Guest Post: Weightless Waiting For The Deflation Descent

Tyler Durden's picture

Weightless Waiting for the Deflation Descent

Submitted By JM

Way-back machines don’t just offer visions of the extremes.  They set a framework for understanding reality.  Simple pattern recognition can be right or wrong.  Combined with logic and human reason it is a powerful way to summon the muse.

If inflation is fiery and vibratory, then deflation is cold and numbing.  Get ready for an icy forecast.

Deflation and Carry Trade:  Frozen East

A carry trade is a short funding currency-long target currency position that takes advantage of interest rate differentials.  Unfortunately, high interest rates typically go hand in hand with interest rate and exchange rate volatility, creating conditions for an unwind crash as the money heads out of risk and back home.  A crash in financial terms means that volatility slowly subsides over time and then the spikes in short order.  It is like getting drunk sitting down.  Standing up when the show is over makes the floor suddenly go vertical. 

Mild deflation makes for low interest rate returns and a weak currency, which are the essential ingredients for a carry trade in the first place.  Kurtosis and skewness specify the nature of The Unwind.

Skewness shows how symmetric the probability measure is.  Options traders understand skew well because it affects the value of buying a call to offset the value of buying a put.  Same thing going on here, folks.   Using data from the Japanese carry trade, the negative skewness shows the impact of unwind is negative for a number of target currencies from 1996 to 2008.

Kurtosis measures tail risk.  Positive kurtosis implies a peaked probability measure and higher chances of an extreme event going down.    

Again using Japanese data from 1996 to 2008, you see the currencies with the highest kurtosis.

Combining positive kurtosis with negative skewness is the worst of all possible set-ups but it is its fundamental nature.  The combo with the highest return on the carry also has the highest probability of an unwind crash. 

Dark Angels Circling Frozen Reflections

There has been much discussion about the possibility of a dollar carry trade.  Although I’ve resisted it, it seems pretty clear at this point I was wrong, and there is full-on dollar carry trade.  This is bad, bad news for everything else, and I’ve nick-named it The Unwind.

It is the Unwind because the dollar shouldn’t be a carry currency:   it is volatile anyway, and that combined with its reserve currency status makes it like playing with gasoline and matches.  Wild swings in exchange rates followed by asset markets are often the result of an incremental leveraging and then a violent unwinding carry trade.  Get ready for some dollar love that will burst many bubbles and illusions. 

The Unwind will initiate the next iteration of debt-deflation.  Don’t let the current optimism and propaganda dull your wits: optimism prevailed from 1929 to the spring of 1931.  From the authoritative The Crash and its Aftermath:

  • By 1931, interest rate spreads declined to their lowest levels since the market crash.
  • The Sterling currency crisis drove them to new high levels.
  • South American country defaults destroyed the foreign bond market.
  • Investment grade bonds collapse.  Utility bonds become the premier investment.

Structures From Silence

I selected those bullets (from the dozens available) for a reason.  Currency unwinds can be the triggers to pure economic carnage.  Emerging markets can literally just give up without a stream of dollars coming in the coffers; if it did this to their bonds markets, what do you think it did to what little equity markets they had?  Even high-grade bonds got smashed, except utilities. 

There is order in chaos.  These events aren’t unique to the United States after the Crash.  The Japanese Lost Decade(s) show the same pattern.  The Unwind will generate the same in kind if different in degree.

If the United States has to raise interest rates to protect the dollar, it’s all over.  If target countries default off bad fundamentals, it’s all over.  The Unwind begins like Shiva smiling on Alamogordo.

Beneath the Icy Floe:  Post-Bubble Price Convergence

Pricing power and to a lesser extent debt profile is life or death in even mild deflation.  Japan’s real estate and rents underperformed the general price level more than 20 years after the event horizon. 

Japanese petroleum product prices (distillates and crude quotes) proxy the commodity complex in the Lost Decades, and it doesn’t bode well for the commodity melt-up going on right now.  Roughly two years after the real estate crash, petroleum products in Japan saw a hefty spike, and then utter collapse.  It took fifteen years for it to recover.  We saw another megaspike in 2007 and then implosion.  Past is prologue.

