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Is Deflation Knocking at the Door?

21 January 2015 in Trading Ideas

Global investors may point to the US as a relative beacon right now, but even that high praise isn’t looking terribly sure-footed.

Earlier this week, the World Bank cut its outlook for global growth in 2015, saying that strength in the US and plummeting oil prices won’t offset deepening trouble in the eurozone and emerging markets.1

According to the Wall Street Journal, the bank’s economists see oil prices, which have lost more than half their value in the last six months, providing uneven benefits to major oil importers.

In the US, oil’s slide has helped the recovery by giving consumers more money to spend, leading the bank to boost its growth projection here by 0.2 percentage point to 3.2%.

But the price plunge is failing to spur stronger growth in importers such as Europe and Japan, while also exacerbating financial problems in major oil exporters, the bank said.

The eurozone is struggling to avert a third recession since the financial crisis as the currency union grapples with high debt and a lack of international competitiveness, the Journal said. The bank cut its outlook for growth in the region by 0.7 percentage point to 1.1% this year.

Meanwhile, growth in emerging markets is slowing more than expected, according to the Journal. Many of those economies, already straining their capacity to grow without major economic overhauls, are being hit by a raft of economic and political headwinds. The bank cut its forecast for all developing economies by more than half a percentage point to 4.8%.

Late last week, however, the question as to how much the US is actually growing became a question when government data showed that the consumer price index dropped 0.4% from the previous month.

That brought the year-over-year pace to 0.8%, the lowest since the fall of 2009, when the economy was emerging from a recession. As the Journal suggested, based on commodity-price trends, the Federal Reserve may find the country slipping into outright deflation just as it approaches its anticipated timetable to raise rates in the middle of this year.2

According to past comments by Fed Chairwoman Janet Yellen, a brief drop in energy prices shouldn’t delay that process. But, as the Journal explained, market expectations for inflation over longer periods are unusually low at the moment.

The 10-year break-even rate implied by inflation-protected Treasury notes is just 1.6% over the next decade. Even the 30-year implied rate is just 1.8%, below the Fed’s 2% comfort level, according to the Journal.

With yields in the German and Swiss bond markets turning negative for shorter maturities, near record-low yields in the US should still be attractive to foreigners. As the Journal put it, “that could be a temporary market distortion or possibly a rational bet on anemic world-wide growth and prices.”

In any event, inflation expectations appear to be on the run. Compared with a month ago, the odds of a June rate rise based on futures tracked by CME Group have fallen by more than half to barely 12%, the Journal said.

For investors inclined to believe that deflation is a legitimate risk to contemplate, it may be worth considering the Deflation motif, which is up 6.9% in the past month. In that same time, the US Bond Index has gained 1.5%.

Over the past 12 months, the motif has gained 31.6%; the US Bond Index has increased 6.6%.

 

1Ian Talley, “World Bank Lowers Outlook for Global Economic Growth,” wsj.com, Jan. 13, 2015.

2Spencer Jakab, “US May Soon Join Deflation Club,” wsj.com, Jan. 15, 2015.

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