As recently as 9 months ago, it was easy to find a quote by anyone (your author included) that inflation seemed to be running rampant. Crude oil was pushing new highs, grain prices were exploding, meats and soft markets were running up as well. The prevailing fear was, as the US entered what we thought to be a simply downturn, cuts by the Fed would lead to extreme levels of inflation. Gold would go to $5,000 an ounce, crude would trade over $200, the cash strapped, debt-laden consumer would be in greater trouble.
Flash forward to November. Crude has fallen over 60% from its’ peak prices. Grains have given back 30% or more of their gains. We are now in a new paradigm, deflation. On the surface, lower prices are good for a consumer that is more focused on making their mortgage payments than buying a new plasma TV. Lower gas prices and lower food prices would seem to benefit individuals, and it will over the short term. Typically, reductions in inflation that are lead by commodities markets are beneficial because it increases consumer’s real income. The problems pop up as you look towards the future, when prices fall too fast in too short of a period.
As futures traders, we are always watching the horizon for things to come. We trade markets for delivery months in advance, so our prices are not a representation of a discounted net present value. We are looking at what might be. The unfortunate offshoot of deflation is that debt becomes more costly to those who hold it. Following economic dictum, households that are debt laden will be more worried about paying off loans more rapidly. One only needs to look at the first and largest level of personal debt, mortgage debt, to see just how much the US consumer owes. It is not a pretty picture. It seems we are headed to an economically disastrous condition known as debt deflation. Debt deflation will have consumers and companies rushing to pay off debt as credit further dries up. This will lead to further price cuts at the retail level and more demand destruction on the product level. Deflation will in fact increase the real cost of debt, which is already historically high. Consumers recent reluctance to spend and borrow coupled with the banks ever tightening credit requirements are exacerbating the problem.
So now that I’ve told you where I believe we are, as a futures trader it is my duty to tell you where I think we will go and how I believe you can follow the trends that debt deflation will lay out. First, I’d like to make the case that commodity trend following (which has done very well during this economic downturn) will continue to do well in this climate. In a debt deflation cycle, real interest rates tend to fall. In the case of the US, I believe the Fed Funds target rate will be cut to .50 in December and further cut to 0 during the first quarter of 2009. I believe the way to play this is to be long Fed Funds futures contracts. Many of the trend followers that we employ are currently positioned this way. In the same way, I expect bond prices to continue to trend upwards across the yield curve. Again, many trend followers use global interest rate markets to trade. Most mangers are positioned long bond prices in the US as well as around the world as this debt deflationary cycle spins from the US across the globe.
The second trade, or method to trade, is one that is long volatility. In this climate, the options markets continue to price in an extremely volatile climate in the global equities markets. Typically, in a high volatility market, S&P 500 swing traders and index speculators tend to outperform. The markets, with their daily swings of hundreds of points, are not expected to slow down any time soon.
So, instead of fearing debt deflation, make it work for you. Your trading theme in 2009 should not be to hide. The money being lost in the market is not vanishing into thin air, especially in futures. Our markets are a zero sum game. The goal is to find yourself on the right side of the trade. If this debt deflation cycle persists, I believe that trend following and long volatility S&P speculators will outperform other methods.
Disclosure: no positions
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This article has 15 comments:
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investor88
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748 Comments
Nov 19 08:02 AM-
Gem Hudson
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23 Comments
Nov 19 08:58 AM-
long_on_oil
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104 Comments
Nov 19 09:15 AMEverything is tied to the price of oil because it is used in producing all goods and services. The price of oil is very fragile because it is based on such a small gap between supply and demand so in the future we will continually experience the current type cycle we are going through. High oil prices=recession, low oil prices=recovery and on and on.
As investors we will just have to be smart enough to get out before the peak and get back in close to the bottom (like now).
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PrudentMan, CFA
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153 Comments
Nov 19 09:18 AMAs we know from our economic history, it is politically difficult to sop up all this excess money. With the House of Representatives incumbents running every two years they (a good reason for Congressional Term Limits) put tremendous pressure on the "Central Bank" (which is supposed to be independent and fifty years would have opposed the moniker) to keep the spickets of monetary supply flowing.
It is inflation we must concern ourselves with. Deflation is self correction unless our Administration makes the mistakes of FDR by exacerbating the problems by destroying incentive and then only bailed out by Hitler's invasion of Poland, contrary to what the historical revisonists say.
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James Blount
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3 Comments
Nov 19 09:42 AMThis is BAD.
Disinflation is when prices fall, though nominal growth may remain positive. This situation may occur, but is far too close to deflation for comfort.