Note what outperformed the general price index over the whole time period consistently?  Electricity, gas, and water charges.  Utilities:  the premier investment in deflation.

Eclectic Swaps in Frozen Intervals:  Debt Deflation Positioning

Selected CDS are popping already, in ways that make me think their pricing is close to sadism.  So I have a lab-works idea:  trading delusional recovery rates.

This view is constructed by bundling a standard CDS with a Digital Default Swap (DDS).   If there is a credit event over the tenor, the short recovery rate side will profit from buying defaulted debt at a lower price than the implied recovery rate.  So if the implied recovery rate on the trade date is 40%, and the reference entity experiences a credit event, buy the bonds on the market at, say, 20% of par.  Receive 40% implied notional and deliver the bonds into contract, and net 20% times notional on the trade.

This strategy could be traded on credit derivative indices.  Without being too specific, I worked through some very assumption sensitive trade P&L, and the choice is between the anti-alpha (picking single-name losers) strategy and the liquidity benefit of indexing is unclear to me.  I likely don’t know as much as some of you do on this issue.

Super-Cooled Bose-Deleveraging Condensates

Don’t expect an economic ice age—such extreme deflation is too dark and troubled to ponder anyway—but do expect years of silent fields and pale winter light.  Remember that when snowflakes dance under bleak cloudy skies they are still beautiful when you look at them.   

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Anonymous's picture

And yet the Grasshopper continues to play and cavort in the meadow enjoying the sun. The Ant is aware that the sun is setting and continues to put away harvest for the coming winter.

I think the rest of this story will see the harvest wiped out and both Grasshopper and Ant freeze or starve in the ice winter grip.

There is a moral to the story. The market will always be liquid longer than you.

Anonymous's picture

i agree - there is a real crap storm coming when rates begin to rise.

Anonymous's picture

"If the United States has to raise interest rates to protect the dollar, it’s all over."

Which is precisely why Fed-controlled RATES ARE NOT GOING TO RISE until some far-off time when banks are completely solvent, non-defaulting housing prices have significantly recovered, consumer debt has been meaningfully reduced, and headline unemployment has dropped at least 4 percentage points. The stock market, bankers bonuses, health care reform, financial reform, who wins the next elections, who runs the Fed, etc etc, are completely irrelevant.

Repeat: There isn't going to be a "real crap storm" from rising rates, because RATES ARE NOT GOING TO RISE for many years. There are many other places a storm can come from, but not from rates.

Psquared's picture

Agree with this ... but I would add that deficit financing is an additional reason rates will stay low.

Anonymous's picture

Rates will be going really soon.
Those mortgages that ARM's need to be foreclosed on yet just like the subprime ones. The bankers want those homes back. Subprime was just phase one .; ARM's will be phast two. For that to happen rates will spike up, putting many millions more out of there homes. Thgis is always ans through history been about bankers confiscating real estate just before the hyper inflation comes.

mathdock's picture

Rich imagery while painting such a sorrowful picture.  Kudos!

Whether/When it comes to pass, we'll know before much longer.  I think I'm a Kodiak, not a basic Black.  Buying the canned chili and corn as we speak.  Bags of corn meal, too!






anynonmous's picture

poetic post

years of silent fields and pale winter light

snowflakes dance under bleak cloudy skies


(JM - you need to finish this)

jm's picture

Between passion and austerity,

A white light inside the womb.


BTW, reminds me of the JAL stewardess Robottrader posted.  Remember her?

Mad Max's picture

You might want to read up a little on ideal storage foods, because those aren't them.

Slash's picture

soooooo, what you're saying is if the US tries to raise IR....which they will have to eventually....everyone who borrowed dollars and bought assets X Y and Z will run to the exit and sell X Y and Z to get those dollars back. Dollar up, XYZ down, carnage and chaos ensues.....


gold (long term) bitches.

Assetman's picture

To extend on Slash's thoughts, how low would the USD have to go to compel the Treserve to push up interest rates?

BTW the OP talks prettier than a $20 whore...


jm's picture

If dollar makes a move below their range of comfort, or a sudden multi-sigma move, they will defend it.  These kinds of things are outside of model, and it would justifiably scare them.

