Flation, From “In-” To “De-”
Remember the days when Goldman Sachs were calling for US$200/bbl oil, the ECB’s Jean-Claude Trichet was hiking rates, lamenting the tyranny of a European ‘wage-price’ spiral, and a US congressional panel launched an investigation into food price inflation?
Well, all that happened within the last eight months. How times have changed.
If you were looking for a trigger for this week’s disastrous downlegs in financial stocks, including the venerable Citigroup, you could do worse than point the finger at this week’s consumer price data. For it revealed a lender’s worst nightmare: deflation could be around the corner. To put it simply, inflation helps a borrower, as the real value of the debt that he took out falls over time. But deflation hurts a borrower, as it increases the value of the debt. And because deflation almost always occurs during an economic slump, it comes at a time when borrowers are least financially able to make their payments, which amplifies the pain. (Sorry to be so simplistic about it, but given the market’s apparent surprise over the recent economic data, I’ve been thinking that the basics need to be spelt out.)
Now, by that logic, deflation should be good for the lender, because the real value of the money coming to them is increasing. But that is only a good thing when they actually get paid back. The banks, already burdened with bad assets, are seeing the situation go bad to worse. Rising unemployment of the kind we have seen in recent months is kryptonite to consumer-related asset backed securities, like credit card debt. The final insult was the US Treasury’s back-pedalling on the TARP programme, declaring that it was no longer going to be used for troubled assets, but rather for buying equity stakes in troubled banks. In doing so, the troubled banks have become even more troubled, as they are suddenly unable to unload their toxic junk onto the government. Spreads on asset-backed securities have consequently blown out across the board, including for AAA-rated commercial mortgage backed securities and junk bonds of all kinds, as pulling the TARP out under the debt markets has removed any semblance of a price floor.
I’ve been on the deflationary theme since mid-2008, when it looked like the dollar could rally (it did), oil could dump (it did, and how), the US economy would slow (with a vengeance), and emerging market central banks would tighten policy to the limit (they did). And now that the market is catching up to the ‘de-’ rather than the ‘in-’, equities are justifiably making new lows, and safe-haven debt instruments like US Treasuries have seen yields hit rock-bottom.
But surely the US Federal Reserve is doing enough to stop the deflationary madness, right? The short answer appears to be, ‘no’, at least as far as the investing public is concerned. The breakeven rate on US 10-year inflation-protected securities is now dangerously close to zero, indicating that investors do not believe that there will be any inflation in the United States over the next ten years. Of course, there are a few tricks that Ben Bernanke and company have not yet pulled out of the bag, but the contents of that magic bag are thinning by the week. We’ll deal with those tricks, and the potential for deflation turning to hyperinflation (yes, seriously), in a future post.