of less than 0.5%. Global deflation is therefore a catastrophic situation for everyone with no good places to hide. That is the reason why our Fed was so willing to vastly inflate the M-1 money supply, knowing that it had tools to fight inflation should it occur, but none that work against deflation. The European Central Bank and Germany in particular with persistent nightmares of devastating hyperinflation did not choose such aggressive action and they are now paying the price for twiddling their thumbs and relying on half measures and hope.

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Re: How does one hedge against deflation?

Post by Mel Lindauer »

I Bonds work well in both inflationary and deflationary periods. Since the composite rate on I Bonds can never go below 0%, the greater the rate of DEflation, the higher the REAL return will be.
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Re: How does one hedge against deflation?

Post by ogd »

garland: very well said! The one thing I'd add is one can prevent "safe instruments being bid up" by holding some longer term Treasuries, or in the short end of the spectrum being able to retreat to 0% cash, which individual investors always are unlike institutional investors who might not have a safe place to hold cash other than market rate bonds. We have FDIC insured banks or the good old matress.

My vote is for Treasuries, the longer the better.
Cosmo wrote:Zero mortgage is a good start. How about renting versus purchasing a home?
The risks of a nominal mortage are mitigated by the ability to refinance. Not fully, because there's no guarantee you'll be credit worthy enough at that point, but to a considerable degree. That call option is worth quite a bit.
Johno wrote:But just taking as given there could be prolonged USD deflation, I don't see US govt bonds as necessarily the right hedge for it, since eventually deflation would seriously erode their credit quality. If the US had issued 30yrs in 1865, it would have required the same taxes on nearly twice the real economic activity to pay the principal back in 1895. If that happened from now with today's prospective growth rates and debt load, it's pretty certain you wouldn't get all your nominal money back, there'd be a restructuring at some point.
This view applied while we were on the gold standard, and it also applies to the Eurozone countries which are on a gold standard of sorts. However, present day US is ultimately able to pay any debt denominated in dollars, for the obvious reason that it can make however many of them it wants. It might be unwilling to do so, but it's always able and I trust that no amount of political stupidity will go far enough. Last time this came to the forefront, summer 2011, the market responded by... bidding up Treasuries. So it was never really worried about default.
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Re: How does one hedge against deflation?

Post by rca1824 »

Real assets are unaffected by either inflation or deflation. Only nominal assets, e.g. bonds, change value.

If you own bonds, your wealth falls with inflation and rises with deflation.
If you issued bonds (i.e. have debt), your wealth rises with inflation and falls with deflation.

So the only hedge against deflation to minimize your net debt (net debt = debt issued - bonds owned)
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Re: How does one hedge against deflation?

Post by SimpleGift »

Though there aren't many empirical studies of deflationary shocks in the U.S. economy, the table below summarizes asset returns during the six deflationary periods since 1900. Surprisingly, even 3-month Treasury bills and 10-year Treasury bonds proved to be decent deflation hedges — so holding 30-year Treasuries in one's portfolio (and taking on their long-term, interest rate risk) may not be entirely necessary.

Image
(Note: For the six deflationary periods taken together, average returns were 5.6% for the 3-month Treasury bills and 7.3% for the 10-year Treasury bonds).
Source: AllianceBernstein

Of course, if a "deflationary shock" turns into a "deflationary decade" or longer (as in Japan's recent experience), then 30-year Treasuries would look very good, as investors would have locked in a fixed interest rate and minimized the risk of re-investing at low or even zero nominal rates. But a deflationary decade seems extremely unlikely for the U.S. — see Mr. Bernanke's instructive 2002 speech.
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Re: How does one hedge against deflation?

Post by Electron »

One concern in a long period of deflation would be maintaining investment income. That is where the long term non-callable bonds come into play. In past years Vanguard newsletters would address the subject of income durability from bond funds.

An interesting thing is that the income stream from bond funds over the last two or three decades has declined significantly and that was generally without deflation. I hold a few bond funds for investment income and have noticed that myself. Dividends were not reinvested.

If one were looking for investment gains from a deflationary period, they would need to buy long term bonds before rates dropped.

Note also that a quality immediate income annuity could also be an excellent investment during a deflationary period. It would be best to purchase before rates dropped. Many have warned about purchasing immediate annuities in recent years because of the low rates. That recommendation would not have been correct if a deflationary period lies ahead.
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Re: How does one hedge against deflation?