They want a cheap dollar.  They don't want a dollar worth zilch.


bugs_'s picture

Remember the declining velocity of money

will seem like a gentle breeze from the

north with tiny pellets of ice tapping your


jm's picture

Even mathematicians get crazy sometimes ;)

Mr Lennon Hendrix's picture

An arctic tundra before a meteor blast; deep solace.  The trees will burn, the snow will melt.  Fire ravages all but the wind.  Precious is the wind.  Precious is the force who brings the fire to the furnace.  

No entiende?  Pray for rain.

Comprendes?  Buy Silver.

rapier's picture

There has to be a stock sell off to delay the rate rise.  Another flight to quality and dollar swoon will be just what the doctor ordered. If that isn't the game plan let me know.

A little swoon and some more bearish talk about the second half. Presto, money flows into bonds and then we get QEII and the bulls take heart again.

Mr Lennon Hendrix's picture

right right.  correction, agreed.  10%-15% hows abouts?  flight to quality?  Absolutely.  To the Doe'Lar?  Holy witches Batman!  Do not drink the brew!  Quality the Doe'Larr is not!  Catch a ray of light in a bottle.  Try.  The alchemy is all in their headz...stupid Masons/'Mericans.  From stocks to...commodities.  The Doe'lar is dead.  Weekend at Bernie's 2?  Sequels are lame.

Mr Lennon Hendrix's picture

Since that post was flagged as junk, lets do this.......if you got punched in the face by an icecream man for buying his icecream, why would you buy more from him?  If you went long the dollar a year ago, what did you get?  A punch in the face!  Do not think the rest of the world is stupid.  Nobody likes to be boxed unfairly.  Foreign holders will all sell their Doe for commodities next time around. Whoever does not will have a lot of green wallpaper.

Junk this!

dnarby's picture

Sounds about right.  I'm thinking no new lows until QE v2.0 epic fails.

Anonymous's picture

Skew is an attribute of differing strike volatility, not whether it is a put or a call. A put and a call at the same strike always have the same implied vol. Because, well, you know, a put and a call are the same when they are are hedged appropriately with the underlying. Kurtosis is deviation from the standard B-S Gaussian implied tail probabilities, almost always implied options vol ladders exhibit kurtosis because nobody wants to short deep out of the money options for a penny. That is to say, the locals are always bid for deep out of the money strikes because the clearing firms VAR margin models can be tweaked by owning the little 'uns and shorting the living daylights out of the at-the-money strike.

Anonymous's picture

I'd prefer my financial analysis in haiku format, please.

Anonymous's picture

dollar petals fall
federal residue
buries the world

strike for return to reality's picture

mighty empire dead

blossom of love republic

the squid eats paper

Anonymous's picture

I don't know if this was a pricing mistake, but I bought a few cases of Prolab Meal Replacements for $32.47/20 Packs on 01/04/2010. I wanted to buy a years worth to get ready for any disaster/inflation. 01/08/2010 the price had gone up to over $53.00/20 Packs.

TimmyM's picture

Welcome to the dark side. An extraneous event will spike the dollar and force unwind long before a rate rise IMO. Stocks will start a gentle correction on worries over no recovery and just a MSM cries buying opportunity some geopolitical spike will break all hell loose. I hope we can audit the Fed by then. It must be true if I can dream it.



vainamoinen's picture





sunlight shining on white snow,


an icy breeze rustles the barren birch trees.


sound and light, one and the same;


sound is god, light is god.




the infinite, eternal,


dark and void




of Black Madonna.



Soon we will all be summoned to prostrate ourselves before Her throne.

Missing_Link's picture

Black Madonna can stay the hell away from my prostrate, thank you very much.

Anonymous's picture


Väinämöinen is the central character in the Finnish folklore and the main character in the national epic Kalevala. Originally a Finnish god , he was described as an old and wise man, and he possessed a potent, magical voice.

