Deflating the Disinflation Trade

Markets are in flux while business writers, raring with artistic assumptions, crouch across inkstands and splatter ink – flecking fresh paper with captivating idioms, coated with technical guff.

Brazen stories warning readers that there is no escape from a currency war in our disinflationary spiral, that central bankers are losing their grip on the economic situation, or this race to the (interest rate) bottom is causing more harm than good, fall upon the facts and figures like firstly snow on a sidewalk, blurring outlines and covering up all the details.

At the surface, markets look fairly ho-hum with 2015 year-to-date performance of the U.S. dollar index +4.88%, gold +4.75%, U.S.10-year Treasury yields -.70bps, WTI -0.52%, and the S&P 500 -0.59%. However, make no mistake about it: Our world is overlaid with widely contradictory growth prospects and central bank divergence and thus, bouts of volatility and periods of hard-driving correlations ensue.

FX & the Right of the Lord (Seigneur) to a Surprise Party

We must remember that our financial system is founded on central banks, more fully than one realizes. The technologies that keep us alive and the technologies that make the technologies are all directly or indirectly dependent upon central banks. In the bloodline of all creation, the central bank is second in significance only to the farmer who ploughs the soil or fisherman who plies the seas. He is a sort of bookish seigneur whose shoulders nearly everything that is man-made is supported. For this reason the actual process by which central bank decisions are made is well worth watching, it may lend subliminal clues to the current market atmosphere.

Four weeks have lapsed since the Swiss National Bank abruptly decided to abandon its peg to the Euro. On the same day, the Royal Bank of India held an impromptu meeting and slashed rates by 25 basis points. The week following, the Bank of Canada – long disgruntled with its falling rates – pushed back with a 25bp rate cut dubbed as a proactive insurance move. The ECB unleashed another unprecedented QE while the Royal Bank of Australia – even amid its booming housing market – snappishly dropped its benchmark rates.

Denmark cut rates three times in ten days. Singapore eased as did Russia. The Peoples Bank of China lowered reserve requirements for small and large banks alike in the name of compensating for its stubborn shortfall in capital inflows. Surprise party no more, the focus now turns to the upcoming Swedish Riksbank on February 12followed by the Bank of Japan slated for February 18, as market watchers look for the next bank to blink.

One of the most noticeable themes of this market - one where central bankers are getting the blame - has been the “disinflation trade” whereby inflation outlooks fall and consequently take oil and treasury yields down with it, while the U.S. dollar and gold rally. This latest theme may be true, partly true, or simply a fad – a novelty designed to sequester our angst on why markets move the way they do. I liken this trade in the same way a beach blanket needs to be moved periodically to compensate for the rising tide; markets will reposition themselves as the economics and crowdsourcing shifts and the key is to recognize the shift for what it is – temporary.

Deflating the Disinflation Trade

After being propped up on the polar vortex and preconceived worldwide civic disruption risk, oil began its 50% + correction in mid-July 2014 as massive and well-ahead-of-schedule oversupply coupled with relative global calm (e.g. Libya, Iraq, and Iran) met flat demand from developed markets and softer-than-expected need from emerging markets.

While spending nine months grinding within the context of a broad yet volatile trading range, 10-year Treasuries ripped higher towards the middle of the fourth quarter of 2014 as growth prospects in Europe began to falter – yields headed lower while the curve flattened – a direct result of our comparative value as compared to government paper elsewhere. In addition, yields experienced downward pressure as issuance in the U.S. dropped – a result of healthy economic indicators.

In late May the Euro/U.S. dollar cross was trading comfortably near 1.40 – precisely the time when the U.S. economic indicators brushed off the effects of the polar vortex and demonstrated enough consistency to allow the Fed to drop casual hints of a pending rate hike as the economy was indeed approaching escape velocity. Robust reports including unemployment, PMI, and Industrial Production pushed the Euro down the sliding board towards 1.21 at year-end. Although gold traded as high as $1390.00/oz. in 2014, it finally succumbed to a low near $1,140.00/oz. as implied U.S. monetary policy (eventual tightening) acted as a giant sword over its head.

So far, 2015 has been different as gold has seen underlying demand forces including the surprise lifting of Indian import restrictions, steadier than expected U.S. coin demand, the Swiss National Bank action, coupled with subdued supply growth from mines dealing with stubborn cost curves.

It’s quite understandable to be tempted or overly focused on past or most recent market relationships and results, a behavior that is sadly too often reinforced by those in whom we are supposed to trust. Relationships and correlations are fun to watch and ponder about however, over-thinking them could disable you from seeing the next bad data point or even the next crisis. Trend today – gone tomorrow.