Deflation trade returning?

While Americans were on holiday, the last couple of days have seen some exciting market action. Stock indexes around the world declined roughly 3-8%, “safe” US and German government bonds rallied, and the dollar plunged to a new low then rebounded very strongly. Gold made a new all-time dollar high at $1196 as the dollar made its low, but when the buck turned yesterday gold plunged to $1130 as US stocks futures (which traded round-the-clock through the holiday) wiped out two weeks of gains in about 24 hours. Higher yield currencies such as the Aussie, Kiwi and South African Rand fell 3-4%, oil extended its decline to under $75, and copper got smacked $0.20 off its new high. One spot of green was natural gas, which extended its bounce to 14% off an area of strong technical support.

Gold showed us what can happen to a levered market after a parabolic move breaks its uptrend. In the wee hours today, it fell $55 in just two hours before rebounding right to resistance (the previous support at $1180, which when broken, precipitated the crash). Here’s a chart of the last two days:


Commentators blame the Dubai default for this week’s gut-check, and the event may have acted as a catalyst, but the fact is that the risk/reflation trade had reached new heights over the last couple of weeks on a wave of complacency. Early this week the VIX nearly hit the teens and the daily put:call ratio put in a super-low print, while the Nikkei, Treasuries and yen offered warnings that all was not well. Browsing through the world index charts on Bloomberg, it is striking how few other markets have followed the Dow to new highs this month. The troops have been losing heart since summer as the generals kept charging ahead, a classic case of inter-market non-confirmation, which can also be seen in the weak action in small-caps and sector indexes like the transports, financials and utilities.

In last few trading hours of the week (this morning), many markets staged a very sharp recovery, as you can see here in this 1-month view of S&P futures:

Source: Interactive Brokers

Today’s pattern played out in nearly identical fashion in oil, gold, silver and other stock indexes. The stall point offered a clean spot for initiating or adding shorts, and those who did so were rewarded nicely in the last 30 minutes of trading as everything sold off quickly.

Next week should be very interesting. The risk trade plateaued for the last two weeks and went through the usual distributive action, so I have been expecting a down leg of some magnitude. Wouldn’t it be nice if this were the one to finally put a nail in the reflation coffin? I am sick of this market, as would be anyone who understands how far out of line these prices are with value or economic reality.

As Dubai’s default reminds us, this credit bust is far from over. There are still trillions and trillions in bad debt out there, and nearly every major bank in the world is still bankrupt and contracting lending (down another 3% in the US in Q3). We have all the hotels, condos and strip malls we’ll need for ages, and the consumer culture of the late 20th and early 21st century is just an unfortunate historical blip. Don’t tell that to Wall Street equity analysts, though — they still think the S&P will earn over $60 next year, just like in boom-time 2005.

PS — check out Dave Rosenberg’s latest essay for a good commentary on the week’s action. You have to sign up, but it’s free.  Click here.

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16 thoughts on “Deflation trade returning?

  1. glad to see you’re back Mike :-)
    I’m still believing on an almost worldwide deflation, but I’m also still long gold while being massively short the equity indices and long the usd versus de euro. the reason being that when sovereign bonds starts to be defaulted on (like dubai…), gold should rise as the only safe place…. wait&pray

  2. Hey PEJ.

    Nothing wrong with the short stocks / long gold trade. Even if gold falls, stocks will fall more. I bet gold will go up 5X or more against stocks in the next few years.

  3. On that note, the average month’s rent in a 1BR Manhattan apartment has gone from 8 ounces in 2000 to 6 in 2005 to 2.5 ounces today.

  4. Very true, on that one, I would tend to disagree with Marc Faber who says the peak of prosperity will be 2007. I think it was earlier, in 2000 or 2001, when gold was bottoming and the nasdaq bubble at its peak.

    Also, I wouldn’t see a decoupling between gold and the USD, and see gold rise in relative terms against the USD and in absolute terms against the baskets of currencies.

