One of the once again widely accepted market certainties is that the economy has now openly reentered a deflationary phase. Nothing surprising here, and it is consistent with huge demand for UST paper, as every incremental auction demonstrates, an outcome that will eventually confirm yet again that credit is leaps and bounds ahead of stocks (today's most recent record of gold priced in Euros is not an indication of inflation or deflation, but merely of mistrust in paper - a totally separate dynamic). Yet, as always, the market is not efficient, and does not exist in its own vacuum - every analysis about market trends has to include at the very top, an assessment of what the Fed will and will not do. And the Fed is fully determined to inflate the economy by any means necessary: the debt maturity cliff in CRE, in Financials, and even in the LBO HY names, is rapidly approaching (yes, that long REIT trade may soon be in jeopardy if nothing is done to "fix" the first issue). Therefore Bernanke has T minus 2 years and counting to pull an ink-stained rabbit out of his monetary printer. The problem, as David Rosenberg points out in his letter from today, is that due to the short maturity profile of government paper, an all out attempt to reflate will certainly lead to that most expected black swan of all - a failed bond auction, absent fully-blown debt monetization. It would also have various other unpleasant side effects, such as a complete eventual collapse of the economy, which is the second backstop reason why gold will likely continue going higher, despite numerous risky-asset liquidation episodes still to come.
Some more perspectives from Rosie:
IT’S STILL ABOUT DEFLATION
Maybe this is why Bill Gross was rumoured to be in buying long Treasuries late last week. It is never too late to change one’s mind, and secular trendlines offer all sorts of opportunities to do so. Imagine the labour market softening at a time when underlying inflation is running below a 1% annual rate. And, we haven’t even seen the full impact of the stronger U.S. dollar and the pullback in commodity prices hit home yet. If German bund yields are heading down to 2½%, make no mistake — Treasury and Canada yields are not far behind.
We highly recommend The Deflation Dilemma (page 18) and A Winding Path to Inflation (page 84) of the current Economist. The second article is particularly enlightening because it shows how ineffective a policy aimed at creating inflation will be because the bond maturity profile of most industrialized countries is short. Over half of U.S. government debt and 40% in Germany and France roll over within the next three years and so an overt policy to inflate away the massive public debts will be self-defeating if the bond vigilantes demand a higher premium upon refinancing time. Besides, an inflation-is-always-around-the-corner culture still permeates most central banks: the Bank of Canada hiking, the Fed district banks clamouring for a rate hike, the tightening moves this year by India, Brazil and China, as well as the refusal on the part of the ECB to go beyond shifting the composition of its balance sheet and actually expand it in a classic quantitative-easing style.
The biggest problem here, as in dealing with North Korea, is assuming rational behavior out of the Fed, namely one which seeks the best possible outcome for as many participants involved. This is very flawed assumption. The Fed will merely do what is in the best interest of the Wall Street oligarchy, and will most certainly ignore the implications of an increasingly diluted US balance sheet, which even without a new episode of QE, is currently ongoing courtesy of the massive incremental losses incurred by Fannie and Freddie, which have become nothing but a backstopped trash receptacle for all the worst paper in the US mortgage market. The fact that these are still not on the official balance sheet is nothing short of a travesty. Yet even the marginal benefit of GSE dilution will end, and at that point the Fed will be forced to flood the market with even more money. And as we learned over the weekend, the ECB is unlikely to follow the Fed into this most recent printing bonanza. This simply means that the euro will keep on dropping up until some point, at which point the focus currency of devaluation will once again become the dollar, as the schism between the Fed and the ECB becomes fully-blown. At that point, expectations of a controlled deflation or inflation will go out of the window, as we will be in an unprecedented environment, where no historical parallels have any application. At that point, the only safe-haven will be non-dilutable assets, be they vulcanized tires, wheelbarrows, gold, and anything that the Fed can not print billions of on a daily basis.