A hedge against deflation

Deflation has broken out in Europe and Asia. This phenomenon, in which prices tomorrow may be lower than those today, is bad for every business that counts on inflation to drive up sales and resulting earnings. But deflation is good for one particular asset class: government bonds.

That’s because if deflation spreads, deepens and spurs fears of broad consumer price index (CPI) declines in North America, Canadian federal bonds and U.S. treasuries would soar in value because their guarantees of payment – by the printing press, if need be – trump all other debt.

In the event of serious deflation, which would be more than the fraction of 1% that is happening in peripheral European and Asian economies, credit ratings of corporations that have to maintain strong balance sheets would be in a difficult position. Falling sales numbers would crimp cash flow and cut coverage for bonds.

For now, investors appear willing to accept returns on G7 government debt at, or even below, inflation rates. Germany’s 10-year bunds recently have paid 0.5% to maturity, which is close to the 0.6% rise in the country’s annualized CPI in December. At home, Government of Canada bellwether 10-year bonds offered 1.74% in November compared with the 2% annualized CPI growth that same month.

In the event of deflation, these low single-digit returns could rise to double digits as investors reach for government bonds as the safest securities in capital markets.

American economist Irving Fisher watched deflation at work in the Great Depression. His debt-deflation model explains what happens when the CPI trend numbers for a country begin to decline:

If businesses see prices falling and anticipate more of the same, they’ll cut prices today lest they have to sell their products for even less tomorrow. Competitors see the cuts, then rush to cut their products even further. Top-line sales fall, then fall further. Money then dries up and the companies have trouble paying their dividends and bond interest.

Deflation has broken out already in Greece, Italy, Poland, Slovakia, Slovenia, Spain, Sweden and Israel. Zero core inflation is predicted for Portugal and Cyprus. And low inflation of 1% or less is expected for Belgium, the Netherlands, Luxembourg, Estonia, France, Ireland, Germany and Malta, according to Bloomberg LP. As a response, European Central Bank (ECB) president Mario Draghi said in a speech in Frankfurt on Nov. 21, 2014: “It’s essential to bring back inflation – and without delay.”

It’s not just Europe that has a festering deflation problem. Singapore, the Philippines and Taiwan have declining rates of inflation, with average price increases of 1.5% in 2014. For China, CPI growth was just 1.4% at annualized rates in December. And lower commodities prices in energy threaten to take about 0.4% off global inflation in the next quarter, according to an October study by J.P. Morgan Chase & Co.

The implied U.S. inflation rate for the next decade is 1.88%; that’s the difference between the conventional U.S. 10-year treasury bond and the inflation-linked treasury inflation-protected securities (TIPS), the latter of which increase their payouts as inflation rises. So, if inflation is less than 1.88%, then the conventional T-bond wins. If inflation is more than 1.88%, the TIPS win.

But rather than bet on the influence of food and energy prices on top of core inflation, you can just ride the conventional bond, advises Edward Jong, vice president and head of fixed-income with TriDelta Investment Counsel Inc. in Toronto: “With mild inflation, that’s the way to go.” And paying for inflation protection when there is almost no inflation is a waste of money, he adds.

Underlying the role of bonds as hedges against deflation is the effect of inflation on asset prices. Rising sales nudge up asset prices, and lack of inflation implies flat to falling stock prices. After all, why invest in new plant and equipment if what you have already makes enough of what customers are willing to buy?

That’s the heart of the problem, says Chris Kresic, head of fixed-income and senior partner with Jarislowsky Fraser Ltd. in Toronto. Worse, decades of expansive monetary policy, which have suppressed interest rates, have put a mask over the real problem. That’s the excess capacity left by central banks’ market interventions, which keep moribund and even bankrupt companies alive.

“The problem is excess capacity in the economy,” Kresic says. “With interest rates approaching zero and quantitative easing not working in Europe, central banks have run out of tools. Big increases in government spending or job-creation programs would help to boost aggregate demand, but politics forestalls that in affected countries.”

Moreover, governments have to borrow to spend in the worst hit countries in Europe. But those governments and their central banks are caught in a low-yield trap. If inflation generates a rise in interest rates on government bonds, that would push up corporate-bond yields, reducing companies’ zeal to borrow – precisely the opposite of what is desirable.

Central bankers know the drill and have rushed to encourage business investment with nominal short rates close to zero in Canada and below zero in Europe. Banks have happily borrowed government money at rates as low as the 0.05% now being used by the ECB, then bought longer government bonds that pay more. This is almost riskless profit. The only risk is that long bond yields will suddenly rocket upward – although no one puts much stock in that possibility.

Inflation drivers, such as energy prices, are weak around the world. In this economic environment, the low returns on senior government bonds can be seen as the opportunity cost of buying deflation insurance. And if deflation worsens, government bonds’ miserly returns would soar.