Post by Aptenodytes »

Some people are recommending getting rid of your personal debt, but that's a bad hedge. When deflation occurs, people with debt will suffer, but it doesn't follow that during current conditions someone wanting to protect against the possibility of deflation should eliminate debt. A hedge is something you do at modest cost because it provides offsetting gains against risks the rest of your portfolio is exposed to. If the cost becomes too high it isn't a hedge, it is a gamble.

Upping Treasuries makes sense as a hedge -- it gives a boost if deflation happens but you don't suffer by taking them on the same way most people would suffer if they had to do without personal debt (e.g. I would have to move into a house half as big as what I have now).
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Re: How does one hedge against deflation?

Post by Johno »

ogd wrote:
Johno wrote:But just taking as given there could be prolonged USD deflation, I don't see US govt bonds as necessarily the right hedge for it, since eventually deflation would seriously erode their credit quality. If the US had issued 30yrs in 1865, it would have required the same taxes on nearly twice the real economic activity to pay the principal back in 1895. If that happened from now with today's prospective growth rates and debt load, it's pretty certain you wouldn't get all your nominal money back, there'd be a restructuring at some point.
This view applied while we were on the gold standard, and it also applies to the Eurozone countries which are on a gold standard of sorts. However, present day US is ultimately able to pay any debt denominated in dollars, for the obvious reason that it can make however many of them it wants. It might be unwilling to do so, but it's always able and I trust that no amount of political stupidity will go far enough. Last time this came to the forefront, summer 2011, the market responded by... bidding up Treasuries. So it was never really worried about default.
Your quote omitted and ignored my statement in the previous paragraph that some might claim a persistent deflation in USD is impossible, and it would be for the reason I took as obvious but you now state explicitly: the theory that the US govt would have to inflate to pay off debt if it couldn't pay it off in the presence of deflation, which is what ',make however many of them (USD) it wants' means, *inflation*. So what you're basically saying is that the premise of the OP is flawed, and there can't be prolonged USD deflation under the current monetary system in the US.

However, besides my original statement being clearly conditioned 'But just taking as a given there could be prolonged USD deflation' , in actual history governments with severe fiscal trouble do not always employ deliberate inflation as an attempt to remedy. The events of 2011 in the US are wholly irrelevant because there wasn't any *but* strictly political reason the US mightn't pay. For governments in general the situation with Russia in 1996 is more illustrative. The Russians could only pay by either deliberately inflating (or continuing to) or stop the cycle by imposing a restructuring on *Ruble* debt (foreign currency debt was not affected). They chose the latter, and it's by no means clear that was 'stupid'. Increasingly accelerating inflation can be more unpredictable and destabilizing than forced restructuring (which has after all, 'structure'), and moreover the two choices hurt various groups and constituencies to differing degrees. And Russia is far from the other only country in history to force restructuring of local currency debt in preference to deliberate inflation.

In the actual world 2% pa prolonged *deflation* is highly unlikely, but lower than previously expected long term inflation or Japan like (~0% inflation) situation on a global basis is plausible IMO, and the credit worthiness of US debt would be eroded in that case from what it currently appears. It's misguided to believe this can't be true to any extent because it's local fiat currency debt, or at the least basic logic has to be applied (ie it's logical to claim the lower than expected inflation scenario can't occur, not logical to accept the premise then say it's not a US debt credit problem because the govt can inflate it away... :D ). US debt is not highly safe in the long term because the US govt has a printing press. It's highly safe in the long term if one has high faith the long term fiscal problem will be addressed by a combination of tax and spending reforms and pro-growth policies before the concept of 'restructuring so rich bond holders also pay their fair share of the problem' makes its way into the political mainstream. And again the restructuring option is not easily dismissed as 'stupid' in a future scenario where the political pain of a spending/tax solution has become high enough, and efforts to accelerate trend growth have failed. It's far from a fringe view that restructuring may be part of the solution to debt crises throughout the developed world in decades to come, and shouldn't be. An even mildly deflationary environment will make it all the more likely.
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Re: How does one hedge against deflation?

