The Market's Measure
Fretting About Deflation?

Fretting About Deflation?

Don’t worry. Be Happy. Unless the yield spread inverts

Sir John Templeton, who knew something about money, once said “The four most dangerous words in investing are: ‘this time it's different.’”

I recalled the quote when I last regarded the daily inflation chart which reveals a precipitous fall in inflationary expectations over the past year. Inflationary momentum can be gauged by watching the ever-changing relationship between commodity prices and interest rates. A quick-and-dirty indexing of daily fluctuations in the GreenHaven Continuous Commodity Index ETF (NYSE Arca: GCC) and the iShares 7-10 Year Treasury Bond ETF (NYSE Arca: IEF) shows expectations broke in deflation’s favor when WTI crude oil prices sank below $100/bbl in July.

 

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If you’ve been rooting for inflation (that’s you, Ms. Yellen, right?), you’ve been sorely disappointed in 2014. Maybe there’s some surcease in your pain.

Technically, the chart points the inflation index to a test of its December 2008 level which was reached after a stunning 76 percent swoon in oil prices. As crude fell so, too, did gold though less dramatically. Bullion slid by nearly seven percent in the second half of 2008.

And now?

Since this summer’s breakdown, oil’s slipped 48 percent while gold dropped 11 percent. It’s hard to think of those developments as anything other than deflationary. Figuring prominently in both the 2008 and 2014 scenarios is a resurgent greenback. Between July and December 2008, the U.S. dollar gained 19 percent. From mid-year 2014, the buck’s risen 12 percent.

So what, if anything, differentiates 2014 from 2008? In a word, fear. There was a lot more of it in 2008, at least as measured by the spread between the ten-year Treasury note yield and the dividend rate offered by S&P 500 stocks. In recent years, bad things have happened when dividends greatly exceeded Treasury yields.

 

 

In December 2008, stock prices had tanked severely, pushing dividend yields more than 80 basis points past the Treasury rate. In other words, the yield spread, expressed as “notes over stocks” went negative.  Currently, the spread remains positive, though it has shrunk since the top of the year.

So things are different now. But they’ll only stay different if the current spread doesn’t shrink by another 40 basis points.

Keep your eyes peeled.

 

Brad Zigler is former head of marketing and research for the Pacific Exchange's (now NYSE Arca) option market and the iShares complex of exchange traded funds.

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