The Market's Biggest Fear for 2009

For years, you've had nightmares about it. Last year, grocery stores and gas stations fed your fears. As you struggled just to keep bringing home a paycheck, let alone trying to get a raise, you knew you were falling behind as you saw its impact again and again.

It's inflation, and until this year, no other danger created more fear in investors' minds. Now, though, bond market traders are convinced that an even larger threat has taken inflation's place -- and they're putting their money behind their convictions. Who's right?

TIPS and you
The best view people get of what pros expect about inflation comes from the Treasury market. Although most investors are most familiar with conventional Treasuries, you can also find special Treasury securities that adjust upward and downward for inflation and deflation. These bonds, known as TIPS, give you added insight into what bond traders expect.

There are two interesting things the Treasury markets are showing us:

  • Yields on TIPS are virtually the same as those on conventional Treasuries. That suggests that investors expect very low inflation rates over the next 10-20 years.
  • Comparing TIPS of slightly different maturities, pricing disparities show an inordinate amount of fear of deflation.

It's that second point that's most interesting. TIPS come with a special protection provision whereby no matter how much deflation there is, each bond will fetch at least its original $1,000 face value. For newly issued TIPS, that means that even if deflation strikes hard, you'll still get your investment back.

For older TIPS, however, it's more complicated. Over the years, their inflation-adjusted values have increased to as much as $1,350. Although the inflation adjustments have added to their value over time, it now leaves them more vulnerable to deflation, as they have a long way to fall before reaching that $1,000 minimum.

You see the oddest behavior in TIPS when you compare new bonds and old bonds with similar maturities. One newer bond due in April 2013 yields less than 2%, while an older one slated to mature in July 2013 pays almost 4%. The only difference is that the July bond could lose as much as 16% of its value in a prolonged deflation.

The danger of deflation
From an individual standpoint, the biggest impact of deflation that we've seen so far has been in the housing and consumer credit area. For housing, falling home prices have killed demand in formerly hot housing markets, creating oversupply and thereby decimating profits for new-construction homebuilders like Toll Brothers (NYSE: TOL  ) and Pulte Homes (NYSE: PHM  ) .

Meanwhile, in the credit arena, falling asset prices have combined with tightening credit standards to restrict consumer lending. Although mortgage rates have fallen for those who can qualify for loans, many other sources of borrowing, such as credit card financing, are drying up quickly as banks like Citigroup (NYSE: C  ) and JPMorgan Chase (NYSE: JPM  ) rein in their leverage levels.

Obviously, that's bad news for companies that depend on high credit card volume, including card processors Visa (NYSE: V  ) and MasterCard (NYSE: MA  ) . But it's also just the first step of a potentially ever-worsening cycle that will ripple beyond the financial sector. As those with less access to credit reduce spending and investment, the resulting slowdown will potentially cripple other areas throughout the economy -- as we've already started to see in capital-intensive businesses, including the automakers and big energy stocks like Chesapeake Energy (NYSE: CHK  ) .

What we're trying to avoid
That vicious cycle is exactly what government officials like Fed chief Ben Bernanke are trying to avoid right now. By creating massive programs like the $700 billion bailout and trillion-dollar backstops of the commercial paper and money market mutual fund markets, the U.S. is pulling out all the stops in an attempt to avoid the deflationary spiral that many blame for the severity of the Great Depression in the 1930s.

Whether all those efforts will work remains to be seen. At least for the moment, though, Treasury yields show that bond traders still believe deflation has the upper hand.

Given the huge amount of government-provided liquidity being thrown into the financial system throughout the world, however, anything short of a multi-year economic full-stop could quash the deflation scare. Then we could quickly whipsaw back toward being frightened of high inflation -- with big profits for those who defied the traders and bought TIPS now.

For more facing up to the market's fears, read about:

When it comes to earning income, the team at Motley Fool Income Investor doesn't just stop at bonds. We look for stocks that combine steady income with the prospects for growth down the road. Curious about what we're recommending now? Take a look with a free 30-day trial.

Fool contributor Dan Caplinger has been buying TIPS fairly steadily over the past few months. He owns shares of Chesapeake Energy. JPMorgan Chase is a Motley Fool Income Investor recommendation. Chesapeake Energy is a Motley Fool Inside Value selection. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy gives you nothing to fear.


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