Deflation hedges

[kevin4u2]

A major conflict or maybe even WW3, will happen well before any of this deflation thing plays out.

 

Then you have the Helicopter Ben theory.

 

Do you guys really think that world powers will let their economies unravel like Japan did for years without doing anything even if it is dangerous and stupid?

 

Cardboard

 

China is doing a great job of keeping their economy from unraveling.

[rb]

A major conflict or maybe even WW3, will happen well before any of this deflation thing plays out.

 

Then you have the Helicopter Ben theory.

 

Do you guys really think that world powers will let their economies unravel like Japan did for years without doing anything even if it is dangerous and stupid?

 

Cardboard

 

China is doing a great job of keeping their economy from unraveling.

Right China is having an economic slow down and their stock market dropped to the level it was in February. Behold the unraveling!

[wisdom]

I don't think I have said that. Yor are mistaking what I have said with other posters.

[wisdom]

One way of thinking about it may be:

http://www.bloomberg.com/news/articles/2015-09-01/morgan-stanley-central-banks-are-playing-a-game-of-chess-that-results-in-an-endless-cycle-of-easing

 

[rb]

I don't think I have said that. Yor are mistaking what I have said with other posters.

I know you didn't say that. But those numbers are still a fact. So if you need negative inflation for the CPI derivatives to pay out and right now you have positive inflation so you're moving away from the strike how are the contracts supposed to get into the money pretty quickly? You're not talking about a slowdown or a recession you are talking about a crushing economic catastrophe the kind that would push unemployment to 20% or higher. It would be nice if you could explain how we get there from where we are today and what the probability of it happening are.

 

By the way, to address your earlier point about money printing and why it hasn't caused inflation. It is pretty standard economic theory that increasing the monetary base in a deleveraging cycle with zero interest rates doesn't cause a lot of inflation. That's the whole idea behind the concept that you need fiscal stimulus in depressed economies.

[mcliu]

A major conflict or maybe even WW3, will happen well before any of this deflation thing plays out.

 

Then you have the Helicopter Ben theory.

 

Do you guys really think that world powers will let their economies unravel like Japan did for years without doing anything even if it is dangerous and stupid?

 

Cardboard

 

My question is, if monetary policy is so powerful and printing money is so easy, why did Japan have such a hard time getting out of deflation?

 

Japanese M2 is up almost 30% since 2007 and BOJ balance sheet has tripled, but CPI has essentially gone nowhere.

 

Is the BOJ so incompetent that they just can't print enough money to revive inflation? and are the other central banks around the world more competent than the BOJ?

[Guest JoelS]

What would you expect to happen to the price index given the following conditions over a ten year period?..

 

Population increases by 26%

Fuel consumption doubles.

Real value of manufacturing output increases by 2/3rds.

Volume of grains and cotton consumed increases 50%.

Exports of wheat increase 3 fold, corn 4 fold, cotton 60%.

Employment increases at a rate of 3% per year.

 

This was the period 1870-1880 in the USA and the wholesale price index fell by 25%. In the 1880's deflation continued at about half that rate, before flattening out at zero inflation in the 1890's. Note that from 1875-1900, money supply doubled.

 

Companies that were hit hard by the this adjustment were those that had heavy fixed interest and dividend obligations, without a locked in revenue stream (railways, financials..)

 

The lesson for me is - anything can happen & i'm not smart enough to know what will happen. My response is to look for companies that throw off predictable cash-flow with built in price increases.

[rb]

What would you expect to happen to the price index given the following conditions over a ten year period?..

 

Population increases by 26%

Fuel consumption doubles.

Real value of manufacturing output increases by 2/3rds.

Volume of grains and cotton consumed increases 50%.

Exports of wheat increase 3 fold, corn 4 fold, cotton 60%.

Employment increases at a rate of 3% per year.

 

This was the period 1870-1880 in the USA and the wholesale price index fell by 25%. In the 1880's deflation continued at about half that rate, before flattening out at zero inflation in the 1890's. Note that from 1875-1900, money supply doubled.

 

Companies that were hit hard by the this adjustment were those that had heavy fixed interest and dividend obligations, without a locked in revenue stream (railways, financials..)

 

The lesson for me is - anything can happen & i'm not smart enough to know what will happen. My response is to look for companies that throw off predictable cash-flow with built in price increases.