Post by ogd »

Johno wrote:Your quote omitted and ignored my statement in the previous paragraph that some might claim a persistent deflation in USD is impossible, and it would be for the reason I took as obvious but you now state explicitly: the theory that the US govt would have to inflate to pay off debt if it couldn't pay it off in the presence of deflation, which is what ',make however many of them (USD) it wants' means, *inflation*. So what you're basically saying is that the premise of the OP is flawed, and there can't be prolonged USD deflation under the current monetary system in the US.
Johno: I was not ignoring the statement, but unlike you I am not conflating paying off debt with new money with automatic inflation. It's becoming apparent that it's hard for governments to make inflation rise through monetary policy because they have to get that money circulating first. And even if you are making that automatic connection, you'd have to accept that there is a middle ground where the actions to "inflate to pay off debt" would first solve the deflation problem that is the subject of this thread before becoming an inflation problem themselves.

The fundamental problem with what you said was the use of examples from the gold standard era, which are not applicable to the present situation.

I do believe that deflation in USD is possible. I do not view it as a contradiction to then say that Treasury defaults are nevertheless impossible if you assume even an ounce of sense in the political class or their economically attuned backers.

The Russian action of 1996, a very unique example that I was aware of, is very hard to justify and many economists think that it was a mistake. But it would be downright inexplicable if it was done under deflationary conditions, that is here we are facing a deflationary problem ravaging our economy, but we're going to default and shock the system further because we're too afraid of inflation. In any case, we should not be taking our cues from a broken country and government like Yeltsin Russia.

The last part of your statement ("it's highly safe in the long term if...") is very political and we can't discuss it here without getting in trouble. I just wanted to highlight two things that hopefully steer clear of that zone: 1) that examples from the gold standard era or Eurozone are not applicable; and 2) that there's a problem with the view that debt might not be payable in times of deflation because of inflation.
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Re: How does one hedge against deflation?

Post by technovelist »

A large non-recourse mortgage matched with a position in long-term Treasurys would probably work as a hedge, because one could walk away from the mortgage without penalty (other than having to move, of course), and still keep the Treasurys.
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Re: How does one hedge against deflation?

Post by Johm221122 »

Mel Lindauer wrote:I Bonds work well in both inflationary and deflationary periods. Since the composite rate on I Bonds can never go below 0%, the greater the rate of DEflation, the higher the REAL return will be.
EE bonds also guaranteed to double in 20 years
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Re: How does one hedge against deflation?

Post by Grt2bOutdoors »

Johm221122 wrote:
Mel Lindauer wrote:I Bonds work well in both inflationary and deflationary periods. Since the composite rate on I Bonds can never go below 0%, the greater the rate of DEflation, the higher the REAL return will be.
EE bonds also guaranteed to double in 20 years
John
You beat me to it today, but I've been recommending them since 2008 when the current rate was higher than 1%. Nothing wrong with 20 year zeros if you can hold to initial term for absolute floor money, take your risk with equities. I bonds work great during rising inflation, not so much when inflation is zero or below the 20 year rate of 3.5%. Now that I've posted that, look for the Treasury to change the EE program.
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Re: How does one hedge against deflation?

Post by Johno »

ogd wrote:
Johno wrote:Your quote omitted and ignored my statement in the previous paragraph that some might claim a persistent deflation in USD is impossible, and it would be for the reason I took as obvious but you now state explicitly: the theory that the US govt would have to inflate to pay off debt if it couldn't pay it off in the presence of deflation, which is what ',make however many of them (USD) it wants' means, *inflation*. So what you're basically saying is that the premise of the OP is flawed, and there can't be prolonged USD deflation under the current monetary system in the US.
1. Johno: I was not ignoring the statement, but unlike you I am not conflating paying off debt with new money with automatic inflation. It's becoming apparent that it's hard for governments to make inflation rise through monetary policy because they have to get that money circulating first. And even if you are making that automatic connection, you'd have to accept that there is a middle ground where the actions to "inflate to pay off debt" would first solve the deflation problem that is the subject of this thread before becoming an inflation problem themselves.

2. The fundamental problem with what you said was the use of examples from the gold standard era, which are not applicable to the present situation.

3. I do believe that deflation in USD is possible. I do not view it as a contradiction to then say that Treasury defaults are nevertheless impossible if you assume even an ounce of sense in the political class or their economically attuned backers.

