Interest Rates - Inflation or Deflation?

I keep returning to interest rates every time I read a persuasive inflation article. I think the inflation-deflation debate is critical when looking at asset class allocation. And I am more interested in price action than high level academic discussion regarding what is deflation and what is inflation.

I am more interested in the symptoms of inflation and deflation as an investor. In other words, I am interested in predicting stock, commodity, and corporate bond prices and the value of holding cash rather than winning a theoretical academic discussion about what inflation actually is. A valid argument can be made that neither heavy inflation nor heavy deflation are healthy for stock market prices. In heavy deflation, stock and corporate bond prices get hurt in both nominal and "real" (i.e. inflation-adjusted) terms (i.e. the 1930s). In heavy inflation, stock prices may hold up relatively well in nominal terms but suffer in "real" terms (i.e. the 1970s).

Commodities are a disaster during deflation and do well during heavy inflation. Cash is a disaster during heavy inflation and a good investment during deflation. Gold is a hedge, as it is a form of cash and holds its value well during deflation but often tracks commodities during heavy inflation. I don't see a "muddle through" middle ground as a reasonable option at this point in time and all of these statements about these asset classes are obviously generalizations.

Anyway, I think the key to this debate lies with interest rates. The chart below in my mind gives a big picture overview that screams "deflation" rather than "inflation." It is a long-term monthly chart of 90 day U.S. Treasury Bill rates from 1915 thru July of this year, stolen from thechartstore.com:



I have shown this chart before, but want to stress its importance. In aggregate, the bond market is a huge and relatively sophisticated market. Why is this market not predicting inflation? All markets can be manipulated in the very short-term and can be distorted by governments, but what is the explanation for the long-term trend, which remains down for interest rates? If we are about to go thru the 1970s on steroids, why aren't interest rates rising?

I think we have entered a Kondratieff Winter and interest rates will follow the path of the 1930s. I think anyone who can manage to hold onto their money somehow will be able to buy stocks, corporate bonds, commodities and real estate at pennies on the dollar. I think peak oil and the secular oil bull market is over. I think general stock market indices in almost every country in the world are headed for new lower lows and I think the prices of real estate are going to fall much further (so far that it will shock the permabulls who are constantly looking for a bottom even though they never even saw the top coming).

Gold is my cash. I prefer Gold to U.S. Dollars because I worry about geopolitics and I also worry that politicians will find a way to devalue our currency against something (perhaps a new international trading dollar?). The Dollar may do fine and my fears may remain unfounded, but holding Gold is a risk I'm willing to take. And remember that even a one-time currency devaluation is not going to cure deflation (just like it didn't in 1934) - debt must be purged from the system before a new inflationary cycle can begin. America is drowning in debt and has reached the saturation point in aggregate.

The credit/debt markets cannot be ignored when examining inflationary factors in our "modern" fiat system and debt markets are collapsing in the private sector. Since the government does not create the primary trend, they are largely irrelevant. Gold, of course, hedges against government instability and bank holidays anyway so it offers insurance against a scenario in which the government overwhelms the private system through brute force and incompetence (not impossible...). The unconstitutional, non-federal, for-profit federal reserve bank corporation will look out for its own interests and protect its lucrative franchise - for a bank, this does not mean making reckless loans to the private sector when you know you won't get paid back.

Even if Gold declines slightly in nominal price, it will continue to rise relative to all other major asset classes and thus will increase the wealth of those who hold it. It is a better play than stocks, commodities, corporate bonds, municipal bonds and real estate in deflation. I am not saying that people should put all their money in physical Gold, but they ought to hold a little in this environment. Unfortunately, most won't acknowledge or realize this until the stock markets have made their next major lows, which will be lower than the March, 2009 lows.