Big Question #2: Fed Rates

In my previous post "Big Question #1: Deflation or Hyperinflation", I settled on deflation as the more likely scenario.

The next question, of course, is the Fed rate. If we expect deflation, then we might want to short the stock market. However, what do we use for sweep? Short term government debt, or long term government debt?

Short term is "safer" in that it's less speculative. During the Great Depression the Fed jacked its rate up to 15% -- the reason is that even though we experienced deflation, the dollar fell in value relative to other currencies, so the Fed was obligated to "prop up" its value by increasing the interest rate. Because of this, those that held long-term government debt gained less during deflation than those that owned short-term government debt -- the short term owners renewed at the higher interest rate. Of course, both gained overall from the deflation.

However, there are other deflationary crashes where the short term government debt pays a 0% interest rate, such as Japan's recent deflationary crash. In this case, owning long term government debt can cause a huge gain (Jim Shepherd estimates a 200% increase in the long term bond's value in this case).

So: will the U.S. have a 0% rate (in which case you want to own long term bonds) or a high rate (in which case you want to own short term debt)?

The prudent bear fund is betting on long term bonds, which I agree with. I think that the funds rate is related to the amount of deflation that occurs. The Great Depression was deflationary, but the deflation experienced was comparatively mild to what we're about to go through next. As the previous post explained, a 50:1 ratio of debt to debt-money could easily initiate a historic deflation, much larger than Japan's deflation. Therefore, I'm placing my bets on long term debt rather than short term.

However, unlike the other posts, I need to warn you that I'm less of an expert on this topic. Therefore, you may consider a 50/50 combination of long term and short term debt. Also, do some research and leave me a good comment with a link :)

Either way you go, you'll gain from the deflation. In fact, shorting the market coupled with deflation can produced exponential gains. And if you're right about the long term / short term question, then you may experience additional multiplication of your gains.