4. The Russian action of 1996, a very unique example that I was aware of, is very hard to justify and many economists think that it was a mistake. But it would be downright inexplicable if it was done under deflationary conditions, that is here we are facing a deflationary problem ravaging our economy, but we're going to default and shock the system further because we're too afraid of inflation. In any case, we should not be taking our cues from a broken country and government like Yeltsin Russia.

5. The last part of your statement ("it's highly safe in the long term if...") is very political and we can't discuss it here without getting in trouble. I just wanted to highlight two things that hopefully steer clear of that zone: 1) that examples from the gold standard era or Eurozone are not applicable; and 2) that there's a problem with the view that debt might not be payable in times of deflation because of inflation.
1-3. Yes the whole point is that your theory means there can't be severe prolonged deflation past some point, because of govt monetizing its debt to repay/roll it is *inflationary* (not necessarily resulting in high absolute inflation). Therefore you are basically challenging the premise of the OP, not arguing with me. I said *if* deflation was as follows, here's what would happen to US debt credit quality. The 'if' is in line with the OP question. If OTOH there can't be a lot of deflation, we don't need to worry about hedging it that much.

But it *is* a contradiction to say there could be prolonged deflation and no impairment of government debt quality, also starting with today's high debt load and already slow growth, the description of my thought experiment (whereas in the Long Depression the US had less debt to GDP and was growing faster). And your contention in any case is not proven by anything, and is a matter like many things of how long is 'long term.' Japan has now expanded its debt/GDP ratio to ~250% in part due to existing debt failing to shrink with inflation for a long time, and now years of trying to create sustained JPY inflation. JGB's have been a reasonable deflation hedge (earning ~1% more than just holding cash). But perhaps we should see how that debt mountain is resolved before certainly stating it can't lead to a restructuring at some point just because it's local currency debt.

4. Far from unique, just the latest major example. A significant % of sovereign defaults in history have included local currency debt in one country currencies. The logic is widely applicable, not unique to Russia: richer and/or more foreign oriented entities often own local currency debt, more local and smaller entities tend to bear the brunt of high inflation. And this comment I think was clearly stated as more general, not particularly applicable to deflation scenarios. It isn't necessarily 'stupid' to break the cycle of run away indebtedness with a forced restructuring: it can become a lesser evil at a certain point, even for fiat local currency debt.

5. This is reality, whether dubbed 'political' or not. The printing press does not insure credit worthy govt debt. Long term credit worthiness is a function of govt fiscal and growth policies, insofar as govt can influence growth, within a given set of exogenous economic circumstances it doesn't wholly control. It might or might be achievable, and is looking less achievable in a number of rich democracies because of their pre-existing high debt loads entering a period of aging populations and possibly lower working age participation and productivity gain trajectories than previously expected. The US is one of them.
Last edited by Johno on Mon Oct 20, 2014 12:30 pm, edited 1 time in total.
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ogd
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Re: How does one hedge against deflation?

Post by ogd »

Johno wrote:1-3. Yes the whole point is that your theory means there can't be severe prolonged deflation. The point isn't that I'm saying any particular level of inflation would be caused by govt monetizing its debt, but it is *inflationary* relative to the scenario where it doesn't take such monetizing actions. Therefore you are basically challenging the premise of the OP, not arguing with me.
Johno: I don't at all agree that the ability of a government to always pay debt in its own currency means there can't be deflation. However, I don't think this will be a productive discussion and I am for now content to have expressed in this thread my view on what the present monetary regime means for the safety of Treasuries.
Johno
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Re: How does one hedge against deflation?

Post by Johno »

ogd wrote:
Johno wrote:1-3. Yes the whole point is that your theory means there can't be severe prolonged deflation. The point isn't that I'm saying any particular level of inflation would be caused by govt monetizing its debt, but it is *inflationary* relative to the scenario where it doesn't take such monetizing actions. Therefore you are basically challenging the premise of the OP, not arguing with me.
Johno: I don't at all agree that the ability of a government to always pay debt in its own currency means there can't be deflation. However, I don't think this will be a productive discussion and I am for now content to have expressed in this thread my view on what the present monetary regime means for the safety of Treasuries.
Didn't say 'can't be deflation', there was brief deflation just recently, but there's no escaping the connection between monetization as the cure for govt credit quality deterioration and choosing hedges for prolonged periods of deflation. One definitely acts against the other at least in theory. Though again let's hope to live to see how the Japan debt mountain is resolved, if it's not 'political' to discuss that (because it's Japan, you assume I'm not from Japan I take it?), to see if a floating fiat monetary system insures the long term safety of JGB's starting from 250% debt/GDP ratio. That's all that matters right, the printing press? If the US already had 250% treasuries would be just as safe, and no reason to think it any safer if the US ratio was 40% like it was not that long ago, and projected to decline. The printing press makes it safe, everything else is 'political' and shouldn't be thought about. :wink:
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Bustoff
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Re: How does one hedge against deflation?

