This is a reponse to a comment I made in another post. I thought I would make a new post of it since it is lenghty. I noticed that some who have read the "Reggie Middleton's Take on Investing for Inflation, pt. 5" are looking at inflation and deflation as being mutually exclusive. It is not necessarily an academic, zero sum game and we can quite possibly see a combination of both. I made it clear in my 5 part series, and I also currently posit that those who think they know what will happen in the medium term are guessing at best. We are in the midst of a real-time global macro experiment, an unprecedented one at that. No government has ever tried what the Fed has/is doing, at the scale that it is doing it at, as well as other C banks around the world.

Input costs do not have to rise much to cause havoc, and inputs costs can manifest in a variety of ways. For instance, the obvious is commodities, which may have been in a bubble, but still are relatively high in relation to the last couple of years, see Bloomberg today http://www.bloomberg.com/apps/...GzTIvbgLec, input costs are still on the rise. The cost to build is still relatively high, but since we have so much supply, it is a non-issue. The killer caveat is the biggest input cost of all, the cost of capital. This is currently rising, and threatens to rise much faster in the very near future, at the same time that the government is attempting to artificially suppress it to stimulate inflation. This will raise the input costs for consumers, corporate and banks, while at the same time significantly depress productivity, risky and real asset prices. The cost of capital has been too low for too long. Since many indsutrials and manufacturers count commodity prices as a cost of goods sold, it is in essence a cost of productivity capital for them, which has the chance to spike further, and even if it doesn't, I can almost guarantee that the cost of debt and credit will rise, if for nothing but the massive demand from the US government and its cohorts to fight the battle against deflation. Ironically, the cost of battling deflation will cause a spike in rates which is quite likely deflationary. The question is, where will the other input costs end up.

If you look at this as a zero sum game, this may escape you. In the past, stagflation was marked by negative supply side shock, ex. war in a major oil producing country made oil more scarce (just as conflict in Iran might do in the near future), hence driving prices higher. I posit that the cost capital, as a primary input cost, is at extreme risk of a negative supply shock, which will cause its cost to shoot upwards. It doesn't even have to shoot that high for damage to be done due the current situation where the government feels it has to suppress rates (to resuscitate banks and consumers) at the same time it has to access said capital markets for said resuscitation. 100 bp rise in rates will severely crimp already very weak banks, overstretched consumers and over-leveraged consumers, and a still inflated housing market (price-wise) as a glut of inventory is still arriving due to new construction and foreclosures.

As a matter of fact, the housing market is a good example of non-zero sum scenario (which I may have labeled stagflationary as a layman) pressures, where you have high housing prices in relation to income, low yet rising input costs (cost of construction which is actually fairly high in relation to, the cost of capital) and massive supply waiting to be absorbed. Many look at things as high demand (w. low rates) or low supply (w. high rates), ex. demand/supply. Now we have low demand, very low historical rates (that are low due due to govt. interference with the markets but rapidly rising in a quest for equilibrium), high supply (and increasing).

Remember, this is not an economist speaking, just a lowly individual investor, but one who has seen this entire scenario play keenly, well in advance and well ahead of most academics and industry pundits/analysts. The ability to do so was grounded in my looking at the here and now and seeing what was actually going on versus what was told to me or what was academically supposed to be going on.

Facts and tidbits

• In 2009, 'green shoots' of recovery, higher inflation expectations and concerns over fiscal sustainability have burst the bubble in Treasuries. The U.S. government is expected to issue nearly $2 trillion of debt into the $5 trillion Treasury market to finance its rescues of the financial system. Yields have risen and the yield curve has steepened since January, with price losses concentrated in the long end rather than the short end: 10yr and 30yr Treasuries are yielding between 3-5%, 2yr notes yield 1-2%, T-bills remain near zero. The TIPS market is anticipating 2% annual inflation for the next 10 years and 0.05% annual inflation in a year

• In 2008, the Treasury market had its best annual rally in more than 25 years on fears of global credit crisis, recession, deflation. 10yr and 30yr Treasury yields fell to all-time lows and T-bill yields even dipped into negative territory for the first time since the Great Depression. The total return of the 30-year bond was c. 45%, its best year since 1982. Treasuries in general returned 14%, outperforming S&P 500 by 53 percentage points

