The Slow Start of Deflation: A Case for Bonds

Commodity prices are cracking up left, right and centre. Ospraie - one of the stars of the commodity hedge funds - has blown up. The speed at which things unravel is sometimes startling.

Slowly but surely, the global real estate asset price deflation is moving to other asset classes. Is there any link between asset price inflation/deflation and consumer price inflation/deflation? Considering that we had a period of 2002-2007 (and many more periods before that), when asset prices (esp real estate) moved up sharply while CPI remained contained, one would argue that these are two different categories of inflation. So one should be careful in extrapolating asset price deflation to CPI deflation.

At the same time, I would be really surprised if we continue to have asset price deflation and CPI inflation. I haven't read any paper which has looked at the historic correlation between these two, so this is more of a hunch than anything else.

If this assumption indeed is true, it has profound implications. The wrong thing to do in a CPI deflationary environment is to buy equities. When prices that companies charge for their goods fall, they might pull down absolute profits left for shareholders, because it is not necessary that price declines lead to volumes picking up in a depressingly deflationary environment. The best time to buy stocks are when interest rates are rising from low levels to moderate levels (in response to accelerating growth), than when they are being cut from high levels to moderate levels (in response to decelerating growth).

So one needs to be higher up in the capital structure. Considering that spreads on bonds are also quite high these days when everyone is still worried about inflation, one can end up making a killing in bonds on a risk-adjusted basis. Over the next 5 years, inflation might come down and spreads might compress, so there is money to be made.

My biggest bet of the last year - being long on USD and short on Rupee - has wiped out all losses from 1H08. But, if things in the US are as bad as I think they still are, the Fed will cut more. The recent commodity price deflation and the USD strength has given them enormous wiggle room. So we might see another period of USD weakness in the next 9 months. But that again is bullish for bonds. The interesting thing to watch would be whether it leads to another commodity spike.

There was one more trade I had tried to do earlier this year - shorting the pound when it was at 1pound = 2USD. I couldnt figure out how to execute it economically. Now it is $1.80. It is amazing to see how currencies move around to transmit the positives/negatives across countries and continents.

Verizon (VZ) will make a bid for Vodafone (VOD) in 2012 - the depreciation of the pound has not ended by any stretch of imagination.

Comments

[adan:]

interesting stuff; good info to think about at at time like this when the crossroads are many and muddied by the currents

thanks!

2008 Sep 03 11:20 AM

[Tony Daltorio:]

Anyone owning bonds at these levels is a fool who will soon be parted from their money.

2008 Sep 03 01:08 PM

[carey_jim:]

You are right to take a look at the possibility of deflation.

The point is, the future is dreadfully difficult to predict and thinking anything else is financial suicide.

Thanks for doing the research and please keep us posted on future new findings.

2008 Sep 03 01:27 PM

[JasonC:]

The original writer is correct, bonds (not treasuries, corporates that actually have spread on them) will do quite well over the next 3-5 years. If you think treasury rates may move higher you can hedge part of the IR risk by being short T-note futures for about half the size of your long cash position in corporates. I would not try doing 1 to 1 as widening spreads can make the Ts outperform for short periods - but they aren't going to beat spreads this wide over the medium term.

Some of the financial preferreds are also interesting at these levels. You can get 8% on the soundest names, and 10% on moderate risk ones. The regional banks are up around 12% for credits that are objectively single A strength, which is an insane level of discrimination against the sector. If you have any fears about those, though, just use the better ones and settle for a 8-9% blended yield.

There are also a few floating rate preferreds which are interesting as a way to hedge interest rate risk, if you are unsure about the short rate outlook. Goldman preferreds can be bought today to yield over 6%, and will yield 140-150% of LIBOR if it rises, with a floor at the current rate. Those are a nice carry; the rate without any leverage isn't that interesting though.

For all of these ideas, sell if the spreads tighten up to 0.5% (or 0.75% more conservatively) again. Over a 3-5 year horizon that is likely - "this too shall pass". And it will involve double digit returns over that stretch, from the base rate plus the eventual re-tightening of spreads. With a lot lower risk than common stocks.

2008 Sep 03 04:37 PM