Joel, I don't know if you are just misinformed or disingenuous. The period you mention 1870-1880 is called the long depression. It was called the great depression before the 1930s came around. During that time you have what is still the longest contraction in US history at 65 months (50% longer than the 1930s contraction). In that time you have a catastrophic uncontrolled deleveraging, financial panic, bank runs and outright chaos. There were massive waves bankruptcies including hundreds of banks and 10 states. From the end of the initial recession in 1879 the economy continued to be shaky until the 1900 with the US economy being in recession for 114 out of 253 months. (source: NBER).

 

It sounds like a lovely economic period. Also back then there was no central bank. All of this was caused by a massive monetary tightening in 1873. It has since been referred as the crime of 1873. As congress passed legislation to loosen the money supply deflation eased.

 

It really sound just like the situation we're in today.

[rb]

A major conflict or maybe even WW3, will happen well before any of this deflation thing plays out.

 

Then you have the Helicopter Ben theory.

 

Do you guys really think that world powers will let their economies unravel like Japan did for years without doing anything even if it is dangerous and stupid?

 

Cardboard

 

My question is, if monetary policy is so powerful and printing money is so easy, why did Japan have such a hard time getting out of deflation?

 

Japanese M2 is up almost 30% since 2007 and BOJ balance sheet has tripled, but CPI has essentially gone nowhere.

 

Is the BOJ so incompetent that they just can't print enough money to revive inflation? and are the other central banks around the world more competent than the BOJ?

Well as I said before there are certain fundamental differences between the western economies and Japan. One of them being that the Japanese are prodigious savers and not very consumerist. The Americans are about the opposite of that. This results in chronically weak domestic demand in Japan. If you want to disregards that fact go ahead.

 

There is more to creating inflation than printing money. You need to have people that want to spend it. You have more of those in America than Japan. It's also easier to prevent an economy from going into deflation than to pull it out.

 

On weather the BoJ is incompetent, I don't know about now but it certainly was massively incompetent in the past. It was very shy about QE, failed to supervise its banks, failed to clean them out after the crisis, and it let its economy fall into deflation. And yes, there are certain central banks that are more competent than others. The fed was definitely the most competent in the 08 crisis. The Bank of England was next. ECB and Bank of Canada weren't that good. It seems that the ECB got way better under Draghi but it's hampered by a lot of rules he has to dance around.

[kevin4u2]

I am just saying that I do not have as much confidence in authorities as you guys. I do not mind having insurance in place especially when 7 years of money printing and low rates still have not increased inflation.

 

I am fairly sure if we get a recession or slow down those hedges will be in the money pretty quick. We would not require actual deflation to take place.

 

YOu are saying you are sure we will not have deflation.

 

I am saying I am sure that we will have a dlow down at some point and FFH is likely to do well.

 

Actually only 11% of the notional CPI derivatives require less than 0.5% inflation to pay out. The rest require outright deflation to pay out. So wisdom please make the case of how they get in the money pretty quick. What kind of recession do you need for that to happen? How do we get that kind of a recession given current conditions?

 

Up to now your argument is basically that the deflation hedges will pay out because you say so.

 

The people working at AIG had the same mentality.  They too never thought they would never have payout on the CDS they wrote.  For the most part they were right but unfortunately on a mark to market basis they were bankrupt in the meantime, despite many of the contracts expiring worthless. 

 

So no, you do not need deflation for the hedges to pay out.  It is no different than making money on out of the money stock options or warrants.  The underlying value of the contract has value depending on market perceptions.

 

FFH didn't hold their CDS position to maturity either.  If they had, they majority of them would have expired worthless too.  They sold the majority of their CDS positions during the meltdown, long before maturity and for a huge profit.  The remaining 5.9 billion notional effectively expired worthless.   

 

They do not need to hold the deflation hedges to maturity either.  It wouldn't take much of a recession at this time for deflation expectations to change big time. 

[rb]

So kevin, basically your economic argument and investment thesis is fingers crossed?

[eggbriar]

 

Well as I said before there are certain fundamental differences between the western economies and Japan. One of them being that the Japanese are prodigious savers and not very consumerist. The Americans are about the opposite of that. This results in chronically weak domestic demand in Japan. If you want to disregards that fact go ahead.

 

 

 

not anymore:

 

http://www.nytimes.com/2015/03/20/business/international/japans-recovery-is-complicated-by-a-decline-in-household-savings.html?_r=0

 

"The country’s savings rate, long one of the highest in the world, is now below zero. In short, Japan’s citizens are spending more than they earn. By comparison, the rate in the United States, where consumers have a reputation for living beyond their means, is on the rise, hitting 5.5 percent in January."

 

 

[mcliu]

A major conflict or maybe even WW3, will happen well before any of this deflation thing plays out.

