Monday, June 15, 2009

Fed: Deflation? Over my dead body.

Many Accrued Interest readers will gafaw at the memory of John Ryding, economist at Bear Stearns from 1991 until the bitter end in 2008. Intelligent man, I'm sure, but also something of the Nouriel Roubini of the bond market. I think he was bearish on interest rates basically my entire career, which is ironic, since for most of my career, interest rates have been falling.

Anyway, the one really good piece of advice I heard from Ryding over the years was if you have a view on inflation, don't change your inflation outlook, change your Fed outlook. In other words, if you think forces are aligning toward higher inflation, bet on Fed hikes, not on inflation itself. I think this is a smart way to approach the bond market, because the Fed may actually short-circuit inflation itself (making a bet on, say, TIPs a loser).

Today St. Louis Fed President James Bullard declared that the Fed had averted a deflationary outcome, and is now considering an exit strategy. As readers know, I've been touting deflation as the Fed's primary concern for some time now. But in talking about deflation as the primary risk, I'm still thinking of Ryding's advice. I'm not necessarily betting on deflation per se, but on a Fed ready and very willing to fight it. That's why I've been willing to bet on massive rate cuts, unorthodox liquidity programs, etc.

But will we see CPI print below zero? Only if the Fed fails. In other words, sustained deflation remains a remote possibility. But sustained Fed interference in the markets in attempt to avert deflation is a strong probability.

So the bet should be not on deflation outright, but on the fallout from attempts to fight it. Weaker dollar. Higher commodities. Low short-term rates (including buying 2-year bonds as opposed to holding cash). Flat yield curve. Lower mortgage rates (at least from here).

That's is how I'm playing my deflation view.


Advant Guard said...

Deflation by itself will mean a stronger dollar and lower commodity prices. While the Fed lowering interest rates will fight against these trends, I am sceptical that in the current political environment, the Fed will ease enough to actually reserve those trends in more than short term bounces. You more likely to see volatility in both directions as the two force each get temporary advantage.

In Debt We Trust said...

I noticed that you left out shorting Treasuries. Does that mean you advise readers not to fight the Fed?

EconomicDisconnect said...

Great take. I wonder if we can have deflation AND a weaker dollar? So far that has not been the case, but I can see scenarios where the FED actions could weaken the dollar even as deflation takes hold. This debate is not going away!
Great site.

In Debt We Trust said...

Meanwhile, Russia and China are convening their own version of the G8 Council:

Basically, it's a who's who of disgruntled foreign buyers of Treasuries.

EconomicDisconnect said...

Linked to this post tonight.

The Oriole Way said...

In Debt We Trust,
Did you see comments from the Kremlin overnight last night? They may be disgruntled, but there is almost nothing they can do to act on it. And, when they let their angst be known, they are talking against their position.

And didn't we see negative CPI prints in May (April reading)?

EconomicDisconnect said...

There is a school of thought that believes the CPI, as it missed rampant home price inflation to the upside, will now rely on the old rent model to cover the deflation we all know is going on. Must be nice to control data sets ( as a scientist I wish I could)

Accrued Interest said...


Shorting tsy is tough. I thought QE would be more successfull in keeping tsy rates down. Its possible that once some of the BRIC/USD confusion dies down, we get a good sized tsy rally. Maybe its already happening. Anyway, an extended period of low fed funds should lead to a flat yield curve, so I think that's the way to play it.

Earl Weaver:
I should say we won't see a string of negative CPI prints, i.e., TIPs aren't an automatic short (although they are stupid rich right now).

Anonymous said...

Interesting take. But the argument for inflation is at its core a political one, not an economic one. It's based on a regime change that makes the FED unable to raise rates due to political pressures. In normal times, the Fed can always put on the brakes by raising rates. But we are moving into non-normal times. Yes, inflation is always and everywhere a monetary phenomenon until you look behind the curtain and see what manner of social and political conflict determines the range of a central bank's actions. When the conflicts can't be resolved in the political sphere, the likely outcome is inflation. That is what we may be facing, and the smart move is to hedge against this possibilty.

David Foster said...

If we have a weaker dollar and higher commodity prices AND general deflation at the same time, then some set of prices would have to be going down *a lot* to overcome the upwards effect of commodities and other imports.

Would you agre with this? If so, any thoughts on what categories of goods & services would be most deflationary?

In Debt We Trust said...


You might be right about the Tsy mkt, I bought some July TLT calls and TBT puts about 2 weeks ago. I made some money on TBT but got greedy waiting for TLT to appreciate more.

Anyway, do you see a cyclical market for a Tsy rally in mid-summer?