Why You Should Really Worry About Deflation

Mere days after I wrote about how most people were deluded that prices were always rising at an increasing rate, US inflation expectations slipped to new lows. If you haven't already, read my previous article on my views regarding the complex topic of inflation, and why I think we are in for a protracted period of price deceleration, which is bad news for all of us.


Not a canary in a coal mine

I'm not mincing my syllables on this one. Disinflation is widespread. It isn't isolated to the developed economies the likes of whom are still experiencing financial repression. America will start to face declining prices after the holiday season ends and the snow thaws; Europe is on the precipice of outright deflation; Japan continues to muddle through its cyclical wax and wane cycles within its liquidity trap. As economies experiencing deceleration in inflation exports cheaper constituents to their trade partners, I can reasonably foresee this chill to spread beyond the West to the East.


The market has been dead right for years

My measure of forward inflation expectations is by way of subtracting the real yield of TIPS (treasury inflation-protected securities) that trade on the secondary bond market, from the nominal yield of similar maturity/duration treasury notes to derive the breakeven rate.

As I've elaborated in my previous article, the market's forward view on inflation is more crucial and insightful than any other measure because markets are forward looking by nature. If you subscribed to the EMH (efficient market hypothesis) train of thought it is yet another reason to embrace the breakevens.

The following charts show the breakeven rates on the USD on a 5 year and 2 year forward basis. The 5 year window remains the uglier of the two; expectations have surpassed the lows of 2008 when the oil, subprime credit and derivatives bubbles popped, sending oil from $147/bbl to $38/bbl. Texas oil currently trades at $57/bbl; even with a $20/bbl margin, the breakevens are at their lowest ever in the past decade.

So let's get this very straight: the markets are pricing in inflation expectations at levels below those seen during the deepest abyss of the Great Recession of 2008. If this doesn't set your alarm bells ringing

This chart of the 5 year breakeven rates for the respective major currencies highlight how the current climate encourages behavior that causes disinflation. The US still hold the most optimistic view on inflation while Japan ranks last as expected, after being in a liquidity trap for more than a decade. Europe is not much better of, after the ECB embarked on an experiment of historic scales to be the first central bank ever to set negative interest rates.  They all have one thing in common: all are pointing south

This chart of the 5 year breakeven rates for the respective major currencies highlight how the current climate encourages behavior that causes disinflation. The US still hold the most optimistic view on inflation while Japan ranks last as expected, after being in a liquidity trap for more than a decade. Europe is not much better of, after the ECB embarked on an experiment of historic scales to be the first central bank ever to set negative interest rates.  They all have one thing in common: all are pointing south

The 2 year breakeven rate on the USD paints a similar picture albeit less dovishly. Current rates are at what we saw after risk appetite rebounded sharply post 2009 lows, but are at the lowest in 5 years having broken through the 0.92% level that held up for the last 4 dips. We have crashed 170bps lower from 2% seen in March this year to 0.3% now

The 2 year breakeven rate on the USD paints a similar picture albeit less dovishly. Current rates are at what we saw after risk appetite rebounded sharply post 2009 lows, but are at the lowest in 5 years having broken through the 0.92% level that held up for the last 4 dips. We have crashed 170bps lower from 2% seen in March this year to 0.3% now


Black swan or new paradigm?

Although I wish to save this altercation for another day, I will let off some steam here because it has been bothering me too much lately. Are low oil prices good or bad for the global economy? Such a question remains a tough circle to square. If we broke down the major constituents of the global economy, we might be able to deduce a little more color from the otherwise severely desaturated canvas.

In this simple chart from the WSJ, the IMF estimates (large grains of salt to be taken once "IMF" and "estimates" appear together) lower oil prices will be a net benefit to global growth in 2015. It is simple to understand when taken in isolation: net oil importers benefit from cheaper energy; net oil exporters suffer from loss in revenues. Remember also that this is assuming every nation trades oil measures trade in USD. As elegant as the chart posits to be, it barely reflects reality

In this simple chart from the WSJ, the IMF estimates (large grains of salt to be taken once "IMF" and "estimates" appear together) lower oil prices will be a net benefit to global growth in 2015. It is simple to understand when taken in isolation: net oil importers benefit from cheaper energy; net oil exporters suffer from loss in revenues. Remember also that this is assuming every nation trades oil measures trade in USD. As elegant as the chart posits to be, it barely reflects reality

While under restraint from opening what is probably the most contentious Pandora Box of 2014, financial contagion is just one factor from the bevy of convoluting dynamics stemming from heightened volatility in the energy sphere. I've spoken about financial contagion in my one of my earlier articles, and it has proven to yield destructive results if its risks are not appropriately hedged against.

This chart courtesy of ZeroHedge proves how sneaky financial contagion really is. Between oil prices, equity and debt components of financials, they collectively seem to indicate one thing: credit leads, and equities lag. The upper pane illustrates this phenomenon from 2007-2009, the bottom pane leaves us hanging midair pandering to the question of which will be correct

This chart courtesy of ZeroHedge proves how sneaky financial contagion really is. Between oil prices, equity and debt components of financials, they collectively seem to indicate one thing: credit leads, and equities lag. The upper pane illustrates this phenomenon from 2007-2009, the bottom pane leaves us hanging midair pandering to the question of which will be correct

The period of early 2007 leading up to the first major cracks on the sheet of ice globally-interconnected financial institutions were standing on was hallmarked by calm in equities, all while its credit counterpart was trading lower. A divergence, some would say.

Over the last half a decade I've learned that there is a crucial but subtle difference between decoupling of correlations and a lead-lag cycle. 2007 is a case study of the latter; credit led equities starting late 2006 through early 2007 before equities snapped lower. Both components then rebounded (but credit failed to form a higher high), before crashing. In late 2007, equities consolidated why credit continued sharply downward; this would prove to be another example of a lead-lag cycle as equities eventually broke out lower and caught up to credit a weakness (not seen in chart).

The difference between a decoupling event and lead-lag cycle is the former involves a third vector (oil in this case) as the primary reason for the divergence, while the lead-lag eventually sees follow through from either component without the involvement of a third vector. Complicated but essential in out understanding of financial contagion.

Much more on such topics later on...


Bottom line: deflation is going to reign supreme for now

All of my arrows are pointing to a deflationary risk. There will be those that choose to play devil's advocate on every of such occasions, but let's not bother about these shenanigans because they have been plain wrong in their ludicrous calls for high inflation or even hyperinflation for the past 5 years.

So unless one wishes to be on the wrong side of the trade (yet again), take heed and weigh the odds. Depending on your investment objectives, make appropriate changes to your portfolio before the markets incapacitate you.