 

Then you have the Helicopter Ben theory.

 

Do you guys really think that world powers will let their economies unravel like Japan did for years without doing anything even if it is dangerous and stupid?

 

Cardboard

 

My question is, if monetary policy is so powerful and printing money is so easy, why did Japan have such a hard time getting out of deflation?

 

Japanese M2 is up almost 30% since 2007 and BOJ balance sheet has tripled, but CPI has essentially gone nowhere.

 

Is the BOJ so incompetent that they just can't print enough money to revive inflation? and are the other central banks around the world more competent than the BOJ?

Well as I said before there are certain fundamental differences between the western economies and Japan. One of them being that the Japanese are prodigious savers and not very consumerist. The Americans are about the opposite of that. This results in chronically weak domestic demand in Japan. If you want to disregards that fact go ahead.

 

There is more to creating inflation than printing money. You need to have people that want to spend it. You have more of those in America than Japan. It's also easier to prevent an economy from going into deflation than to pull it out.

 

 

Is that true though? Velocity of M2 shows a different story.

 

https://research.stlouisfed.org/fred2/series/M2V/

 

I would recommend reading this piece: https://www.stlouisfed.org/On-The-Economy/2014/September/What-Does-Money-Velocity-Tell-Us-about-Low-Inflation-in-the-US

 

So why did the monetary base increase not cause a proportionate increase in either the general price level or GDP? The answer lies in the private sector’s dramatic increase in their willingness to hoard money instead of spend it.

[rb]

 

Well as I said before there are certain fundamental differences between the western economies and Japan. One of them being that the Japanese are prodigious savers and not very consumerist. The Americans are about the opposite of that. This results in chronically weak domestic demand in Japan. If you want to disregards that fact go ahead.

 

 

 

not anymore:

 

http://www.nytimes.com/2015/03/20/business/international/japans-recovery-is-complicated-by-a-decline-in-household-savings.html?_r=0

 

"The country’s savings rate, long one of the highest in the world, is now below zero. In short, Japan’s citizens are spending more than they earn. By comparison, the rate in the United States, where consumers have a reputation for living beyond their means, is on the rise, hitting 5.5 percent in January."

eggbriar, thanks for posting this. I'm not following Japan that closely these days. It is definitely encouraging to see the savings rate in japan go down. Maybe they'll have a resurgence in domestic demand. We'll see. Interesting stuff.

[rb]

A major conflict or maybe even WW3, will happen well before any of this deflation thing plays out.

 

Then you have the Helicopter Ben theory.

 

Do you guys really think that world powers will let their economies unravel like Japan did for years without doing anything even if it is dangerous and stupid?

 

Cardboard

 

My question is, if monetary policy is so powerful and printing money is so easy, why did Japan have such a hard time getting out of deflation?

 

Japanese M2 is up almost 30% since 2007 and BOJ balance sheet has tripled, but CPI has essentially gone nowhere.

 

Is the BOJ so incompetent that they just can't print enough money to revive inflation? and are the other central banks around the world more competent than the BOJ?

Well as I said before there are certain fundamental differences between the western economies and Japan. One of them being that the Japanese are prodigious savers and not very consumerist. The Americans are about the opposite of that. This results in chronically weak domestic demand in Japan. If you want to disregards that fact go ahead.

 

There is more to creating inflation than printing money. You need to have people that want to spend it. You have more of those in America than Japan. It's also easier to prevent an economy from going into deflation than to pull it out.

 

 

Is that true though? Velocity of M2 shows a different story.

 

https://research.stlouisfed.org/fred2/series/M2V/

 

I would recommend reading this piece: https://www.stlouisfed.org/On-The-Economy/2014/September/What-Does-Money-Velocity-Tell-Us-about-Low-Inflation-in-the-US

 

So why did the monetary base increase not cause a proportionate increase in either the general price level or GDP? The answer lies in the private sector’s dramatic increase in their willingness to hoard money instead of spend it.

What are we doing here mcliu? Playing gotcha games with strawmen?

 

You've asked for a comparison of why things in the US would be different than Japan. Japan has a massive savings rate and thus a weak domestic demand BEFORE they even hit any crisis. In the US you had no such thing. The US households decided to start savings not by choice but because they found themselves overlevered. Did the US savings rate increase? Yes. I've pointed out above on this board that the US households went through a significant delevering. Would that fact be reflected in M2 velocity? Of course. Did the US have a deleveraging-deflation spiral? No because the government stepped in to close the demand gap and control that deleveraging.