Worry about excess money when the worst of evils, deflation, is gone.
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Danmcl
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7 Comments
My Website
Nov 19 10:49 AMThe sad fact is that a massive deflation is possible, only because of the massive inflation that distorted markets, incentives and expectations. The fiscal and monetary authorities ar taking steps right now to ensure that we will have another massive inflation, tremendous credit and asset bubble and an even worse collapse not too many years into the future.
It should be apparent in the next couple of year what assets will be the primary bubble market.
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James Blount
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3 Comments
Nov 19 11:24 AM> Mild deflation is no worse than mild inflation. Markets can
> adjust their expectations.
I suspect "markets" may adjust but people, especially the poor, may have less flexibility.
Have I misunderstood the history of the 1930's? - surely, even "mild" expectation of deflation was an intractable and chronic economic condition, more corrosive than inflation expectations?
> It should be apparent in the next couple of year what assets will
> be the primary bubble market.
I envy your clarity, and would welcome any concrete recommendations?
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carey_jim
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552 Comments
Nov 19 11:49 AMAlso, deflation is not bad in itself unless it is extreme. Just like mild inflation, mild deflation can be a good thing.
When prices are continually dropping, people are encourage to save to buy things in the future but they are also encouraged to buy now, especially if they (like us) have experienced inflation all of their lives.
We are used to that concept when we purchase electronic equipment: I can by a Dell Latitude for a few hundred dollars that would have cost me two thousand only five years ago. This is true for almost all goods that are dependent on technological advancements.
For people who are cash rich, deflation makes everything cheaper and that can't be a bad thing (unless you are an economist of course ;)
Bring it on!
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popcorn65
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1 Comment
Nov 19 12:49 PM-
L. David
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1 Comment
Nov 19 02:30 PML. David
On Nov 19 08:02 AM investor88 wrote:
> Good article particularly the point about the high cost of debt in
> a deflationary environment. Although interest rates are low, the
> cost of debt is high due to deflation of assets as people and companies
> rush to deleverage.
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Elaine Supkis
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60 Comments
My Website
Nov 19 03:06 PMIt is the same today. As soon as OPEC tightens oil, the tensions caused by low oil prices in the Gulf will lead to insurrections and wars and the price of oil will shoot up again, triggering more inflation.
The US is far, far, deeper in debt this cycle. We were barely in debt during the seventies and we were hammered by high oil prices/high inflation waves that led to interest rates rising to over 12%.
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swaps
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81 Comments
Nov 19 03:36 PMBut it appears much of the new money being created out of thin air is just to plug huge holes on balance sheets where credit (money) has evaporated. While there may be trillions of new "dollars" out there, are these dollars not actually just credits - obligations to be repaid? because that is what modern fiat money is. A credit against a debt. Much of the private debt has truly evanesced into the mist, never to be seen again. Thus fiat credit dollars have been lost forever.
Inflation is caused by huge buying pressure from below, which pushes up the cost of goods. But excess compensated rich people can do even more to push up inflation through leverage. Really rich people had so much excess money they turned it over to hedge funds, which then borrowed "out of thin air" money manufactured by the banks to leverage their rich people's contributions 10 fold or more. Then this out of thin air money was unleashed to buy up the prices of stocks, commodities, non-existent fraud mortgages etc. Basic commodities like energy got pushed up so high by this hot air money the buying pressure obviously exceeded the actual buying pressure from fast growing countries competing for post-peak oil. In turn, the consumers had to stop buying so much of a high priced commodity.
You can only deductively reason that the out of thin air inflationary dollars overpriced tangible assets from oil and steel to Brandywine Real Estate Trust and Freeport Moran and Fortress Investment Group. Because no tree grows to the sky, the puncturing of the containers holding these hot air credit dollars did indeed evaporate into thin air.
There does not seem enough hot air dollars salvaged in reserve to pump up asset classes anytime soon. That will require banks to start pumping credit dollars out of thin air again, but they are reluctant to do so.
And we will not have inflation until conjured up credit-collars are once again in the hands of the little people at the bottom of the pyramid.
A 5.8 percent payment boost for Social Security recipients is a start, a weak start, but a start toward getting money lower down on the social class structure.
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kurt walter
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409 Comments
Nov 19 05:32 PM-
johnny2chord
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1 Comment
Nov 20 09:53 AM-
still renting
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144 Comments
Nov 20 01:15 PMAlso, I believe it would take quite a while for the presses to print enough hard currency to actually back all the "virtual money" created by the credit bubble, even AFTER it crashes. If this is true, the amount of money being printed is but a drop in the bucket regarding real money supply. I could be off on this though.