Post by Bustoff »

Simplegift wrote:High-quality bonds, preferably Treasuries ...
Interesting in that William Bernstein has recommended short, high-quality bonds as an inflation hedge.
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ogd
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Re: How does one hedge against deflation?

Post by ogd »

Johno wrote:Though again let's hope to live to see how the Japan debt mountain is resolved, if it's not 'political' to discuss that (because it's Japan, you assume I'm not from Japan I take it?), to see if a floating fiat monetary system insures the long term safety of JGB's starting from 250% debt/GDP ratio.
Johno: perhaps we can agree that Treasuries stand a good chance to see you through the deflationary period, until the mountain of debt has whatever effect it may have on inflation? That, and "in the long term, we're all dead", which I think was uttered in strong connection to this type of probem.

It's not Japan or even monetary discussions that are political, it's the "fiscal problem will be adressed" by variously leaning policies. Forbidden zone, I'm pretty sure.
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SimpleGift
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Re: How does one hedge against deflation?

Post by SimpleGift »

Johno wrote:But it *is* a contradiction to say there could be prolonged deflation and no impairment of government debt quality, also starting with today's high debt load and already slow growth...
With Japan's decades-long struggle with deflation and many large European countries poised on the brink of deflation, just for fun, one can check the market's opinion of the chances of government bond defaults by looking at sovereign debt default swaps (found here). These are the daily prices of insurance against default on the open market:
  • United States…...…..$17.50
    Germany……..…..….$20.83
    Japan………..….……$48.50
    France……….....……$57.62
    Spain…………....….$105.48
    China……….………$130.00
    Italy……………....…$148.47
    Portugal………..…..$219.30
    Greece………..…….$776.57
The market seems to feel Japan's sovereign debt is relatively secure, but several of the high-debt, low-growth countries of Europe are considered a much higher risk for default.
toto238
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Re: How does one hedge against deflation?

Post by toto238 »

One thing to be mindful of:

In 2004, it was common wisdom that housing prices would always go down. Sure prices may have a small 1-year dip every once in awhile, but it would never be sustained because the long-term trend is for real estate prices to rise.

In 1995, it was common wisdom that the internet was going to change the world and any company based on the internet was going to be an unbelievable success. You were a fool to bet against technology. Sure, it had up days and down days and not every tech stock turned into a gold mine. But if you weren't putting every dollar you could into the tech sector, you were a fool!

In 1927, it was common wisdom that stocks would always go up. Sure they had down days, sometimes very big down days. But over the long-term, you'd expect to make a fortune on stocks. You should be putting every dollar you can into the stock market, and maybe even borrowing money so you can put more in!

Today, in 2014, it is common wisdom that the price level will always go up. Sure prices may have a small 1-year dip like in 2009 every once in awhile, but it would never be sustained because the long-term trend is for inflation to increase. Prices are always going to keep rising, and you should be heavily in debt to leverage that inflation.

One of my favorite movies has a semi-famous quote you may recognize: "1500 years ago, everyone KNEW the Earth was the center of the universe. 500 years ago, everyone KNEW the Earth was flat, and 15 minutes ago, you KNEW humans were alone on this planet. Imagine what you'll know tomorrow."

Now that's not to say that America is on the precipice of a giant bout of deflation. But when everyone starts saying it's impossible for something to happen, it may be a good idea to hedge against it.
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SimpleGift
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Re: How does one hedge against deflation?

Post by SimpleGift »

No one has mentioned TIPS as a deflation hedge — and since they have a more complicated response to deflation than nominal Treasuries, I'll give it a go (and bond experts, please chime in if I go astray!).

