Is It Time to Fade the Deflation Trade?

For years I have been bullish on T-Bonds consistently rejecting any notion that high inflation was on the horizon, consistently saying that QE was not inflationary, saying that there was no risk of a solvency event in US government bonds, etc. But 2015 is the first year in a long time where I feel like the deflation/disinflation trade has been overdone. That is, the idea of a permanent lowflation appears to be fully expected and perhaps expected for much longer than is realistic.

My general thesis is that low inflation expectations are more than priced in now with break-evens in many countries pricing in 2-10 year deflation and that there is a high probability that these lowflation beliefs could end up looking wrong in the coming years. This doesn’t mean that there is suddenly a risk of high inflation. But when we think about the markets we have think not only about how the market is priced, but what the probability of the market’s expected result is. Although I don’t expect inflation to surge any time soon I do not think the deflation/noflation environment is a high probability – especially in the USA. And this creates the risk that long duration fixed income is much riskier than the market is currently pricing in.  If inflation even modestly surprises to the upside in the coming years then fixed income could experience a whip lashing that will feel a lot like 2013 when long bonds experienced double digit losses.

My thinking was perfectly summarized in a recent report by Morgan Stanley’s excellent muni bond analyst Michael Zezas who outlines my thinking much more succinctly than I have over the last month. He is recommending shorter bond durations based on three major trends:

1. An expectation that oil price declines will cease as supply/demand conditions tighten (see The Commodity Manual, January 19, 2015)

2. Further improvement in US labor conditions and subsequent wage growth once the economy has worked through “pent-up deflation” (see US
Economics: The Search for Wage Growth, January 9, 2015).

3. Improvement in European economic fundamentals (see European Economics: Closing the Books on 2014, Pondering What 2015 Brings, January 5, 2015), which should boost real growth expectations in the bond market and lessen US importation of disinflation, aiding an increase in inflation expectations.

Zezas added a nice data set on the muni curve in similar environments showing that the long end tends to underperform in similar curve flattening environments:

 (via Morgan Stanley)

I went into each of the aforementioned points in some detail last month when I presented at AAII, but the short version is as follows:

• Commodities look modestly attractive for the first time in a long time as a form of uncorrelated returns in the case of any inflation bounce back.  Oil could go lower, but the current price looks like the best risk/reward play we’ve seen in years. The same can be said across much of the commodity complex.  In the case of an upside inflation surprise in the coming 18 months there could be substantial upside in some commodities.  And if we get any wage inflation in the back half of 2015 then watch out because any boost in oil prices will make year over year inflation comps look alarmingly high given current expectations.
• The US economy continues to be stronger than most think. Not only is the de-leveraging over, but we’re seeing consistent signs of labor market tightening and even some signs of wage growth in indices like the Employment Cost Index.
• Europe could be close to a moment of truth where more pro growth policy takes hold as a result of the changes in Greece (or, the downside risk being that it unravels, something I am willing to bet against).  Furthermore, QE should provide some modest boost to economic growth given the irrationally deflationary policies that have been in place thus far.

The big risks to this view are:

• A deflationary collapse in global demand as the global economy turns out to be significantly weaker than markets presently expect. This is the most probable risk given the weakness in Europe, the slowing in China and the potential downside risk in the USA.
• The Europeans somehow allow Greece to leave the Europe thereby throwing the Eurozone into economic chaos. This carries substantial political risk, however, it would be colossally stupid for the Europeans to allow this environment to even begin to unfold. The Euro currency is an egg that has been scrambled and cannot be unscrambled without making a huge mess that potentially causes more problems that it solves.
• Commodity prices continue to collapse under weaker economic growth or growing supplies.  More specifically, if energy prices decline substantially as the supply led declines continue. This, however, appears like a low risk at this juncture given the likelihood of a supply crunch as the fracking boom slows.   If the rumors about Saudi price depression are true then this means that any increase in demand could actually be met with a decline in demand – econ 101 says this should actually support prices.

None of this means a high inflation is on the horizon. It just means that the market could be pricing in a sustained deflation/disinflation that is not all that rational.  And if the market is caught even remotely flat footed here then some of the safest instruments in a diversified portfolio suddenly begin to add a significant amount of permanent loss risk when they should be providing you with protection from precisely that.