Hyperinflation: What It Is, How It Can Happen, And How To Trade It

Recently there has been an increase in expectations of hyperinflation in the US in some schools of economic thought, as the notion that the ongoing stimulus packages, coupled with the declining tax base, could lead to a loss of confidence in the US dollar. In this post I’ll attempt to provide a quick breakdown of hyperinflation - what it is, how it can happen, and how to trade it.

What is hyperinflation?

Hyperinflation is when the rate of inflation is 40%+ per year. One of its most important characteristics is a breakdown in commerce; i.e. a return to barter, and a reluctance to take on financial assets.

What causes hyperinflation?

Hyperinflation is an economic AND political phenomenon. It is also characterized by both expansion of the money supply as well as a collapse in demand.

If it does happen, when will it occur?

Herein lies the key question, and one that is not easily answered, as psychology plays a critical factor. Amongst those who consider it likely, expectations range from 2010 to over a decade away.

What to Watch For Over the Long-Term

Recall our previous post on the five indicators of US dollar stability; they are still worth watching. Here is an update on some things to watch for in our current environment:

1. Credit Default Swaps.

This can be thought of as an insurance policy on an underlying asset. If credit default swaps for the US
sovereign debt is rising in price, it suggests concern about US Treasuries - and if demand for Treasuries falls, the ability of the US government to finance itself without devaluing the dollar comes into jeopardy. And thecost of insuring Treasuries via credit default swaps is rising; See this article from Marketwatch.

2. Fed Funds Rate.

Bernanke and company still have rates essentially at zero. This in and of itself will have little if any inflationary impact in our current environment, though it does reveal that the Fed wishes to create inflation. The psychology of the Fed is extremely important.

3. Public debt/GDP ratio.

The bailout/stimulus frenzy has resulted in an increase in public debt. At the same time, the contraction in the economy is reducing the tax base. If this continues, it leads to greater and greater amounts of debt monetization - i.e. printing money - as well as increasing the likelihood that debt holders will run from the debt and sell their holdings, thus leading to a run on the dollar. Currently, the US debt/GDP ratio is over 180%. The median public debt-GDP ratio among countries that defaulted on their public debt during the last 30 years is about 50 percent.

4. Gold/Treasuries trade.

Long gold/short 20+ Treasury bonds is the trade for those who expect inflation in the long-term. If this trade continues to do well, it will be a signal of inflation expectations in the market’s psyche. Long silver/short 20+ year Treasuries has done even better, and is also worth watching.

5. China.

China is a massive buyer of US Treasury bonds, and has recently been griping publicly about concerns that the stimulus packages will result in dollar devaluation, thus weakening the value of their US Treasury bonds.

China’s PM Wen nervous over holding U.S. Treasury bonds - UPI.com
China frets over the safety of its trillion-dollar investment in U.S. Treasury bonds. - By Ben Whitford -
Slate Magazine

6. Failed Treasury auctions.

The US is still addicted to debt and needs to raise more debt on a monthly basis. Should a Treasury auction fail, it would lead to monetization to make up the difference. More crucially, it could be the “black swan event” that creates a panic out of Treasuries.

Trading Hyperinflation

As hyperinflation is extremely detrimental to an economy, it will create a few issues for traders, should it arise. Such as:

1. Trading may not be possible.

Hyperinflation is associated with a breakdown of trading financial assets. The US stock markets, derivatives markets (including futures and options), and bond markets remain the most vulnerable.

2. Watch for government response.

As we discussed in our series on trading in a centrally planned economy, playing defense against government policy is extremely important in hyperinflation. Thus far in the crisis, the Federal Reserve has taken the approach of addressing the symptom (breakdown of credit markets) rather than the cause (fiat, debt-based monetary system with unsound banking legislation that resulted in a credit bubble and a depletion of savings). If this continues, we can expect greater regulation of markets, as well as price controls (the symptom of hyperinflation). This will result in shortages of critical assets, and will result in the creation of black markets as well.

3. Decoupling is not dead.

The more one expects hyperinflation, the more one is expecting decoupling - the notion that the foreign countries will discontinue financing the US economy through the purchase of Treasury bonds.

4. Precious metals, foreign currencies commodities.

They are the safe havens, and perhaps some in physical form as well, if you are particularly concerned.

5. Tradeable commodities.

Hyperinflation is a currency crisis, and requires other commodities to barter with. Precious metals are the time-tested choice, though they are likely not to be as readily tradeable as other currencies. For this reason, having some non-US dollar currencies in physical possession - i.e. euros, yen, Australian dollar, etc. - may be worthwhile. Decoupling enthusiasts will prefer Eastern currencies, namely the renminbi, yen, Australian dollar, and New Zealand dollar. In terms of historical precedents, the currency crisis in Russia saw bottles of vodka become currency.

The Psychology of Hyperinflation

One of the most challenging aspects of hyperinflation, and perhaps a reason why many do not discuss the likelihood of it, is because it is psychologically uncomfortable to do so. Those who seek psychological comfort should avoid financial markets, as the entire thing is a psychological game, from my perspective.  With that said, the importance of maintaining a sound psyche - not succumbing to fear, greed, or rage that
will distort one’s thinking - is extremely important to preserving one’s wealth. With that in mind, I  recommend the following to preserve psychological health:

1. Ignorance is NOT bliss.

One would think that those who ignored the warnings of the collapse of 2008 would have learned their lesson that ignorance is not bliss, but for many, this does not appear to be the case. In any event, honest pursuit of the truth is essential to maintaining psychological health, and thus one’s wealth, in all times - but
especially during hyperinflation.

2. Seek psychological security.

Those who are interested in the psychology of trading often note the importance of overcoming fear and greed. Indeed, I could not agree more with this timeless advice. In addition, though, I personally recommend finding that which provides psychological security - and making sure you have that firmly secured. Perhaps this is spending time with your friends and family. Perhaps it is making sure have you the time and place to  meditate or engage in art therapy. Whatever it is that provides psychological security will become more important in the face of hyperinflation - not only in terms of preserving your happiness, but also in terms of preserving your ability to rationally analyze opportunities in managing and growing your wealth.

Leading Voices on Hyperinflation

To learn more about this topic, I recommend the following economists:

John Williams
Jim Sinclair
Eric Janszen (particularly the hyperinflation commentary for subscribers)

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Comment by mjB

2009-03-21 17:43:00

The nightmare of Weimar 2 is coming, probably faster than we can imagine. G20 meeting will be a determining factor…

http://tinyurl.com/clck4y

mB

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