Making inflation pay

Share

The U.S. government will inflate away its huge financial liabilities to such an extent that the U.S. dollar will become worthless. That is the central theme in a new book, Profiting from the World Economic Crisis: Finding Investment Opportunities by Tracking Global Market Trends, written by Bud Conrad.

Mr. Conrad is the chief economist for Stowe, Vt.-based investment advisory Casey Research. He is also a veteran trader of futures contracts.

With the inflation genie about to be let out of the bottle, says Mr. Conrad, investors need to avoid long-term holdings in bonds and annuities, and build up holdings in physical assets such as agriculture products, energy or gold.

However, the "trade of the decade" will be betting on interest rates to rise, he declares.

Gold is a logical choice for a world headed for currency debasement but it has staged a big rally since 2001 and is no longer cheap. Oil and other commodities are also choices but their prices are up a lot too.

Interest rates, now at 50-year lows, are much better bargains than gold or commodities, argues Mr. Conrad.

U.S. interest rates would seem to have considerable scope to rise. The bailout of the banking industry, stimulus packages, military spending and social programs have resulted in a trillion-dollar budget deficit for the U.S. federal government. The only way out, it seems, is for the government to go deeper into debt and crank up the printing press.

As government indebtedness and money creation ratchets up, it increasingly puts upward pressure on interest rates. Here are four transmission channels:

• first, when the expanding supply of government bonds begins to overwhelm demand, higher interest rates will need to be offered to attract purchasers;

• second, when an economic recovery emerges (from all the printed money spent to fund the government deficit), the Federal Reserve will no longer have a reason to hold down interest rates on government bonds;

• third, the borrowing needs of businesses will climb during the recovery phase and compete with government needs, adding additional impetus to rising rates;

• fourth, the pickup in economic activity will give rise to inflationary pressures, and bond investors will demand higher yields to compensate for erosion in the real value of their principal and interest payments.

Like the 1970s, the upward trend in inflation may be interrupted periodically by policy-induced slowdowns in the economy. But with the U.S. financial system so fragile, there will be little stomach for the kind of recessions that tame inflation. Stimulus will be re-administered at successively higher rates of inflation and lead to higher peaks in inflation.

The Federal Reserve saved the U.S from hyperinflation in the early 1980s by clamping down hard on the money supply. But that is not likely to work this time around, Mr. Conrad postulates, because imbalances have built up so much at this stage in the debt supercycle that there is no way to return to stability through normal means.

In short, the only recourse left for the federal government is to devalue its debt through an inflation that ultimately evolves into hyperinflation. This process will eventually culminate in a collapse in the U.S. dollar and the creation of a new currency.

Cat:e528746c-3414-401a-b14b-50247e3bdf01Forum:d0fa4e14-88d2-41f9-8a19-896bdff9544b

In Mr. Conrad's opinion, the rise in interest rates will go far, even beyond the traumatic levels reached in the early 1980s. Once inflation takes off, the inflation premium in bond yields can soar.

To play the uptrend in U.S. interest rates, Mr. Conrad recommends:

• ProFunds Rising Rates Opportunity Fund (RRPIX)

• ProFunds Rising Rates Opportunity 10 Investor (RTPIX)

• Rydex Inverse Government Long Bond Strategy Fund (RYJUX)

The above are U.S. mutual funds with annual expense ratios ranging from 1.4 to 1.6 per cent. Much lower annual expenses are available on exchange-traded funds, such as:

• UltraShort 20+ Year Treasury ProShares (TBT)

• UltraShort 7-10 Year Treasury ProShares (PST)

• Horizons BetaPro U.S. 30-year Bond Bear Plus (HTD, on the TSX)

These instruments use derivatives to replicate daily moves in interest rates on U.S. government bonds and are, in many cases, leveraged. Because of these features, as Mr. Conrad warns, their performance is path dependent.

That is, the ETFs will only return twice (or the same as) the rise in rates over periods longer than a day if rates rise steadily without too much volatility. If there is volatility and/or long stretches without direction, the funds will not return twice (or the same as) the rise in rates. They could even record losses.

For this reason, a trading approach might be used. Entry could be arranged when a flight to the safety of government bonds (like recently) has bid bond prices up and pushed yields down to low levels. Exit could be timed when rates have had a good run up and macroeconomic conditions aren't supportive of increases in the short to medium term.

Mr. Conrad also mentions using interest-rate futures to play rising interest rates. They require a through understanding of how futures contracts work as the leverage involved can quickly erode the investor's capital. There are free quotes at futuresource.quote.com and more information at cmegroup.com.