• Because of the low income on Treasury securities, it would take only a small rise in yields for total returns on Treasuries to turn negative (Merrill)

• Given the level of extension in yields, it would not be difficult to generate losses of say 10% in the 10-year Treasury bond, and as much as 20-25% in the 30-year Treasury bond over a very short period of time (Hussman)

• The last time investors lost money on U.S. government bonds was the year after the 1998 bailout of LTCM and Russia's default sent investors rushing to Treasuries. Yields on 10-year notes rose to 6.44% in 1999 from 4.65%

• The specter of deflation and Japan's experience in the 1990s suggest bond yields could fall significantly further - 10yr JGB yields went on to find a low of 0.45% despite massive fiscal stimulus. Ironically, it was the start of quantitative easing in March 2001 when yields ticked up (JPMorgan)

• If Treasury yields rise, mortgage yields and corporate bond yields can be expected to follow suit. And they are. Yields on 30Y fixed term mortgages have risen by about 65bp, to well above 5.0%. And we are now beginning to see mortgage refinancing activity dwindle again after a promising uptick in recent months (ING)

• It's unlikely the rise in bond yields will derail the tepid recovery we anticipate for 2H09. This should be clear from the decomposition of nominal yields into real yields and inflation discussed above. What matters for the real economy are real interest rates, not nominal rates, and real interest rates have fallen rather than risen. Late last year, when deflation fears were widespread, consumers probably held back spending in the expectation of lower prices. This is less likely to be the case now that inflation expectations have normalized (Morgan Stanley)

• If the dollar holds steady, Treasury bond prices are likely to plunge; if Treasury prices hold steady, the value of the dollar is likely to plunge. Either way, foreign holders of Treasury securities are facing probable losses, and they know it (Hussman)

Bubble Origins

• This bubble was motivated by fear rather than greed. Investors were seeking to protect themselves against deflation and declining stock markets by blindly acquiring "risk-free" government bonds

• Institutional investors also contributed to the bond bubble. Pension funds, insurers and others sold off toxic securitized triple-A rated bonds and replaced them with Treasuries. Government bonds were attractive for diversification purposes since they held up while just about everything else in their investment portfolios collapsed

• The Federal Reserve's decision to buy longer U.S. government maturities added momentum to the epic rally

• Overview: By June 18, the average 30-year rate dropped to 5.38 percent from 5.59 percent a week earlier. Rates are down from 6.46 percent in late October, and up from a record low of 4.78 percent in the first and last weeks of April. From 4.92%, the 15-year rate averaged 4.89 percent for the week ended June 18..

NEGATIVE IMPACTS:

• May 29, Tracy Alloway:With the mortgage market currently in a Treasury-related turmoil, the ability of homeowners to refinance their mortgages at low rates is in danger. The delinquency rate seems to be spreading to safer mortgages, and the the struggle to find refinancing in the current market (everyone is after it, banks are overloaded with requests, etc.) means many people have yet to take advantage of the low interest rate environment

• May 29, WSJ: "Higher rates: makes it less likely for homeowners to be able to lower their monthly payments by refinancing, which can put a crimp on consumer spending. Also means lower earnings for banks, which have profited from increased refinancing. In addition, higher rates are likely to put more downward pressure on home prices and sales. In terms of the burden on home buyers, Credit Suisse estimates that each rise of 0.10 percentage point in mortgage rates is equivalent to a 1% rise in home prices."

INTERESTING FACTS:

• The yield curve (measures the risk associated with longer dated maturities) is at record levels, 2.75 percentage points."several analysts suggest the current ten year sell-off is due to concerns about increased Treasury issuance to finance the deficit."

• May 28, Bloomberg: Delinquency rates. In Q1 2009 the U.S. delinquency rate jumped to a seasonally adjusted 9.12% from 7.88%. One in every eight Americans is now late on a payment or already in foreclosure and the number of borrowers at least two months behind on their mortgage is hitting 5.22%