IN A DEFLATIONARY SCENARIO, TREASURY BOND PRICES RISE WHILE STOCKS AND COMMODITIES FALL -- FALLING RATES DON'T HELP MUCH IN THAT ENVIRONMENT -- INCREASE IN MONEY SUPPLY WEAKENS DOLLAR WHICH MAY BOOST GOLD
BONDS AND STOCKS DECOUPLE ... With fears of deflation growing, I thought it a good time to review some of my previous writing on that subject and to explain what happens in a deflationary environment. Most traditional intermarket relationships remain the same, but some don't. My 1991 book entitled "Intermarket Technical Analysis" explained how the four major asset classes -- bonds, stocks, commodities, and currencies -- impact on one another. It explained that the dollar and commodities trend in opposite directions, as do bond and commodity prices. Those relationships have mostly held true over time. One relationship has changed -- the relationship between bond and stock prices. The reason is deflation which I first wrote about in my 1999 book entitled "Technical Analysis of the Financial Markets." I'm qoing to quote here from page 427 of that book which is found at the end of Chapter 17 on Intermarket Analysis.
Chart 1
DEFLATION SCENARIO ... "The intermarket principles described herein (Chapter 17) are based on market trends since 1970. The 1970s saw runaway inflation which favored commodity assets. The decades of the 1980s and 1990s have been characterized by falling commodities and strong bull markets in bonds and stocks. During the second half of 1997, a severe downturn in Asian currency and stock markets was especially damaging to markets like copper, gold and oil. For the first time decades, some market observers expressed concern that a beneficial disinflation might turn into a harmful deflation. To add to the concerns, producer prices fell on an annual basis for the first time in a decade. As a result, the bond and stock markets began to decouple...Investors were switching out stocks and putting more money into bonds...The reason for that asset allocation adjustment is that deflation changes the intermarket scenario. The inverse relationship between bond prices and commodities is maintained. Commodities fall while bond prices rise (Chart 1). The difference is that the stock market can react negatively in that environment...Deflation is good for bonds and bad for commodities, but may also be bad for stocks." (Technical Analysis, 1999).
Chart 2
A DEFLATIONARY WORLD... The quote from 1999 continues: "The deflationary trend that started in Asia in mid-1997 spread to Russia and Latin America by mid-1998 and began to hurt all global equity markets. A plunge in commodity prices had an especially damaging impact on commodity exporters like Australia, Canada, Mexico, and Russia. The deflationary impact of falling commodity and stock prices had a positive impact on Treasury bond prices which hit record highs (Chart 2). Market events of 1998 were a dramatic example of the existence of global intermarket linkages and demonstrated how bonds and stocks can decouple in a deflationary world" (TA, 1999). Do any of those earlier trends remind you of events of the past year?
Chart 3
1997 AND 1998 WERE ONLY A DRESS REHEARSAL ... My 2004 book entitled Intermarket Analysis included a chapter on "The 1997 Asian Currency Crisis and Deflation". Here's an excerpt from a paragraph on page 53 of that book headlined: 1997 and 1998 Were Only A Dress Rehearsal. "The way the financial markets reacted to the initial deflationary threat during 1997 and 1998 was only a dress rehearsal for the devastating bear market in stocks that started in the spring of 2000. During the worst three stock market years since the Great Depression, bond prices rose continuously while stock prices fell (Chart 3). The Fed lowered interest rates 12 times over an 18-month period with no apparent effect on stocks. Stocks kept falling along with rates which fell to the lowest level in over 40 years. Those who heeded the warnings of 1997 and 1998 were on the alert that rising bond prices (and falling rates) do not help stocks in a deflationary environment" (IA, 2004). For the record, bond and stock prices have remained "decoupled" in the ten years since 1998.
Chart 4
2008 TRENDS REFLECT DEFLATION SCENARIO ... The financial markets during 2008 have followed the deflation scenario. Chart 4 shows stocks (black line) and commodities (red line) falling sharply, while Treasury bond prices (blue line) have risen. Deflation is much harder to combat than inflation. Inflation can be stopped by raising interest rates enough to slow the economy. Sometimes that can be painful and often leads to a recession, but it can be done. Deflation is much tougher. That's especially true when short-term rates are nearing zero as is the case in the U.S. Once short-term rates reach zero, the Fed can't lower them anymore. That makes traditional monetary policy less helpful. Japan's deflationary spiral of the 1990s took place with its short-term rates near zero. The problem is that you can't force people to lend or to spend. Economists call that "pushing on a string". That's why the Fed has shifted its emphasis to innovative forms of "quantitative easing" that include putting huge amounts of money into circulation. One side-effect is a weaker dollar.
Chart 5
FED ACTIONS WEAKEN DOLLAR ... One of the side effects of putting a lot of money into circulation is that it weakens the U.S. Dollar. [When you increase the supply of dollars, you lessen its value]. Some people have complained that policy is inflationary. I suspect the Fed would love to see a little inflation at the moment. That seems unlikely, however, until the current crisis has passed. The last time the Fed was worried about deflation in the spring of 2003, it lowered rates sharply (and kept them low) which helped start the housing boom. It also weakened the dollar which started a bull run in commodities. The housing boom helped keep the 2001 recession relatively short, while rising commodity prices were viewed as a sign of global strength. Both of those bubbles have now burst (and there aren't any new ones in sight). The only thing going up now is Treasury bonds. One possible beneficiary of these trends is gold which usually thrives in an environment of lower interest rates, a falling dollar, and weak global equities. During the depressionary years from 1929 to 1932, the only two assets that rose were Treasury bonds and gold stocks (bullion was set at a fixed rate). One thing seems clear from all of these deflationary tendencies. It seems doubtful that the Fed's lowering the Fed funds rate from 1% closer to zero will make much of a difference to the economy or the financial markets. It won't hurt, but it probably won't help much either. With additional short-term rate cuts off the table (after today), the Fed will have to rely on unconventional ways to get the economic levers working again. One way to do that is to start buying longer-term maturities to lower long-term rates. The Fed has already hinted it's moving in that direction.
