Ending 2011 On A Deflationary Note

Includes: IEF, TIP
by: Michael A. Gayed, CFA

"The opposite of the happy ending is not actually the sad ending--the sad ending is sometimes the happy ending. The opposite of the happy ending is actually the unsatisfying ending." - Orson Scott Card

With 2011 now over, it's worth looking at how the inflation/deflation debate is going by looking internally within the bond market to see what expectations are for the future. As followers of my writings know, I focus on the idea that conditions matter more than predictions, and that one of the most important conditions relates to what expectations are for future inflation. Going "risk-on" into equities depends very much on whether inflation expectations are rising, versus "risk-off" in bonds when deflation expectations are on the uptick.

One way of gauging if inflation expectations are rising or falling (and subsequently if conditions favor being risk-on/off) is by looking at the relative price ratio of the iShares Barclays TIPS Bond Fund ETF (NYSEARCA:TIP) to the iShares Barclays 7-10 Year Treasury Bond Fund ETF (NYSEARCA:IEF). As a reminder, a rising price ratio means the numerator/TIP is outperforming (up more/down less) the denominator/IEF.

The trend in the above ratio is what matters. An uptrend means TIPS, which offer some degree of inflation protection, are outperforming nominal bonds which do not. A downtrend means they are underperforming, which means nominal bonds are being favored due to deflation concerns (when that inflation protection is really not as much of a desire or bond investors).

The main thing to take away from the above chart is that the trend does appear to be headed lower. This seems to be happening in spite of the ECB's lending and newly printed money which was borrowed by hundred of European banks a couple of weeks ago. We basically ended 2011 with the above ratio falling which is indicative of deflation concerns. This does not seem to bode well for equities as the first few months of 2012 unfold. This suggests that the bias may be towards lower prices ahead in the near-term.

This is not necessarily a bad thing. Within the context of the Winter Resolution idea, a trend down would be less volatile day to day than what was experienced post-Summer Crash of 2011, and could be much more exploitable from a strategy standpoint. It also seems to suggest that the bond market is sensing that Europe's responses are not enough to convincingly force inflation expectations back into the system.

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