Wednesday, August 04, 2010

Overpriced Deflation or Bond Bubble?

If Mr. Market is asking questions on whether we get Deflation or Inflation, you'd think that he had been on a telephone sales course selling Deflation and received a Distinction in "closed question" asking. "So Sir, would you be taking the 'Really Bad Deflation' or the 'Not Quite So Bad Deflation' or maybe our 'Japanese Deflation' option?".

We understand that equity market players are usually a pretty optimistic bunch (well, they kind of have to be, given they are dependent on an income-stream supposedly linked to growth), but bond guys are clinically depressed, worrying about inflationary risks one minute and then deflationary risks the next. This schizophrenia was most clearly demonstrated in 2008 with a 250bps pendulum swing in 5yr note yields. TMM bring this up because they believe that the pendulum may be approaching its zenith.

One of the biggest fears macro punters have at the moment is the Core PCE Price Index (see below chart) going negative. Now, as far as TMM can see, it is near the bottom of the range of the last 17yrs or so, but given the Fed is generally assumed to have a 1.75% target for this number, it does not seem particularly unusual for it to be this low at this stage in the cycle. The *real* oddity was that it was so high between 2004-2008...

...perhaps because of the BRICs and the pass-through of commodity price increases, along with Fed policy having been too loose. So the recent increases in Commodities, particularly Wheat are worth keeping an eye on (see below chart of normalised percentage appreciation of Wheat - white, Oil - orange & Copper - yellow - since the beginning of the year)...

...given that survey-based inflation expectations (chart below - green line) are more a function of *current* CPI (orange line) than the core PCE (brown line), and are "upside" sticky. If food & energy prices continue to ramp, the appears little danger of inflation expectations morphing into deflation expectations. This is significant as far as the expectations-augmented Phillips Curve model is concerned.

Over the past few days there are signs that the fixed income frenzy is becoming increasingly, dare we say, "bubble-like", with the 10 day autocorrelation of the 5yr Note's returns hitting new highs of 0.85 at a time when its price exhibits a clear trend. This is important as evidence of "return chasing", a key phenomena evident in bubbles. TMM would add to that the recent media hype about both deflation, the possibility of the Fed extending QE, economist calls for more QE, along with the WSJ today publishing a "Defending Yourself Against Deflation" article.

Now, all of the above may well be true, but it looks to TMM as though punters have the trade on, and we all know what happens to consensus trades. Speculative positioning in 5yr notes as a percentage of total open interest (see chart below) has also begun to plumb the highs of 2008, a period when fixed income actually had room to rally. TMM is struggling to see any risk-reward in being long fixed income...

...while Commercial Bank holdings of USTs as a fraction of GDP are at their highest since the early-90s. Basel III may well result in banks buying a lot more of these, but the relaxation of these rules to be scaled in over the next 10yrs means that the duration risk on balance sheet is pretty large.

Combining this with speculative positioning, Team Macro Man cannot help but remember just how consensus the Carry Trade was back in late-1993...

...just before thishappened:

Team Macro Man have learned over the years that when smart corporates begin to issue debt that it is usually indicative of a top (or at least, a short term top) for bonds, and yesterday's news that IBM's 3yr note cleared at 1% was the red lights and klaxon "DIVE! DIVE! DIVE!" in their submarine.

Although the chat out of Washington regarding a GSE-sponsored refinancing wave is just chat for the time being, the level of rates mean that the 2009 mortgage vintage is likely to begin to refinance (they are not LTV-constrained as anyone who got a mortgage in 2009 clearly must've had a good credit score).

Now to TMM, we either get the deflation that has largely become priced by certain parts of the fixed income market, or else there is a serious risk of a 1994-style unwind in the rates market. We won't know about the former for some time, probably, but short-term, at least, it seems to us as though things are ripe for a turn...


gk said...

Nice post. But technically, there is still lots of room left for bonds to rally in long term. There may be risks in yields going up but only in medium term.

Deflationary forces seems to be much stronger than inflationary ones and there is visible divided view politically on blowing up new sovereign debt bubble which may have the ability to conquer deflationary forces.

