Thursday, October 02, 2008

A Look At a Deflating Market




Since July, we've seen commodity prices collapse (top chart), the U.S. dollar rally furiously versus the euro (middle chart), and high-yield bond prices collapse (bottom chart). It's not exactly the inflationary scenario that some envisioned as the result of the rescue legislation--at least not yet. This is a market that is punishing anything associated with risk, which explains the massive flight into short-term Treasury instruments despite their paltry (and significantly negative real) yields.
.

2 comments:

Firebird said...

Dr. Steenbarger,

Yes, this situation is - at least so far - contrary to what common wisdom would have it.

We could also add that gold was plunging today and that it is 18% off its March highs.

However, 30 year bonds are failing to gain traction and as the stock market makes newer lows, they keep making lower highs - an indication of changes to come, maybe?

Best trading,

Jorge

dgoverde said...

Two things:

First, I disagree about common wisdom having it that the problem in the near future will be inflation. Common wisdom is that we'll get deflation all around. That's what you get in a world-wide recession, or at least that's what they'll tell you.

Second, the recent strength in the dollar is actually weakness in the Euro and Pound, which enjoy the lion's share of the trade weighting in the basket of bilateral rates that make up $DXY. Whether or not we end up faring better than Europe, there isn't a very good chance that we fare better than Asia and South America. The credit crisis is domiciled here. Of course it's contagious, but our government is the one that is going to try to inflate their way out of this.

How else are we going to service our $10 trillion national debt?

Jorge, I fully expect people to stop buying dollar-denominated bonds. Of course, this won't happen overnight, but eventually people will figure it out and start buying Asian or South American bonds instead: their interest rate will be higher, and their currency risk will be less! This is exactly what I've been advising people to do. And again, I'd like to underscore that I see a future run-up in commodities being driven not by demand, but by a persistent decline in the dollar.

Now I admit, gentleman, that I could be dead wrong about all of this. The dollar might actually get stronger! And if it does, then my investment advice won't look so good. But don't start congratulating yourselves just yet, gentlemen. This thing is a long way from being over. Note, however, that when the bailout bill passes, we will have just added close to $1 trillion to our national debt, and if I'm going to be making long-term investment decisions, I want to put myself on the correct side of such an event.

Doc, thank you for focusing on this topic. Regardless of which way the cards fall, this is the question that matters right now, so we might as well debate it.

With love,
dgov