. . .
Tolkien indicated that his stories of Túrin Turambar were a retelling of the Kullervo myth from Kalevala so it is possible that similarities between Gandalf and Väinämöinen were intentional or unconscious rather than coincidental.

strike for return to reality's picture

In a normal world, a rise in the interest rates of the dollar would be expected to result in a rise in the value of the dollar.  (This is what happens in every other currency, well maybe not Zimbabwe.)

However, the ROW (rest of the world) has various countries who have large piles of USD, not because they borrowed them (or even really want them).  China, of course, is first place on this list. This is very different from the situation with the Yen carry trade (where it was mostly Japanese who had big piles of Yen because they figured that saving was a good thing to do).

If the USD carry is not like the Yen carry, we should not automatically assume that an increase in USD interest rates will produce an outcome seen in other carries (such as the Yen).

The most obvious alternate outcome would be that the Chinese use a little bit of USD strength to dump as many dollars as that strength allows.  In this scenario, interest rates might rise quite a bit before China has disposed of all of its dollars.

Actually, I will take this a little bit further.  A rise in the USD interest rate, may (by allowing China to sell its USD without market disruption) result in a further rise in prices of the commodities that China is most interested in acquiring.

Why does everything seem to work out in China's interest?

Perhaps because the vampire squid that owns Treserve has gutted the USA in manner that makes the Russian oligarchs look like boy scouts.

MrPalladium's picture

+1 "The most obvious alternate outcome would be that the Chinese use a little bit of USD strength to dump as many dollars as that strength allows.  In this scenario, interest rates might rise quite a bit before China has disposed of all of its dollars."

And thus the rising rates produce a rising dollar during the selling, thus allowing the falling prices on their treasuries to be counter balanced by the currency gain - provided that China is willing to lift a leg on its currency peg, which it would do because while allowing the yuan to fall as the dollar rises would anger the U.S., it would certainly goose China's trade surplus vis-a-vis the rest of the world.

If the U.S. stagnates this option will become compelling for China and it is something that everyone would be advised to watch for in their charts.

Hephasteus's picture

You can't carry trade a nation without savings. Which is why the proposal that China carry trade the dollar to get it's money back was rediculous. That would have run at an inflationary pace that was unreal. It would have made zimbabwe look like the kansas flat lands.

crzyhun's picture

I' m amazed at this analysis!

trav7777's picture

Yen carry unwinds first, Japan defaults.  This is/was my prediction.

Carry unwinds will be what it takes to make them full-on devalue/print.

They will institute capital controls to prevent this, full on trade war etc.  BRICs will not let the BOJ or Fed destroy their economies with paper BS.

strike for return to reality's picture

The very idea that there can be over all deflation in a period of such extensive QE (Quisling Enormous?) should be put to rest.  (That it is not put to rest is because it is essential to create worries about the prospect of a deflation to allow Treserve to sell debt and do QE.)

Actual deflation destroys Treserve and the vampire squid. It must be common knowledge by now that the deflation of 2008 would have bankrupted the squid except that Treserve gave money to AIG to pay to the squid to keep it solvent.

During this period of economic hardship do some prices fall?  Yes, a large percentage of the productive sector has been screwed by the thefts of the squid.  If you've lost your job and all your neighbors have, too, you might have to sell your house for a bus ticket to a place with jobs.  Look at house prices in Flint, Michigan.) Likewise a long list of other things.  However, the squid has not yet stopped the dispossessed from eating or heating their apartment, etc... so prices for food and energy rise.  (More money chases the same size pile of goods.)

However there has not been serious debt default deflation because Treserve buys bad debt at more than its actual value.  (Probably all to often at face value.  Wouldn't want a bit of an audit to find out though.)

What there has been is, of course, a renewed asset bubble.  Treserve has done its best to direct this bubble in its approved direction (read stocks and real estate).  So far, so good with stocks.  So far, not quite so good with real estate.  (However, a smaller decline is still a relative success, and my view is that we've seen this in real estate.)

Treserve needs to have inflation.  (For several reasons, not least of which is that it needs the MBS on its asset list to inflate to the face value that it paid.)

The United States govt is a borrower on a massive scale.  Deflation would destroy it.  Inflation will whittle its debts away at the cost of those nations which own US govt debt.

