If Mr. Market is asking questions on whether we get Deflation or Inflation, you'd think that he had been on a telephone sales course selling Deflation and received a Distinction in "closed question" asking. "So Sir, would you be taking the 'Really Bad Deflation' or the 'Not Quite So Bad Deflation' or maybe our 'Japanese Deflation' option?".
We understand that equity market players are usually a pretty optimistic bunch (well, they kind of have to be, given they are dependent on an income-stream supposedly linked to growth), but bond guys are clinically depressed, worrying about inflationary risks one minute and then deflationary risks the next. This schizophrenia was most clearly demonstrated in 2008 with a 250bps pendulum swing in 5yr note yields. TMM bring this up because they believe that the pendulum may be approaching its zenith.
One of the biggest fears macro punters have at the moment is the Core PCE Price Index (see below chart) going negative. Now, as far as TMM can see, it is near the bottom of the range of the last 17yrs or so, but given the Fed is generally assumed to have a 1.75% target for this number, it does not seem particularly unusual for it to be this low at this stage in the cycle. The *real* oddity was that it was so high between 2004-2008...
...perhaps because of the BRICs and the pass-through of commodity price increases, along with Fed policy having been too loose. So the recent increases in Commodities, particularly Wheat are worth keeping an eye on (see below chart of normalised percentage appreciation of Wheat - white, Oil - orange & Copper - yellow - since the beginning of the year)...
...given that survey-based inflation expectations (chart below - green line) are more a function of *current* CPI (orange line) than the core PCE (brown line), and are "upside" sticky. If food & energy prices continue to ramp, the appears little danger of inflation expectations morphing into deflation expectations. This is significant as far as the expectations-augmented Phillips Curve model is concerned.
Over the past few days there are signs that the fixed income frenzy is becoming increasingly, dare we say, "bubble-like", with the 10 day autocorrelation of the 5yr Note's returns hitting new highs of 0.85 at a time when its price exhibits a clear trend. This is important as evidence of "return chasing", a key phenomena evident in bubbles. TMM would add to that the recent media hype about both deflation, the possibility of the Fed extending QE, economist calls for more QE, along with the WSJ today publishing a "Defending Yourself Against Deflation" article.
Now, all of the above may well be true, but it looks to TMM as though punters have the trade on, and we all know what happens to consensus trades. Speculative positioning in 5yr notes as a percentage of total open interest (see chart below) has also begun to plumb the highs of 2008, a period when fixed income actually had room to rally. TMM is struggling to see any risk-reward in being long fixed income...
...while Commercial Bank holdings of USTs as a fraction of GDP are at their highest since the early-90s. Basel III may well result in banks buying a lot more of these, but the relaxation of these rules to be scaled in over the next 10yrs means that the duration risk on balance sheet is pretty large.
Combining this with speculative positioning, Team Macro Man cannot help but remember just how consensus the Carry Trade was back in late-1993...
...just before thishappened:
Team Macro Man have learned over the years that when smart corporates begin to issue debt that it is usually indicative of a top (or at least, a short term top) for bonds, and yesterday's news that IBM's 3yr note cleared at 1% was the red lights and klaxon "DIVE! DIVE! DIVE!" in their submarine.
Although the chat out of Washington regarding a GSE-sponsored refinancing wave is just chat for the time being, the level of rates mean that the 2009 mortgage vintage is likely to begin to refinance (they are not LTV-constrained as anyone who got a mortgage in 2009 clearly must've had a good credit score).
Now to TMM, we either get the deflation that has largely become priced by certain parts of the fixed income market, or else there is a serious risk of a 1994-style unwind in the rates market. We won't know about the former for some time, probably, but short-term, at least, it seems to us as though things are ripe for a turn...
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