Deflation or Reflation

If you follow FinTwit (financial twitter for my readers who are less hip or who have other things to do with their lives than follow economic tweets on Twitter. Hi Mom!), you know that the main theme right now is Reflation. The common hypothesis goes that now that we have a vaccine, as soon as we reach some unknown but foreseeable level of protection, the economy will bounce back, people will start going to restaurants again, and everything will be fine. In theory, all this will result in inflation that shows up in a variety of places like stocks and gold and Bitcoin. Reflation is the predominant meme. It’s an attractive one especially if you have a kind of short term, first order view of the world.

However, there is a much less dominant theory but one that I think has more merit. Steven Van Metre and Travis Kimmel talked about it in depth over at Real Vision this week and that theory is that we are still due for a deflationary period in the short term (12-24 months) where many of the effects of COVID on the economy that have been kicked down the road through forbearance and other can kicking activities start to show up.

When COVID first hit, we had a massive dislocation in the market. The world economic function sort of just rolled over and died briefly. Stocks plunged, bonds exploded upwards and the Fed largely struggled to get control of the situation at that moment. Since that time, there’s been a Presidential election (in case you live under a rock), a great deal of can kicking and a general run up in stocks and a very specific run up in Bitcoin. Yields are starting to climb again in bonds (the 30 year treasury is approaching 2%) and it really does look like inflation is on the rise.

However, we still have millions of people on unemployment. Unemployment rate in the US is currently 6.7% which granted is a massive improvement over the April 2020 numbers of around 15% but is still exceptionally high for the last 20 years. The improvement seems to be stalling in recent months as well. On top of of that, 2.7 million people are still in some sort of forbearance program with their mortgage. At some point, the music has to stop and people are going to have to start paying again. And eventually the extended COVID relief will stop.

All this leads me to think that we are likely a few years from a real inflationary period. Some of the forbearance programs are payment plans but others may be a lump sum required upon expiration of the program. People aren’t going to suddenly have that kind of cash laying around and they are going to get foreclosed on. The service sector has obviously been obliterated and new restaurants aren’t exactly easy to start up and be profitable. In general, it seems like there are some less flash and crash events but more “slowly grinding lower” type events on the horizon.

As the government programs begin to expire, all the past will come due in some way. Best case, terms of loans get extended into the future. However, in a capitalist society, I wouldn’t count on servicers operating in the best interest of their clients. More likely to me is that based on some house price data, they think they can just foreclose and then sell the property to someone else. This is fine if it’s gradual and spread out. It’s not fine if it happens suddenly in a contagion.

One way out of the deflationary winds would be if the government came up with some plan to make good on the debts that will come due. However, this would be politically difficult in my mind. If it did happen, it would likely be truly inflationary though there still exists the very real problem of people not having jobs. You hear people refer to the money that’s come from the government as “stimulus” but there is nothing stimulating about $600 a person. That’s just aid, aid that is brief, small and unlikely to cause a real inflationary event. There are a great number of people still suffering and that’s just a drop in the bucket compared to a 12 month lump sum mortgage payment coming due or an end to unemployment benefits.

What do I think that means for investing? Not entirely sure as I’m just barely knowledgeable on the subject. However I do think that bonds still have room to run for 24 months even though they have shown some weakness in recent months. Granted, bonds look just as bubbly as stocks in some ways but if it turns out that we really do have to pay for all this can kicking, bonds will go up as the Fed turns the spigot back on for QE 85 or whatever. The next 6-12 months will be key and it will largely be dependent on how the government programs wind down.