The past couple of months have been a hoot to watch. Yellen’s premature tightening has set in motion a self reinforcing deflationary feedback loop that has made many investors puke out their inflationary themed trades. To be fair most of these trades had been going down for quite some time, but the selling reached a crescendo last week when crude oil once again flirted with new lows.
For the past few weeks we have been inundated with all sorts of “Central Banks are pushing on a string” and “secular trends will mean low inflation and even lower growth for decades to come” talk. Reflecting this deep routed pessimism, the cover of this weekend’s Economist sums up the mood perfectly:
Although I understand why the market is freaking out about deflation, the worries are misplaced. This entire episode was self inflicted. Given the massive Central Bank easing by the likes of the BoJ and ECB (and maybe even the PBoC), all it would take to stop this negative feedback loop would be for Yellen to ease off the hawkish rhetoric.
In fact, it might be already happening. Over the past week there has been increasing dovish coos coming the Federal Reserve Open Market Committee members. Notable hawk James Bullard exemplifies the change in tone (from Reuters):
It would be “unwise” for the U.S. Federal Reserve to continue hiking interest rates given declining inflation expectations and recent equity market volatility, St. Louis Fed President James Bullard said on Wednesday in comments that mark a stark change of direction for one of the Fed’s more hawkish inflation foes.
Bullard for much of last year argued for an earlier rate hike, but said he now feels key assumptions supporting higher rates have been undermined.
Inflation expectations have fallen “too far for comfort,” making it more probable inflation itself will fall and continue to miss the Fed’s 2 percent target, Bullard said in remarks prepared for delivery to a gathering of financial analysts.
“I regard it as unwise to continue a normalization strategy in an environment of declining market-based inflation expectations,” Bullard said. In addition, declining equity prices and other tightened financial conditions have made dangerous asset bubbles “less of a concern over the medium term.”
Taken together, Bullard said he sees them likely giving the policy-setting Federal Open Market Committee “more leeway in its normalization program.”
Recent comments by Fed officials already made it seem unlikely the U.S. central bank would raise rates when it next meets in March, but Bullard’s comments indicate broad concern over the conditions facing the Fed. Bullard, who votes on the rate-setting committee this year, has been among the stronger advocates of higher rates, but feels the case has grown weaker since the Fed’s “liftoff” rate hike in December.
“Two important pillars of the 2015 case for U.S. monetary policy normalization have changed,” Bullard said.
The market is already showing signs of the deflation trade being “fully baked in.” While investors were busy proclaiming the end of all growth and inflation, look at what gold, iron ore and the CRB industrials have done recently:
Although you might argue gold is rising due to uncertainty, no such argument can be made for the price of Chinese Iron Ore or the CRB Raw Industrials Index. Even though growth is supposedly such a problem, these assets have been rising for the past couple of weeks.
Name me a currency that has collapsed due to deflation…
I have always been confused by the argument Central Banks are powerless to create inflation. If you were to say they are powerless to create real growth, then I am all aboard. But powerless to create inflation? Seriously?
Ask yourself, throughout history, how many currencies have collapsed because of deflation? And now ask how many have disappeared because of hyper inflation. I don’t know a single currency that has succumbed to the overwhelming effects of deflation, but there are literally hundreds of currencies that have been inflated away to nothing.
Although I understand the current deflationary forces, given a desperate enough situation, Central Banks can (and will) create inflation. The only question is timing.
China steps on the accelerator, just when the Fed eases off the brake
Given the terrible economic performance in China, it was only a matter of time before the Chinese government officials propped up their economy. Many smart guys like Kyle Bass predicated the stimulus would come in the form of a currency devaluation. And it still might, but in the mean time, in an attempt to save face, instead the Chinese have pumped credit into the system.
In January, Chinese credit expanded more than any other period:
It’s no wonder stuff like the iron ore and the industrial commodities are running. The Chinese are back to their old tricks.
Now you might argue this will not produce sustainable real growth. And you would probably be correct. But who cares? We aren’t trying to decide if we will get real growth, but instead discussing the likelihood of deflation overwhelming the global economy.
It will be difficult to get deflation when China is pushing hard on the accelerator, just as the Fed eases off the brake.
Market expectations for inflation are low, but that’s good for us
The market has priced in the lowest amount of forecasted inflation in quite some time. It isn’t as bad as 2008, but we are still probing new lows for this move:
What exactly is a “breakeven rate” anyway?
The break even rate is calculated by taking the 30 year Treasury Inflation Protected yield and comparing it to the nominal yield on the regular 30 year Treasury bond. The difference is amount of inflation the market is predicting for the period of the bond. It is not quite so clean because the TIPs cannot have “negative” appreciation due to deflation, but it gives a basic estimate.
As investors predict less inflation, their demand for TIPs decreases, and the price relative to regular Treasuries declines. The “break even” rate then declines.
Time to backup the truck?
Right now the market is assuming an inflation rate of 1.55% over the course of the next 30 years. Given the recent CPI release was 1.4%, this doesn’t seem that out of line.
But wait. Isn’t crude oil and all the other commodities down 25% to 50% during the last year? Shouldn’t we be experiencing deflation?
If we are currently getting 1.4% year over year CPI readings, what is going to happen in the coming months when the comparisons don’t include commodities that have been halved?
And what if during this period China is also aggressively expanding their credit to stimulate their economy?
Wouldn’t it be ironic if inflation showed up at the very moment it was least expected…
The chances of increased inflation in the coming quarters seem much higher than the market is expecting. I am backing up the truck and betting on increased break even levels.
At 155 basis points for 30 years, these TIPs are dirt cheap. Have a look at the CPI index over the past 100 years:
How many times did inflation not average 1.55%? Apart from the 1920s, every other dip was temporary in nature.
For the trade not to work, it will have to mean the Federal Reserve fails to achieve their inflation target of 2%. Although I understand the possibilities of short term constraints causing this to happen, over the long run I am extremely confident of all Central Banks’ ability to screw it up with too much inflation, not the other way round.
I wish I had found this…
On Friday, after the release of the red hot inflation CPI number, I was discussing the trade with one of my trading buddies. I told him that since I am an odd lotter with no ISDA and massive credit prime broker credit lines, it was difficult to execute this trade with any leverage. Sure I could simply buy TIPS, but when compared to all my other reckless ill conceived speculations, I was sure to bore of it quickly. But then my pal emailed me back with a symbol - RINF. The answer to my prayers had been already created!
The RINF is the ProShares 30 year TIPS/Treasury spread ETF. It tracks the Dow Jones Credit Suisse 30 year Inflation Breakeven Index. Brilliant! Exactly what I was looking for. With this product you can trade the breakeven rate directly.
It doesn’t track perfectly and it is a no bastion of liquidity, but for hacks like me, it is a God send. I have been picking away at this product and will buy more in the days to come.
Before this cycle is through…
The Central Bankers are out of control, but ironically most investors are assuming this will mean deflation. I will take the other side of that trade. Before this is madness is over, investors will be bidding up TIPS to stupid levels. I think there is a decent chance Treasury Inflation Protected Securities are the next big bubble… Buying them now when they are being given away seems like a good speculation.
Thanks for reading,