Backed by the full faith and credit of the U.S. government, TIPS of any maturity should do well during a deflationary shock and flight-to-quality episode, just like nominal Treasuries. But should deflation become prolonged over years, the effect on TIPS is more nuanced:
  • • TIPS that have been outstanding, say, 5 or 10 years have likely accrued a fair amount of inflation in their current value. If deflation was prolonged over years, these TIPS would eventually lose that accrued inflation down to the par value of the bonds (the amount the bond holder is entitled to at maturity). Their value can't go any lower, however long deflation lasts, as the Treasury guarantees their original principal amount at maturity.

    • Newly-issued TIPS, because they've accrued no inflation and are close to par value, would not lose value during prolonged deflation and their prices would not be discounted due to future deflation expectations.
IN SUM: During deflation, both newly-issued and long-outstanding TIPS will have their semi-annual interest payments adjusted downward — but only TIPS that have accrued inflation will lose value and have their prices discounted based on future expected deflation, according to their amount of accrued inflation. This discounted price dynamic for TIPS with accrued inflation played out during the deflationary scare of the 2008-2009 financial crisis, I believe.
LongerPrimer
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Re: How does one hedge against deflation?

Post by LongerPrimer »

I've been negative to bonds since 2008. I may be changing my mind as an investment possibility, not as a moderator to equities. :annoyed
lazyday
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Re: How does one hedge against deflation?

Post by lazyday »

Reduce microcap and SV tilts.

Tilt equity to quality, profitability, large, staples, and/or health care. Deflation can come with depression, when industry leaders often outperform distressed companies. Non-cyclicals can outperform economically sensitive sectors.

A defense industry tilt might hedge against a deflationary depression caused by unexpected conflict.

Long term Treasuries if you don't fear inflation or real rate increases, savings bonds and breakable FDIC/NCUA CDs if you do.
thenextguy
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Re: How does one hedge against deflation?

Post by thenextguy »

toto238 wrote: Now that's not to say that America is on the precipice of a giant bout of deflation. But when everyone starts saying it's impossible for something to happen, it may be a good idea to hedge against it.
You're posting in a thread about how to hedge against deflation. I don't think anyone is saying deflation is impossible. :confused
Enkidu
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Re: How does one hedge against deflation?

Post by Enkidu »

Simplegift wrote:IN SUM: During deflation, both newly-issued and long-outstanding TIPS will have their semi-annual interest payments adjusted downward — but only TIPS that have accrued inflation will lose value and have their prices discounted based on future expected deflation, according to their amount of accrued inflation. This discounted price dynamic for TIPS with accrued inflation played out during the deflationary scare of the 2008-2009 financial crisis, I believe.
What about iBonds or TIPS funds? Seems that iBonds would provide a floor in deflation and also adjust for unexpected inflation. Would a TIPS fund have a capital gain in deflation but continue to pay interest at a lower rate? Not sure.
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SimpleGift
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Re: How does one hedge against deflation?

Post by SimpleGift »

Enkidu wrote:Would a TIPS fund have a capital gain in deflation but continue to pay interest at a lower rate? Not sure.
My understanding is that there's three ways a TIPS fund would be affected be prolonged deflation:
  • • The semi-annual interest payments of the TIPS bonds in the fund would be adjusted downward by each year's deflation percentage;

    • If the TIPS bonds in the fund have accrued inflation (which most likely would), this value would be adjusted downward by each year's deflation percentage, until they reached par value; and

    • Based on future expected deflation, the market would likely discount the prices of those TIPS bonds in the fund with accrued inflation, in proportion to their amount of accrued inflation.
As discussed upthread, an investor is guaranteed the par value (value at maturity) of each TIPS bond in the fund, so this would serve as a floor during prolonged deflation — but the TIPS fund would likely lose value down to where this floor is reached. In short, a TIPS fund would hedge against prolonged deflation, but just imperfectly.
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Phineas J. Whoopee
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Re: How does one hedge against deflation?

Post by Phineas J. Whoopee »

Simplegift wrote:...
  • • TIPS that have been outstanding, say, 5 or 10 years have likely accrued a fair amount of inflation in their current value. If deflation was prolonged over years, these TIPS would eventually lose that accrued inflation down to the par value of the bonds (the amount the bond holder is entitled to at maturity). Their value can't go any lower, however long deflation lasts, as the Treasury guarantees their original principal amount at maturity.

