What You Need to Know About the Deflation Threat

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What You Need to Know About the “Deflation” Threat

We are on the eve of another CPI report. As we look back over the last month, the surprise steep decline in the September CPI release was one of the catalysts that turned this market lower, as focus shifted squarely to dis-inflation and the stronger dollar.

But, it’s important to point out that what we have seen over the past two months in the U.S. was a commodity-led decline in inflation statistics … not full-scale deflation. For those of us who were in the business in 2008, we’ve seen what real deflation looks like (at least as close we ever want to get to it). Major indicators of monetary conditions, credit, economic activity, consumer spending, etc. are NOT showing dis-inflation. CPI is showing dis-inflation, mainly because of commodity prices.

Much has been made of the decline in the 5-year inflation break-evens (the difference in 5-year TIPS yields and 5-year Treasuries). Yes, it is true they have declined sharply. But, keep in mind TIPS are priced off of headline CPI – so as headline CPI drops (with oil and other commodity prices), then the attractiveness of TIPS also drops. Again, that’s because it is directly tied to headline CPI. Case in point, if you look at a chart of DBC (the commodity ETF), you’ll see it closely mirrors the drop in 5-year inflation expectations, and that’s not just a coincidence.

Two very reliable indicators of deflation (which I learned to follow during the ’08 crisis) are the adjusted monetary base and revolving consumer credit.

Adjusted monetary base is one of the most useful barometers of the stock of available money in the U.S. It’s accelerated to a new all-time high and is considerably higher than it was just a year ago, thanks to QE.

Revolving consumer credit (think credit card debt and other consumer-based lending) has exploded so far this year.

So, while things may change in the future, obviously, neither of these indicators are signaling we are seeing any sort of a deeper deflation threat.

PMIs are at multi-year highs. The six-month rolling average of payrolls is at multi-year highs. Durable goods, retail sales, housing prices, etc. are all fine. Weekly jobless claims hit an 14-year low last week.

Nothing in the economy that I can see is screaming dis-inflation, other than CPI and (potentially) the yield curve, which has flattened. But, I believe what’s going on in the bond market is a confluence of the short end selling off in anticipation of the Fed Funds hike next year (so short term rates go up), and the long end rallying as European money flows into Treasuries given their relative value (so long rates decline, flattening the yield curve). If we see a global deflation/depression, then obviously the U.S. won’t be immune, but my point here is to show the difference between real deflation, and commodity price-led dis-inflation.

Bottom line, there is a silver lining to this commodity-led dis-inflation, as it’s a positive for the U.S. consumer. And, over the next few days, we’re going to be laying out a case as to why we think a theme for the remainder of the year is the “return of the U.S. consumer” and why consumer-related stocks (finance companies and select retailers) can outperform if the broader market stabilizes.

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