Bob_in_MA said...

Compare retail gasoline prices in the U.S. to the price of oil over the last 30 days. Have oil prices increased because of increases in final demand, or constricted supply? Or because of speculative bets on a future increase in demand?

Ask P&G about inflation...

Nemo Incognito said...

Bob, you're right in that some of these inflationary forces are coming through for big consumer cos I look at that have operations in EM countries like Brazil and to a lesser extent Indonesia. One countervailing force is that these countries actually seem to be making a fist of inflation targeting unlike, say, India.

Oh - and its all in food and agri inputs. People forget that ag markets are awfully segmented and these things can take some time to filter through.

Bob_in_MA said...


Actually, what I meant was P&G was complaining about downward price pressure on their products.

Nemo Incognito said...

Competition is a bitch... I think in many markets that has to do with more local consumer brands more so than general purpose deflation. In the US its probably all about trading down (and cheap) though.

Leftback said...

Extremely cogent post and well argued, but based on historical perspective. My question is, do normal metrics apply to the credit markets when one has already crossed the Event Horizon into the alternate universe of ZIRP and QE? I am not sure, and we have only one prior example to look at.

For now, I agree with Nemo that shorting bonds from time to time will be a great swing trade in the short to medium term, but as I outlined yesterday, in any secular move to higher yields, everything in the US will implode to a degree that the elite will find unacceptable.

Regarding deflationary forces, I agree with gk. Look, even Voldemort has problems with inflated asset prices coming home to roost:

China to Stress Test Banks for 60% Drop in Property Prices

Once that lot craters, you are running out of parts of the world to inflate, and you might just find the Brazilian, Aussie and Canadian economic miracles come to a screeching halt...

Bubbles.... bonds are not a bubble. Yet.

Leftback said...

BTW, TMM, JGB 10y at or below 1.00%... just a thought!

I really liked: "plumbing the highs.." Excellent.
Keep it up...!

Deniz said...

speaking of housing market, a paper on chinese market came out recently arguing that based on price-rent ratios and user-costs even a small decrease in price expectations might lead to large drop (~40%) in house prices in beijing

the point is that 60% drop is not impossible.

Leftback said...

Some Tokyo property fell 60-80% from the peak, but the banks and RE companies stayed "alive"!

The twin miracles of ZIRP and Keiretsu....

Speaking of fixed income, if China does blow and we have another global slowdown, aren't the govies of the major commodity producers a steal here, if you can hedge your FX risk? Any thoughts on Brazilian bonds?

Leftback said...

I wouldn't buy the US 2y here, but I've been wrong on that for about 27bps ! Amazing scenes...

For those in the mood for a bite or two of Macro commentary over dinner, here is a veritable analytical banquet:

Bond vigilantes might want to have a stiff drink first though, before tasting some of the predictions. The author likes the curve flattener (short the long end at your peril) and has US GDP going negative again in Q4 2010 or Q1 2011, which I happen to think is probably about right.

Some excellent commentary about how the deeply indebted don't borrow, compromised banks and other intermediaries don't intermediate and how QE basically didn't work in Japan...

Rossco said...

Great post, well thought out.

Either way though, Deflation : PM's, equities etc get smoked. Back up in the short end : smoked.

Seems like the markets have backed themselves into a real corner here ..... but then Ive been thinking that for 4 weeks !

Nic said...

I know this is not a technical blog but 10yr yields TNX look triple bottomy here and have made two equal measured moves down (April high to flash crash low and flash crash bounce high to July low) which would normally get me excited about a bounce. FOMC next week might kill it though.

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Daniel said...

IMO next couple of months short USG bonds. October is key month to be become defensive again due to a number of obvious political events.

US treasuries are in a bubble and the approximate time they will begin to decline secularly is when SDR denominated bonds are issued en masse by the IMF. At this point the international investment community will have an alternative to UST's. IMF will need shitload of financing when the next deflationary wave hits and will be forced to increase significantly sdr bond issuance.