Point on Inflation vs. Deflation Debate

Includes: BEP, TLT
by: Erwan Mahe

We have rehashed this issue time and time again, since we began dissecting the danger of the creeping debt deflation process in these lines (see "Capsizing" on November 7, 2008; it seems like an eternity but the issue is a current as ever).

Instead of again ruminating over the structural inconsistencies in the thinking of European leaders, today I would like to focus on the latest inflation figures published yesterday in the United States and on the hyperinflation hysterics of our American Tea connoisseurs since the Fed's (too) modest QE2.

As they say, a few graphs are worth more than a thousand words.

Annual Core CPI since 1960

At 0.6%, inflation is the lowest since this publication began in 1958!

(Click to enlarge)

Not only is this annual inflation rate of 0.6%, excluding food and energy items, at a all-time low in America, but the graph illustrates a clear trend since the beginning of the 1990s, given the impact of globalisation and the influence of Chinese and German deflationist black holes.

There is thus a serious danger that we have gone from a period of disinflation, stemming from efforts in the 1980s to combat excessively high inflation of the 1970s, to a new era characterised by an encroaching deflationist trap in which Japan has already fallen. In the land of the rising sun, core inflation has been negative for over 12 years now, and the current rate is -1.5%!

Some unhappy souls are trying to sidetrack the debate by highlighting the hike in commodity prices since the beginning of the US launched QE, and even go so far as to claim that governments are manipulating inflation indices, which they assert do not reflect real changes in the costs of living.

The little graph below destroys the fantastic conspiracy theories (long live the web!) of our sourpuss friends in one fell swoop.

CRB index Since 2006

Where is the problem?

(Click to enlarge)

Of course, the CRB has climbed back since the apocalypse of early 2009, when it plunged 58% from its peak of 2008. But at around 300 today, it is still at the low range of 2005-2007. And assuming that a good part of the current hike is probably due to the increasing popularity of ETFs and other commodity investment vehicles, we question the future direction of these commodity prices, if hyperinflation fears were to recede.

The Baltic Dry Index illustrates the de-coupling of commodity prices from the real economy; For some strange reason, the indicator has calmed down, in contrast to the controversy surrounding its surges in 2007 and 2008.

Baltic Dry Index Since 2006

Real demand, really?

(Click to enlarge)

So how are commodities, which are supposedly in high demand due to currency debasement and insatiable Chinese demand, doing?

The Baltic Dry has returned to its lows of 2005 and 2006, and is today 80% below its peak of 2008!

Despite the current decline of Bund and T-notes, I see no reason to lift rates in the 5-10 year range in the current economic context. And there is little reason to go on a risky asset shopping spree either. But capital flows being what they are, we are going to wait until the bond market storm is over before proposing bullish Bund option strategies.

One last point: Some argue that while there is little inflation in G7 countries, we should be concerned about inflation in China.

Once again, so what?!

The Chinese have always manipulated their currency exchange rate and have cordoned off their domestic market from Western imports, especially in services where Western firms are more than competitive.

The only ways for the United States to reduce its trade deficit with this country include:
  • A domestic devaluation via a reduction in production costs, mainly in wages: Such an option would not only prove very difficult to implement ("sticky wages" and fairness), but it would also be very dangerous when the country is in the midst of a debt deflation process.
  • Lower the dollar versus the yuan: This is impossible as long as China continues to engage in unlimited currency manipulation.
  • Rising inflation in China, which increases the costs of goods produced there and thus makes American goods that much more competitive: But this is a sensitive subject in China (Tien Am Nen), and we can already imagine the reactions in this area (administrative control of food item prices?).
  • Protectionism, which is inevitable if unemployment remains over 8% for an extended period in the US: This is the only negative scenario for fixed rate instruments, so we will have to keep a close tab on this situation.
Disclosure: Author long 20 years OAT and 30 years BTP Zero Coupons, EDF Corp 5 Years 4.5%, Grece 2 Y and 10 Y bonds.