  5. This whole market, it seems, is driven by excess liquidity provided to banks via QE. The 1T in excess reserves is being borrowed at zero % and is used to purchase every asset under the sun-including treasuries, equities, and commodities.The low interest rates are squeezing the little guy into riskier assets also.Since QE and zipr likely won’t end for years, one can see the general direction of the markets for the foreseeable future-bull markets in all of the above. This excess liquidity can not be used to affect forex, which, in my opinion, is the only honest market at this time. So, as the dollar continues to crump unabaited, every import eventually becomes more expensive, and the prices at stores rise, who is going to argue that we don’t have inflation but rather deflation because”money and credit” are contracting. The end purchaser of products at the grocery store is only going to see higher prices.

  6. Even if QE ends and the US consumer pulls back because of higher prices and unemployment, the amount of money sloshing around the system already will put a bid under all asset classes. I have noticed an unannounced change in Rosenberg’s predictions- he now feels the equity markets are only approx. 20% overvalued. I wish he had said that three months ago. Instead, he seemed to imply that equities were grossly overvalued. This clearly did not take into account that the bank’s excess reserves are not just sitting in vaults but are actually being used to purchase real assets.

  7. PEJ, the current scenario is somewhat different:
    1. I don’t know why, Japanese banks did not buy risk assets as a result of their QE, American banks, I believe, are doing that. This may be a cultural difference. Thus, US equities will have a bid under them, unlike their Japanese counterparts.
    2. I don’t know why, the yen did not get squashed as a result of Japanese QE, thus they saw no price increases. This is the opposite of the dollar – we will likely have price increases as the dollar drops inspite of all the hand-wringing about the definition of deflation.
    3. 1990′s Japanese QE occurred only in Japan. Today, it is global, so there is a lot more money chasing assets. When will that end?

  8. I’m not sure where your getting your statements/assumptions from, but maybe it would be worse documenting them.
    Regarding QE, japan has been doing it for ever, along with the carry trade. They still had deflation. At that time, the real estate bubble was in Japan only, now it’s global. Same causes should cause the same effects.

    Also, not sure where you get that banks are buying risky assets, investment banks do seldom hold those risky assets.
    Excess reserves are not just sitting in vaults because:
    1- they do not exist, they are just accounting gimmicks because m-to-m has been removed and losses unrecognized
    2- even if they did exist, they would be sitting at the Fed, earning them a few % a year, since Bernanke decided to recapitalize banks by paying interest on reserves. This is going to take another 5-7 years to achieve, provided no further losses are incurred.

  9. Leonard,
    Try not to get confused by the term “liquidity”. The financial press and Fed love to use this term as the reason assets go up and down. It gives people a sense that asset prices can be controlled.
    In its simplest form liquidity simply indicates your ability to transact without moving the market. Liquidity as you have used it simply refers to confidence. Take any sentence with the words “excess liquidity” and swap those words with “excess confidence” and it will still make sense. Assets were high in 06/07 because confidence was high. Then they started falling because confidence was damaged. True liquidity only briefly disappeared around Nov-Dec 08. Then confidence bounced back. If confidence turns again assets will fall regardless how much the fed will pump them up….

  10. If “excess” reserves were being used to purchase assets they wouldn’t be showing up in the excess reserves accounting either.

    A lot of speculators are taking out a lot of loans at 0-0.25% to place momentum trades in asset classes of all kinds. This is essentially a “selling dollars” trade and it will work until it doesn’t. Debt-financed asset markets are inherently unstable and highly susceptible to downside price shocks.

  11. The excess reserves that the Fed has bestowed upon the banks free up other funds which they would have had to hold as reserves without the Fed’s kindness. They are the main speculators. GS and JPM are now the main traders on the NYSE. Other banks are probably buying treasuries. How else could you have a bull market in risk assets and derisking assets at the same time, coupled with a falling dollar?

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