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Chasing The Deflationary Dragon
From Nic Lenoir of ICAP
For a while now I have been making for the great deflationary wave that is upon us. We have argued that for demographic reasons, because of the unprecedented productivity gains of the last 30 years, and last but not least due to the bursting of the credit bubble, deflation is inevitable. This is compounded by the fact that the phenomenon is generalized in the western world, China with excess capacity both in terms of production and workers, and with its huge credit bubble in the bursting, will absolutely not be our savior.
This is why despite government officials forecasting 3/3.5% growth over the next 5 years (which is both wishful thinking, an attempt to get the consumer to spend more money he doesn't have, and a way not to have to remark all the unfunded liabilities out there) Federal Reserve officials are worried that we are caught in a liquidity trap. Central banks are in a race to try to reinflate the system using monetary largesse and currency debasement, but that only works when everybody is not in the same boat... For now their liquidity has made its way straight to the stock market and increasingly to hard assets and precious metals. That just means whatever central banks are doing is relatively useless. The core fabric of our economy remains feeble and it's bubble or bust. The more that notion grows in the public's mind, as it is growing fast, the harder it will be to justify creating bubbles with much more cons that pros as the wreckage left after the bursting is usually worst than the state the world was in before it happened. Europe is already trying to implement some fiscal austerity (we remain skeptical on their chances of success).
Under a deflationary scenario and with short end rates already at zero the yield curve is likely to flatten quite a bit. For those who are not keen on holding long dated Treasuries outright or buying calls on 10Y future: meet the bull flattener. We first take a look at the 2Y/10Y treasury yield spread or the 5Y/30Y treasury yield spread. There is a negative carry associated with playing this flattener due the cost of being a payer of 2Y rates but the carry is a lot lower than it was when 2Y was yielding 1% not so long ago. The twist we add to the trade is to consider 2Y swaps against 10Y treasuries, or 1Y1Y fwd swaps against 10Y treasuries. The reason behind this is that if the economy does weaken debt refinancing and banks assets' financing is not going to get any easier which should push out swap spreads much wider. Being a payer of 2Y swap rates under these circumstances would make the cost of the payer position less and add to the performance of the trade. In the case of the 1Y1Y fwd the spread widening would contribute though less than on spot 2Y swaps, but by the same token should fixed income sell off 1Y1Y fwd payer would perform better than 2Y swaps. Note also that should the hyperinflation bugs be proven right and my deflationary theory is bogus, then the US fixed income curve should trade more like a credit curve and 2y/1y1y fwd rates will outperform 10Y treasury yields and swap spreads should widen out aggressively under such scenario as well.
I am looking at ways to express this via options to see if there would be a way to reduce a little bit the negative carry on the position. The only adverse scenario to the trade is the economy does not roll over, short end yields remain low and the curve remain steep. With leading indicators rolling over and unemployment not really improving, it seems that betting on a growth slow down in the second half is far from a long shot. However there is always a cost betting on something that is not priced in, what we argue here is that in this case the cost is worth it.
Good luck trading,
Nic
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"Bubble or Bust". A nice three word summary for our economy of the past 15 years.
Anyone seen any studies regarding the reliability of the open-end bond fund "duration" metric? I know how it's purported to work, just wondering if anyone's seen data on how closely it tracks what it's supposed to.
What the hell is going on with Ford's stock prices?
The tie-up with Flockhart is likely to be expensive.
LOL ... nicely played.
This type of trade will get you looked at by the Spanish secret service.
NOBODY expects the Spanish secret service!
Mark Haines on CNBC is a disgrace. Hysterical reaction to the suggestion that Obama cannot just shut down an international company at his whim. Clearly BP f*cked up, and clearly they're going to pay. No reason to override the rule of law in the process, you dumbass...
Well said, CNBC is best viewed on "mute".
How this guy keeps his gig is beyond stupid on the part of CNBC honchos.
He either owns the network, knows where the bodies are buried, a drunk, or certain damaging proteins have coalesced in his tiny brain.
Did you notice that unemployment claims "unexpectedly" rose?
Loved this comment:
In another news item, the readership of Bloomberg News unexpectedly
declined among Wall Street analysts. Sources say that its longstanding
use of the word "unexpectedly" to describe its repeated inability to
identify and use credible experts to predict economic condition has
rendered them unidentifiable from shrill Democratic partisan sources.
Most have replaced reliance on Bloomberg News to instead consult
Milton Friedman textbooks on economic theory to better serve their
clients with sound advice.
