Deflation risk is disappearing -- extremely positive

For the past few months I have been highlighting the fact that the bond market was terrified of deflation. My most recent post on the subject is here, where I speculated that fears of deflation could begin to decline, and that this would boost TIPS. The only way to explain the existence of extremely low yields (2-3%) on long-term Treasury bonds was that the bond market felt that deflation was highly likely. In the past two weeks, there has been a significant reversal of this sentiment. Deflation risk is now declining in a big way, and that should be very good news for a lot of things.

This chart shows the nominal yield on 10-year Treasuries and the real yield on 10-year TIPS. The bottom (green) line is the difference between the two, which is the market's implied 10-year inflation rate (breakeven inflation). In the bottom right hand corner I've highlight the big change. Inflation expectations began to plunge at about the same time the stock market began collapsing, in early September. Investors were panicked that housing price deflation would be contagious, and that the general price level would decline for years. I noted in November that the valuations of stocks and corporate bonds implied that the market feared something worse than Depression and deflation. Then, about a month ago, inflation expectations started to turn up. As of today, the market's expectation for the average inflation rate over the next 10 years has risen by a full percentage point from its low around year-end. This is very big news.

For the past month, real yields on all TIPS maturing in 10 years or less have declined, while Treasury yields have risen across the board. This reflects a market that has suddenly shifted its concerns. In the fourth quarter of last year, all the action involved the rising risk of deflation and depression. TIPS were shunned, and their real yields rose as a result; Treasuries were preferred, and their nominal yields collapsed to levels not seen since the Great Depression. This past month, the reverse has happened as the market has once again come to appreciate TIPS for their inflation protection and their attractive real yields, while at the same time shunning Treasuries.

The bond market is not always right, but this time I think it is. The Fed together with all other major central banks are massively easy, and gold prices are closing in on $1000/oz. Core inflation is still quite positive, and most commodity prices are up from their lows. The economy is certainly weak, but that is no reason to think that all prices are going to decline for years to come.

Once the investing public accepts that deflation risk has been reduced significantly, as I and the bond market think it has, this should be extremely positive for corporate bonds, commodity producers, emerging market economies, and equities. Deflation is Bernanke's worst nightmare (and everyone's, for that matter), and he is doing everything he possibly can to avoid it; this is no time to question his resolve or his ability to achieve his objectives.

I am aware of the supposed "January effect" which says that when stocks produce negative returns in January (as they just have) then we are likely to see negative returns for the rest of the year. But the past never repeats in exactly the same way, and this period is so unlike any other that trying to draw parallels to the past is futile at best. I look at the fundamentals, and they tell me that deflation risk is disappearing. I see real estate at or close to a bottom. I see swaps and implied volatility gradually returning to normal levels. If people can lose their fear of a downward price spiral, then today's valuations are so compelling that money (and there is more money in the world than ever before) will be desperate to come back to all the markets that have been so depressed. This is very good news indeed.

Now, if we could just convince Congress that a massive spending bill is insane, the world could get on with its business. If we could convince Congress that tax cuts are in order, a panic rally would surely ensue.