When Treserve needs inflation, Treserve gets inflation.  They don't call him "helicopter boy" for nothing.

Perhaps another poster would care to pick up on why Larry Summers* is the Q (Quisling) in QE.


* Posts about why Summers is also the Enormous in QE would be in bad taste and not PC in a world that should not laugh at fat people.

TimmyM's picture

Why has Japan failed to stop deflation?

strike for return to reality's picture

I don't know enough about Japan to make a serious suggestion.  My guess is that an extreme tendency towards saving (Yen) by the Japanese people is the main factor.

The point of my post is that the USA is not like Japan. 

MrPalladium's picture

+1 "The very idea that there can be over all deflation in a period of such extensive QE (Quisling Enormous?) should be put to rest.  (That it is not put to rest is because it is essential to create worries about the prospect of a deflation to allow Treserve to sell debt and do QE.)"

Brilliant insight.

Although private debt is falling, the gummint (federal and state) has been adding debt more than sufficient to offset the private debt decline up until now. But as the Treserve plays its temporary game of chicken with the oncoming train of deflation and QE-1 tapers off, debt will begin to decline. The popular stock averages could take a nasty tumble into late summer 2010 until the Treserve jumps off the tracks and into QE-2.

Anonymous's picture

Good Lord.

I guess this answers the age old "how many quants does it take to screw in a lightbulb" question. "They don't know but they'll run regression on it and build you a model"

Lovely writing but dumb analysis presumably written by someone too young to remember 1991 and with no grasp of commodities.

The, ahem, spike in 1991 was due to this little thing called the first Iraq war and most of the "deflation" in petroleum products had nothing to do with demand as you seem to imply. The main imput cost is crude and that was falling for much of the 1990's on supply and because the Yen was gaining on the dollar and dropping the input price - in Yen terms - until the late naughties move (in the world price) and weakening Yen drove it higher near the end of your graph.

I don't discount the dangers but there are way too many people around who try to make direct comparisons of the US and Japan (which are both screwed balance sheet wise now, agreed) that ignore things like a massive appreciation in the Yen after the kaka hit the fan in '90. With QE galore, rock bottom rates and a wrong way rate spread that outcome seems pretty unlikely in the US. Japan was in aggregate a massive creditor nation through most of the lost decade (s) - the US, not so much.

jm's picture

The main imput cost is crude and that was falling for much of the 1990's on supply and because the Yen was gaining on the dollar and dropping the input price - in Yen terms - until the late naughties move (in the world price) and weakening Yen drove it higher near the end of your graph.


Isn't that part and parcel of a carry unwind?

mrmortgage's picture

The Google Charts are pointing to a very tough year economically. I learned a long time ago to watch behavior and action above all else. I do the action test when out in the real world. Full Post here..


Not Just[ Jumbo Loan]( "Jumbo Loan") Talk Either.

jm's picture

Options traders understand skew well because it affects the value of buying a call to offset the value of buying a put. 

The article should say selling a put.  Sorry.

Anonymous's picture


long call + short put (same strike) = long underlying future

usually referred to as a combo, the price always equals future - strike. There is a lot to say about skew, but first you should know what it is.

jm's picture

You make me frown 'cause I'm thinking of the vol smile.

Anonymous's picture

good article.

Maybe the US $ will ask before he goes up in ZH for permission. Also gold before its going down (deflation).

Anonymous's picture

LOL and they'd shorting this rally, so contrary from SA readers is the best way to make money, a lot of money.
When the carry trade unwinds, after 1 - 2 month they will feel it. To late like always. ( I m wondering why they always need months to understand a 2 month old situation. For the actual situation thy need other 2 month.

jm's picture

You think that was it?

That's like losing your virginity to a turtle, dude.


Anonymous's picture

No jm, I dont think "that was it"
I know the situation is very bad.
But I know the ZH readers are always to late to understand a new trend. See the carry trade, this i the new trend
US $ up, gold down, commodities down, oil down,
stock down. For ZH readers gold is god.
I m short commodities, oil, now stocks.
I m not care about bens ( taxpayer ) money, he will lose the fight.

Anonymous's picture

Why not just buy the dollar?