As recently as a year ago, it was hard to find anyone besides Bob Prechter who would even talk about
deflation, never mind actively warn that deflation was on the way for the U.S. economy. Nowadays, it's almost commonplace for people to talk about deflationary prices and for economists to worry out loud about the
effects of deflation. "If inflation is falling by 2% a year, people won't buy a car or TV, because they know anything they'll consider buying will be cheaper next year," said UC Berkeley economics professor Barry Eichengreen to a Marketwatch reporter. "If no one's buying, no one's producing and no one's hiring – that's the problem we are trying anxiously to avoid."
As housing prices continue to decline – at a rate of 12% in the fourth quarter of 2008, according to the National Association of Realtors – the price of gasoline for the Kia and milk for the kids keeps cascading down, too. So, the question becomes, as deflation progresses, what will happen to bonds and the dollar? Bob Prechter has the answers in this Q&A taken from the book, Prechter's Perspective. Remember, he was ahead of the times, as this Q&A took place in the early 2000s.
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Q: In the 1970s, when the economy and the stock market sputtered, real estate did reasonably well.
Bob Prechter: As big as the disaster in stocks is likely to be over the next five to 10 years, it will almost certainly be matched by the upcoming disaster in real estate–related investments. The 1970s were inflationary: the next period of difficulty should be deflationary.
Q: Are there manifestations of euphoria in real estate?
Bob Prechter: In the past five years, people have been erecting "McMansions" all over the place – million dollar homes crowded in like condos. It's all financed with credit, and that game is ending. The trap is set.
Q: Credit will contract?
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Bob Prechter: Yes, from long-term bonds all the way down to the broader measures of the money supply.
Q: The credit implosion you see leads you to contradict the most deeply held convictions on Wall Street, like the conventional belief that bonds rise when the economy slows. You see most of them falling in a weak economy.
Bob Prechter: It's plainly not good for bond values if the issuers of bonds, i.e., the borrowers, suffer financially to the point of not being able to pay interest or principal, is it? In fact, billions of dollars' worth of bond defaults in recent years clearly reveal the problem. What economists should say is that (1) in an environment of general growth and inflation, (2) when only a recession occurs, and (3) when the recession brings a reduction in inflation, then bonds typically rise in price as interest rates fall. Unfortunately, to most economists, the post-World War II period is the only relevant history, so bond investors don't place their view in the larger context of economic possibilities.
Q: At what point might the economy deteriorate so substantially that its condition and trend are no longer bullish for bonds, but bearish?
Bob Prechter: When it reaches depression, and a depression is exactly what is on the agenda if the stock market fails to the extent that the
Wave Principle suggests. The only way for a bond investor to survive a depression is to hold bonds issued by a strong borrower. Weak borrowers, such as most corporations and municipalities, will default. As investors come to the realization that default is a risk, rates on weak debt will rise as its prices fall.
Q: What happens to the dollar?
Bob Prechter: During the deflation, the dollar's domestic purchasing value should rise, as debt instruments denominated in dollars are defaulted upon. As dollars disappear, the value of the remaining dollars will rise. The same thing has been going on with the Japanese yen in terms of how much you can buy for it in Japan. But how the yen or dollar will perform against other currencies, I couldn't say. We'll have to follow the wave counts.
Q: After the initial deflationary hit, what will turn currency values back down?
Bob Prechter: It will be the pressure on national governments to create paper money to pay off their debts. Which ones will be destroyed depends upon what course each government chooses when faced with bankruptcy. I am not optimistic that most will take the honest course. Whether or not all paper currencies eventually go to zero, it will be wise to own gold after the deflation.
Out of the Frying Pan, Into the Munis? Sound like a good way to re-direct your investments? It might be better to read the special section of the just-released February issue of The Elliott Wave Financial Forecast to get some useful information. Not only about municipal bonds, but also about the equity markets, bond markets, gold and silver. Learn how to subscribe
here.