    • Newly-issued TIPS, because they've accrued no inflation and are close to par value, would not lose value during prolonged deflation and their prices would not be discounted due to future deflation expectations.
...
Hi Simplegift,

I believe that's in error, but I can see how it would be an easy mistake to make.

With respect to the value Treasury bases the interest payments on, it very much can go below the original par. The original value probably isn't the floor market price, either, except for TIPS with very little time remaining until maturity.
The Treasury Department wrote:Treasury Inflation-Protected Securities, or TIPS, provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.
[Emphasis added]

The underlined sentence can only make sense if the principal may be adjusted below its original value, in the face of deflation.

PJW
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SimpleGift
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Re: How does one hedge against deflation?

Post by SimpleGift »

Phineas J. Whoopee wrote:The underlined sentence can only make sense if the principal may be adjusted below its original value, in the face of deflation.
This is the explanation from the Treasury Direct website :
Treasury Direct wrote:What happens to TIPS if deflation occurs?
The principal is adjusted downward, and your interest payments are less than they would be if inflation occurred or if the Consumer Price Index remained the same. You have this safeguard: at maturity, if the adjusted principal is less than the security's original principal, you are paid the original principal.
So, technically, you're right. The principle can be adjusted below par value, but the investor would be guaranteed the par value amount (value at maturity). Thanks for the correction!

PS. Because of the Treasury's guarantee, wouldn't a TIPS bond whose adjusted principle was below par value due to prolonged deflation likely be valued "at par" by the market?
Last edited by SimpleGift on Tue Oct 21, 2014 11:57 am, edited 1 time in total.
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Phineas J. Whoopee
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Re: How does one hedge against deflation?

Post by Phineas J. Whoopee »

Simplegift wrote:...
PS. Because of the Treasury's guarantee, wouldn't a bond whose adjusted principle was below par value due to prolonged deflation likely be valued "at par" by the market?
By that reasoning, nominal treasury debt would never trade below par, because of the promise to return all principal and the lack of credit risk, and yet we observe that it sometimes does.

I would expect TIPS to respond to changes in real rates the same way other treasuries do to nominal ones.

PJW
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Re: How does one hedge against deflation?

Post by Valuethinker »

Simplegift wrote:
PS. Because of the Treasury's guarantee, wouldn't a TIPS bond whose adjusted principle was below par value due to prolonged deflation likely be valued "at par" by the market?
If close to maturity, yes it would trade at par.

If there was significant deflation a long way before maturity (a few years, say) then it could trade to a discount. The 'redeem at par' is a floor in price only when near maturity.

Once the TIPS fell below par, it would (mathematically) have to offer a real return to an investor-- making them quite attractive instruments.
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Phineas J. Whoopee
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Re: How does one hedge against deflation?

Post by Phineas J. Whoopee »

Valuethinker wrote:...
Once the TIPS fell below par, it would (mathematically) have to offer a real return to an investor-- making them quite attractive instruments.
How would a TIPS trading below par because of a rise in real interest rates have a higher real YTM than one just issued offering the same recently-risen real rate?
PJW
Valuethinker
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Re: How does one hedge against deflation?

Post by Valuethinker »

Phineas J. Whoopee wrote:
Valuethinker wrote:...
Once the TIPS fell below par, it would (mathematically) have to offer a real return to an investor-- making them quite attractive instruments.
How would a TIPS trading below par because of a rise in real interest rates have a higher real YTM than one just issued offering the same recently-risen real rate?
PJW
I did not assert that?

If a TIPS bond is trading at 90, due to cumulative deflation, with 5 years to run, then the investor is guaranteed a $10 nominal return over 5 years-- a positive amount.

Even further deflation would only reduce the coupon not the final payment. Say prices fell another 50%, you'd still make a nominal return of 10 (and a real return of 60) + coupon.

Conversely high inflation would simply increase the redemption amount. Say prices doubled before redemption. You'd get a nominal return of 90 x 2 = 180 - 90 = 90 (0 per cent. real on your principal) plus your coupons indexed to that inflation.

Therefore, mathematically, the bond would have to give you a positive nominal return. And (I think,without working through the problem) a guaranteed real return as well.

That's pretty attractive. I would guess ibonds have the same characteristic (not being USian not too familiar with same)?
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