 

I've also mentioned in my post that there is no immaculate relationship between money printing and inflation at zero lower bound. I see that you have decided to not include that in your quote. That is what you see in the M2 velocity. So what is your point?

 

Yes the US households have been saving, yes they have delevered, yes the M2 velocity has decreased, yes the debt overhang over US households is lower, yet no deflation.

[TwoCitiesCapital]

http://www.reuters.com/article/2015/09/03/us-ecb-policy-idUSKCN0R30O120150903

 

Euro area to cut inflation expectations through 2017. Seems like QE was only good for a few months and the disappointment is already setting in. What's the over-under on ECB doubling down and expanding the current program?

[no_free_lunch]

Despite all the market turmoil Fairfax stock (in CAD) is down just a couple percent over the past month.  I am trying to understand if that is because the deflation hedges are overwhelming losses in the stock portfolio -or- is the market assigning a higher cost to the defensive benefits of fairfax?

[rb]

I think it's more about the equity hedges. They are really a more substantial portion. With markets going down they're gonna recoup some money off of that. For better or for worse it's money in.

[no_free_lunch]

I found this site which lists the CPI index in Japan.  Since fairfax is betting on CPI indices in US & Europe I thought this was relevant.  You will have to tweak the graph to get the long term numbers but except for brief periods there has been no deflation, as measured by the CPI, in Japan except for brief periods.  Certainly the type of decline that would be needed for the FFH CPI bets to pay off hasn't occurred.  So, we would need a deflationary event greater than what has occurred in Japan in order for these things to hit.

 

http://www.tradingeconomics.com/japan/consumer-price-index-cpi

 

[vinod1]

I found this site which lists the CPI index in Japan.  Since fairfax is betting on CPI indices in US & Europe I thought this was relevant.  You will have to tweak the graph to get the long term numbers but except for brief periods there has been no deflation, as measured by the CPI, in Japan except for brief periods.  Certainly the type of decline that would be needed for the FFH CPI bets to pay off hasn't occurred.  So, we would need a deflationary event greater than what has occurred in Japan in order for these things to hit.

 

http://www.tradingeconomics.com/japan/consumer-price-index-cpi

 

I looked at official Japanese data as well and it also does not indicate the amount of deflation that Fairfax was referencing in their AR. Fairfax used World Bank or some other global org data (I cannot recollect) which showed a much higher deflation amount than official Japanese figures. Do not know why.

 

Vinod

[no_free_lunch]

I wasn't aware that they were referencing other numbers, good to know.  I guess the problem then is they are bench-marked to the official CPI numbers where the government is motivated to be cautionary.  Even if the real deflation is -1 or -2%, if the official CPI number is 0 then that is what the hedges work off of.

 

I have been thinking about this deflation debate in general and it seems to me that deflation is what would happen if the government didn't interfere.  In 08/09 it sure looked like deflation was going to happen and when it didn't the deflationists blamed it on government cronyism, can kicking, deficit spending, propping up failed banks, etc.  I think the deflationists were right on the theory but ignored that government wouldn't stand idly by.  That same issue will exist going forward.  It just seems governments have so many tools to fight deflation, they can run deficits, the federal reserve can print money, they can lower taxes, enact stimulus programs, etc.  All of these things are arguably bad in the long-run but I think we have enough evidence now that that is the way it will go.  If the government can just make money appear, is that not all inflationary and shouldn't that at some point push up prices?

 

 

[Guest Dazel]

The most bullish guy on Wall Street since March 2009 has been Jeff Saut of Raymond James his weekly commentary is always very interesting...I strongly recommend reading it. He discusses  hedging even though he has been a long term  bull. His comments are relevant to where we are today...the commentary link is here but interestingly he adds two charts on the Velocity of money and the labour participation rate in the U.S (which he called down right scary!). Hoisington (Fairfax) constantly use these  charts in their thesis on deflation and low bond yields. Fairfax unlike the others he described hedged and likely covered some equity shorts during the commodities rout we have seen. Jeff Saut uses Talib Nassim in his letter to describe why hedge are needed and how random events could change his views...including the "dow theory sell signal" we had on August 24th which had him turn bearish In Oct 1999 and in Nov 2007!!!!!...

 

It is for this reason that I believe the delation contracts market prices will differ from actual cpi numbers. why? Oil was $148 dollars and we had huge inflation in June 2008...only to see massive deflation in 2009!! It is not where we are...it is where we are going...No one's hedges worked even Ray Dalio got smoked in August...Einhorn, Ackman etc...so the interest in another way to hedge is certainly on the table globally.