Posted by: pablo panadero
It's copy/paste from the BLS. All news writers at Bloomberg, WSJ, Reuters were fired 2+ years ago, and are now dead from alcoholism. Now, it is all 24 year-old chicks with fitted tops doing this all day:
www.bls.gov/_____________/ Ctrl-A Ctrl-C Ctrl-V
www.bls.gov/_____________/ Ctrl-A Ctrl-C Ctrl-V
www.bls.gov/_____________/ Ctrl-A Ctrl-C Ctrl-V
www.bls.gov/_____________/ Ctrl-A Ctrl-C Ctrl-V
www.bls.gov/_____________/ Ctrl-A Ctrl-C Ctrl-V
www.bls.gov/_____________/ Ctrl-A Ctrl-C Ctrl-V
Thanks. It's good to have ones gut feelings verified.
I think a big part of the problem is that all the economic models have failed, and nobody knows what 'actionable' information is anymore. Too many years of misreading the signal/noise ratio. Might as well copy/paste, it's all bullshit anyway.
"All" economic models have not failed. Just the single Keynesian socialist central planner ones:
Taxing everything out of the economy to be spent by politicians will be more effective.
Government control of everything it can grab will fix things.
Punishing earners and savers while rewarding debtors and dependents will create growth.
The "money multiplier" is greater than one so the more we spend the richer we are.
Etc.
Oh riiiight, Randian dogma will save us all.....if only we'd try it. First we all have to become perfectly rational, whatever the fuck that means. We don't have a 'central planner', we have millions of them, and they are swimming in a soup of randomness with unpredictable consequences. Read more than Atlas Shrugged and wake the fuck up!
Not millions of central planners, millions of individual self-planners replacing the central planners.
In other words, people being left alone to live their lives and make their own decisions. Completely unacceptable, right?
There are no central planners in any meaningful sense. Even if such an animal really existed, they have almost no way of knowing if their 'plan' would produce the results they intended. The model is broken, and until that is corrected, the more 'planners' in the mix, the higher the randomness/volatility. Individual calculation is no panacea. Read Mandelbrot.
NotAlwaysSo
I was going to give you some sort of specific rebuttal, but your just entirely wrong about everything. You need to stop what ever your daily pattern is and start telling yourself the truth. Cancel your cable or something.
Keep telling yourself that. You'll be ok...really. You can't offer a specific rebuttal because you don't know what I'm talking about, and not in the way you'd like to think.
p.s. I don't watch tv.
why cant everyone be correct on this one? deleveraging and deflation seem to be the logical outcome of what happened since 08-09, likely a repeat... and while i cant be sure, which is why i am still buying metals at these prices, i would bet pms will drop just like they did in 08-09. however, once the bottom is hit, then the inflationary process starts again... if you look at the 10 year charts for most commodities, they will show a large spike leading up in 06-08, but if you smooth it out over time, the clear trend is the begining of a parabolic function. this makes the 07-09 look like "noise". my opinion is that we will see a repeat of 08-09 in terms of a deflationary shock on commoditiy prices, but they will not bottom out as hard as they did last time, the bottom will be higher so to speak, and after the deleveraging process takes place, hyperinflation will set it... lead of course by the pm market.
+ 1 . Makes sense to moi. Guess it all gets back to distrusting the proper valuations of all fast rising bubbles.
Like most everyone here, I have been asking myself these sort of questions since late 08 when the FED started to buy anything and FASB marked to infinity and beyond.
If anyone of us knew the answer and the timing of this for sure, we wouldn't be here reading ZH.
We don't.
What the poster (Nic) writes, is very convincing and eloquent.
What you write is equally forceful and could also come to pass.
Have you two considered the possibility that inflationary and deflationary forces are both hard at work. They are not mutually exclusive. Think of a tire leaking as it's being pumped up. Right now, the holes are getting bigger so we're pumping harder than ever.
But no one can predict with certainty whether the tire fiasco will end with a dramatic bust or a less dramatic fizzle.
"Have you two considered the possibility that inflationary and deflationary forces are both hard at work. They are not mutually exclusive."
Not only have I considered this possibility, it is what I have believed since late 08-early 2009.
In 08 I believed that deflationary forces were stronger.
That the FED, though scared, was still a credible force.
By April/June 09 I changed my mind and thought the FED had won.
Today, I have no idea.
Policeman retires; $170,000 a year for life. Deflation?
Pension Tensions in Santa Cruz (California)
Santa Cruz Police Chief Howard Skerry has worn SCPD blue for 29 years. So when he turns in his gun and badge in September to retire, he’ll take home a pension of about $170,000 per year for the rest of his life. It’s the same deal every cop and firefighter in Santa Cruz gets: stay on the job until at least age 50, then retire with 3 percent of your salary for every year spent on the force. .... Today, Watsonville offers the plan, along with Monterey, Capitola, Scotts Valley, Alameda County, Santa Cruz County and about 320 other public agencies in the state…City Manager Dick Wilson (also soon to retire, but at the “miscellaneous employee” rate of 2 percent of his salary for each of his 28 years) says the model is “completely unsustainable.” …
Santa Cruz has more retired cops and firefighters than it has working ones.
