Deflation/Inflation Expectations and the Summer Crash of 2011

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 |  Includes: IEF, IVV, SPY, TIP
by: Michael A. Gayed, CFA

Early last week I published an article on Seeking Alpha titled “The Summer Crash of 2011, or the Great Re-Adjustment,” in which I argued that the relationship of certain defensive sectors relative to the broad market (NYSEARCA:IVV) (NYSEARCA:SPY) was warning of a major decline ahead, and that the bond/stock ratio should subsequently be far higher than it currently is as a result. The bond market has been screaming that an economic slowdown is in sight, with yields pushing lower even as the Federal Reserve winds down its sequal to Quantitative Easing.

Nothing has changed since then – I still believe that the odds of a significant market decline are much higher than the market is pricing in. But, for argument's sake, let's look at inflation expectations as a way of gauging the possibility that the market will instead rally as opposed to falling off a cliff. Take a look below at the price ratio of the iShares TIPS Bond ETF (NYSEARCA:TIP) relative to the iShares 7-10 Year Treasury Bond ETF (NYSEARCA:IEF). As a reminder, a rising price ratio means the numerator/TIP is outperforming (up more/down less) the denominator/IEF.

Click to enlarge

Click to enlarge
Notice that the peak of the ratio was hit in early April this year after roughly reaching early 2010 levels. Since then the ratio fell hard for about two months, as deflation concerns crept back into the bond market. As economic data weakened, and emerging markets continued to lag, “risk off” came back because risk assets tend to do better when inflationary expectations are rising, not falling as the recent price ratio analysis would suggest.

Over the past few days, however, there has been a mini-spike in the ratio, and inflation protection relative to nominal bonds caught a bit of a relative bid. However, until proven otherwise, the trend does appear to be still headed lower. And in many ways, it probably should. This is the first time in three years where there will be no new stimulus to help juice up the economy. The Fed is ending its QE program (a quasi-tightening of rates), and literally every single country with the exception of Japan is raising its own interest rates. Not to mention the deflationary impact of a Greek default.

What all this means is that in the face of still lackluster economic growth and no hopes for new stimulus anytime in the near future, the global tightening cycle may indeed force the market back into a deflation scare. Either way, caution remains warranted in such an environment.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Pension Partners, LLC, and/or its clients may hold positions in securities mentioned in this article at time of writing.