Friday, January 16, 2009

Most of the deflation is behind us

The consumer price index fell 5 months in a row, from August through December. December's decline of 0.7% was actually a bit less than the market's -0.9% forecast, and the great bulk of all the declines was due to a collapse in energy prices. With oil no longer falling (in fact, Arab Light crude is unchanged for the past two months and higher today than its December average), and gasoline prices at the pump up about 12% from the end of December, it's a good bet that we've seen the end of consumer price deflation. Core inflation has moderated a bit, but remains positive.

In contrast, the market (as defined by the difference between Treasury yields and TIPS yields, and as implied in the extremely low level of Treasury yields) is expecting the CPI to be negative for at least the next few years. (Clarification: when I say we've seen the end of monthly declines in the CPI, I'm not talking about the year over year change in the CPI, which is likely to become significantly negative for the next 6-7 months. The TIPS market is ruled by monthly changes in the CPI, not year over year changes.) That's a pretty radical forecast, in my view, considering that monetary policy is massively accommodative all over the world, gold is still well above $800, and commodities as well as energy appear to have bottomed and are now rising.

This means that the market is extremely vulnerable to any signs of an economic rebound, and/or any signs that the overall price level is not declining on a month-to-month basis. Good news, of the kind that would surprise the market and cause equity prices to rise and Treasury bond prices to fall, only has to be "not terrible." That's how bad the pricing is, and how attractive the valuations are in today's market.

So I think the equity market remains extremely attractive, and TIPS, despite their rally since I recommended them a month or two ago, are also attractive. TIPS have been in the dumps for awhile, because who wants inflation-indexed bonds if you expect inflation to be negative? As I noted a month ago here, the end of monthly deflation would be very good news for TIPS, and indeed the prospect of that has led savvy traders to bid their prices up recently. There's still plenty of room for improvement, especially at the front end of the TIPS yield curve, since the curve is significantly inverted (short-dated real yields are higher than long-dated real yields). If the market started to lose its obsession with deflation, then TIPS would become much more attractive and their real yields would fall, while Treasury yields would likely rise.

Full disclosure: I am long TIPS bonds and long TIP.

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