 

http://www.raymondjames.com/images/inv_strat/150908_1.png

http://www.raymondjames.com/images/inv_strat/150908_2.png

 

http://www.raymondjames.com/inv_strat.htm

[petec]

I wasn't aware that they were referencing other numbers, good to know.  I guess the problem then is they are bench-marked to the official CPI numbers where the government is motivated to be cautionary.  Even if the real deflation is -1 or -2%, if the official CPI number is 0 then that is what the hedges work off of.

 

I have been thinking about this deflation debate in general and it seems to me that deflation is what would happen if the government didn't interfere.  In 08/09 it sure looked like deflation was going to happen and when it didn't the deflationists blamed it on government cronyism, can kicking, deficit spending, propping up failed banks, etc.  I think the deflationists were right on the theory but ignored that government wouldn't stand idly by.  That same issue will exist going forward.  It just seems governments have so many tools to fight deflation, they can run deficits, the federal reserve can print money, they can lower taxes, enact stimulus programs, etc.  All of these things are arguably bad in the long-run but I think we have enough evidence now that that is the way it will go.  If the government can just make money appear, is that not all inflationary and shouldn't that at some point push up prices?

 

The referencing can go both ways: CPI is dramatically understating real inflation at the moment (partly because real rents are outstripping the imputed owner's rent nonsense) and I wonder if FFH have built this into their thesis.  Understating CPI is part of the reason the Fed can get away with being so easy with money.

 

I agree that the government is what's stopping deflation.  For me the risks are:

 

1. What happens if they run out of tools?  They've failed to get the fractional reserve banking system to create money, so they've had to do it themselves.  The channels for that are: buy assets and stick them on the central bank balance sheet, putting cash into the hands of the seller; fund government spending with newly printed money; or throw the stuff out of helicopters.  All three of these almost certainly have political limits.  What happens if those limits are reached?

 

2. To keep inflating you need to keep adding debt.  (Borrowing creates money; paying debt back destroys it.  When there is more money, money is worth less; and when there is less, it is worth more.)  But eventually people want to stop borrowing because their balance sheet looks too uncomfortable.  So what happens when, on aggregate, the world reaches that point?  Emerging markets went on a borrowing spree which stopped the world deflating from 2009-2014.  Who is going to take up the baton and drive debt ever higher?  Because if there isn't anyone, deflation is a serious possibility.

 

I don't predict or expect deflation.  But it's quite possible and I like having the insurance!

 

That said, I am for the first time considering some sort of gold exposure to hedge the other way.

 

[petec]

The US households decided to start savings not by choice but because they found themselves overlevered. Did the US savings rate increase? Yes. I've pointed out above on this board that the US households went through a significant delevering. Would that fact be reflected in M2 velocity? Of course. Did the US have a deleveraging-deflation spiral? No because the government stepped in to close the demand gap and control that deleveraging.

 

 

Absolutely right and I wonder where it ends.  *Overall* US debt:gdp is up significantly, although the rate is lower and the tenor longer because it is government not personal debt, but it ultimately still has to be serviced by the people.  Two possibilities:

 

1. The people delever to the point where they can spend again and gdp grows and suddenly government debt:gdp doesn't look so bad (this happened after WW2); or

 

2. The people don't take up the demand slack, the government has to keep spending, the gdp doesn't grow very fast, and the debt:gdp rises inexorably.

 

For the US I am squarely in camp 1, but I think Japan went to camp 2 and it's not impossible.

[no_free_lunch]

It is for this reason that I believe the delation contracts market prices will differ from actual cpi numbers. why? Oil was $148 dollars and we had huge inflation in June 2008...only to see massive deflation in 2009!! It is not where we are...it is where we are going...No one's hedges worked even Ray Dalio got smoked in August...Einhorn, Ackman etc...so the interest in another way to hedge is certainly on the table globally.

 

We really didn't have massive deflation in 2009.  There was a spike up during 2008 of about 5%, which completely reversed by the end of the year.    2009 saw the CPI end within a fraction of a percent of where it started.

 

Here are the end of year CPI numbers for the US:

 

2007: 210

2008: 210.3

2009: 215.9

2010: 219.1

2011: 225.7

2012: 229.6

2013: 233.0

2014: 234.8

 

I guess I can't say with absolute certainty we won't have deflation but we really didn't have any sustained deflation during the 08/09 crisis and there wasn't any in japan over the past 20 years.  That is all I am saying, we have to really get speculative that this will happen.