Gerald Celente says US to collapse this year
http://www.chrismartenson.com/forum/gerald-celente-says-us-collapse-year/40726?#comment-80726
It's deflationary when the pension check bounces when deposited at the bank.
JR,
Yeah, sure,,,,,,,,,,,,reads well.
His chances of getting that Pension (for any extended period), is 0 to NADA..............
All these Pension plan funded retiree's, are going to get screwed worse than SS recipents.
I agree, DosZap; it's not going to happen, which validates earnyermoney’s point. Which raises the long term specter of a John Williams’ Hyper-Inflationary Depression if the fed continues monetizing coupled with no economic growth.
Or is it all just moot, for total financial meltdown?
Not sure if that will hold this time around. The 08 crash was probably percieved as your run of the mill stock market crash which we see once in a while. Lots of fear and panic but nobody was worried about the health of countries and currencies.
This time around if we have a crash the worry will be where to put your money, where banks wont freeze or failing economies destroy its worth.
People will be wondering where on earth to put their money where it will be safe. The last crash people were not worried about holding cash in their bank, this time they will think twice.
This concerne may stop PMs falling the way they did last time, and who knows they may benefit.
If you are in Australia then the worry that immediately comes to mind is a crash precipitating a mortage property bubble burst and the problems that creates with the banks and the rising cost of their funding as well.
The no-inflation mantra from our financial rulers has to rank in the top ten biggest lies in the financial history of the United States. The crime is the followers—the financial media, the bought university economists, and the members of Congress who use the no-inflation lie to cover the wholesale stealing of the public’s money for their lobbyist friends.
Americans all know that prices are higher; they don’t buy into this “cheap” gasoline ruse, i.e., two price steps forward, one price step back equals deflation. John Williams’ Shadow Government Statistics (SGS) gives the “analysis behind and beyond Government Economic Reporting”:
As shown in both the shorter- and longer- range graphs of nominal (not adjusted for inflation), year-to-year change in the SGS-Ongoing M3 Measure sank to a post-World War II record contraction of roughly 5.9%, following a 5.0% contraction in April. …
For those who define inflation in terms of changes in money supply, the current environment is one of deflation. The inflation I discuss, however, is defined in terms of prices for consumer goods and services, and costs there seemed to be reasonably well contained as measured by the CPI-U. Where many people sense that their actual inflation is running higher than that reported by the government, such is covered by the SGS-Alternate CPI; yet the magnitude of inflation problems ahead will dwarf any issues as to how the CPI is measured.
Inflation fears from a post-World War II record decline in broad domestic money supply certainly are counter-intuitive, but that is because the inflation problem is two steps removed from inadequate liquidity strangling business activity. As suggested by the discussion above of contracting real M3, the economy is headed into an intensifying downturn or double-dip recession, which should blow apart forecasts of the federal budget deficit and related Treasury funding needs, as well as trigger massive selling of the U.S. Dollar. Those issues — resulting from the effects of the liquidity squeeze — are what threaten an early breaking of the ultimate inflation crisis… – June 7, 2010 report
Alternative Consumer Inflation Measures. Adjusted to pre-Clinton (1990) methodology, annual CPI rose to roughly 5.6% growth in April 2010, the same level as in March, while the SGS-Alternate Consumer Inflation Measure, which reverses gimmicked changes to official CPI reporting methodologies back to 1980, rose to about 9.5% (9.46% for those using the extra digit) in April, versus 9.5% in March. – May 19,2010 report
http://www.shadowstats.com/
+1
Commodity and consumer staple prices gauged to the level of economic activity are high. Real high.
What more needs to be said than commodity cash prices are above the levels achieved in 2007, at the peak of the last expansion, yet US and global economic activity are severely languishing? Euro-Zone is near 0% growth.
The Fed and many others would like us to believe it's "all China's fault", through their demand. However I contend that, although this is partly true, a very large portion of the fault lies with the Fed's own Reflation Policy. As stated by Nic, lots of the Fed's largesse has flowed into the stock market by design. Commodity inflation is collateral damage.
Those EURUSD bullish warnings have strengthened further today.
Vice versa for the USD index of course.
It seems the current EURUSD downleg has ended.
http://stockmarket618.wordpress.com
Anyone want to place bets on negative interest rates in the coming months?
Is that what the banks pay to have it hauled away?
now all we need is a little mood music for "chasin the dragon" -
http://www.youtube.com/watch?v=8G1tRCfMNxc