A Deflationary Wave

By RANDALL W. FORSYTH  Barron's Up & Down Wall Street

Commodities send a deflationary signal that's being corroborated by TIPS -- the Treasury Inflation-Protected Securities.

Keep calm and carry on. Once again, the British byword from World War II would be invoked in a week following the unspeakable acts in Boston that cast a pall on the entire nation's consciousness. It is almost unseemly to write of markets and mammon in the wake of yet another tragedy caused by evil. But not to keep calm and carry on is worse, as it gives succor to the evildoers.

That the Dow Jones Industrial Average suffered its worst daily loss of the year, a 266-point plunge on Monday, could be only partially traced to the bomb blasts at the finish line of the Boston Marathon as news of the act of terror pushed an already sliding market down about another 90 points. But that was followed by one of the year's best gains for the Dow, a 158-point pop. That would prove the high point for the week, however, as the blue chips slid, ending their worst week of 2013 so far, with a loss of 2%.

But equities' slide was but a part of the global deflationary wave that swept through the commodities and bond markets, featuring the sharpest plunge in gold in over three decades. The drop in a range of commodities, notably economically sensitive goods such as metals and petroleum, came as the International Monetary Fund lowered its projections for global growth and more lackluster data was released for the U.S. economy.

It was the rout in gold -- a 15% two-day crash that culminated with a 9% plunge on Monday -- that got the most attention and elicited an outpouring of opprobrium from various enlightened sources that was captured pithily in a cartoon in the current issue of Grant's Interest Rate Observer. Pictured is a mock front page of the New York Times bearing the headline, "Gold Sucks. And Silver Is Worse."

... while gold has moved mostly sideways after correcting that spike, it wasn't the only asset to get ahead of itself. Over the past 12 months, the SPDR Gold Shares exchange-traded fund (ticker: GLD) is down 15%. During the same span, Apple's shares (AAPL) are down twice as much, breaking below $400, more than $300 below its peak of last September.

The debate over gold has become something of a theological argument, and of course one doesn't discuss religion or politics with friends. On less contentious subjects, the deflationary direction is less controversial. Copper entered bear-market territory on Friday as a further 1.7% decline put the metal more than 20% below its February 2012 peak. Crude oil also extended its recent slide, with the U.S. benchmark well under $90 a barrel and Brent breaking under $100.

The signal from commodities is corroborated by what's happening in the world's biggest, most liquid market -- U.S. Treasuries. Not so much in the trading of the regular notes and bonds, which gets quoted everywhere, but in the market for TIPS, or Treasury Inflation-Protected Securities. TIPS are adjusted for the consumer-price index, so they pay a "real" yield plus the CPI. Recently, that real yield has been negative for shorter TIPS since regular Treasuries yield less than the expected rise in the CPI; think of that negative yield as an "inflation insurance" policy. Demand for that inflation insurance collapsed last week as an auction of five-year TIPS drew the weakest bidding since the crisis of 2008, when investors wanted nothing but regular Treasuries.

This may sound like inside baseball for bond geeks, but the so-called TIPS break-even spread -- the difference between regular Treasury and TIPS yields, which represents expected inflation -- is closely watched by the Federal Reserve.

When this break-even rate threatened to drop below the Fed's 2% inflation target in the past, write Andy Laperriere and Roberto Perli of International Strategy and Investment, the Fed initiated its various rounds of monetary stimulus (quantitative easings 1 and 2, plus its extension of the maturities of its securities portfolio).

The ISI analysts note that the Fed looks at a more esoteric TIPS break-even that reflects inflation expectations five years out (which is real inside baseball), but they don't think the central bank is worried enough about stepping up its current $85 billion-per-month purchases. That came after a comment by St. Louis Fed President James Bullard, a voter on the Federal Open Market Committee this year, that he would consider boosting QE3 if inflation continues to fall.

Even though a pickup is unlikely, this represents a huge reversal of recent speculation that the Federal Reserve would begin to throttle back its securities-purchase program. That reflects the distinctly softer tone of recent economic data, including weaker-than-expected readings for the Philadelphia Fed index and the New York Fed's Empire State Index, plus a dip in the Index of Leading Indicators.

Bet on the QE3 buying to continue through the end of the year, at a minimum. And the 0%-0.25% target for overnight federal funds, in place since the crisis days of December 2008, most likely will extend beyond next year into 2015, as the Federal Open Market Committee indicated in its projections at its March meeting.

But what's clear is the Fed's $1 trillion-a-year buying spree in Treasury and agency mortgage-backed securities isn't overcoming the fiscal drag exerted by the tax increases from the New Year's deal to avoid the fiscal cliff and the March 1 sequestration cuts. In other words, QE3 continues to benefit the stock market more than the real economy.

And though the Group of 20 nations gave Japan a pass on its 60 trillion yen ($603 billion) securities plan, which has lifted that nation's stock market nearly 50% since November, the plan is causing pain in the rest of the region; neighboring countries such as South Korea have seen their export competitiveness hurt by the 20% decline in the yen. A similar dynamic set off the 1997 Asia crisis, notes Albert Edwards, chief strategist at Société Générale. And in a bit of historical symmetry, Thailand is complaining about the appreciation of the baht caused by capital inflows seeking higher yields, a significant portion no doubt emanating from the Land of the Falling Yen.

At the same time, the Bank of Japan's balance-sheet expansion shows little sign of achieving its domestic objectives. Richard Koo, chief economist of the Nomura Research Institute, contends that, in the absence of borrowers' desire to borrow and banks' willingness to lend, money and credit won't increase, and the economy won't get a boost.

The message seems to be that there are limits to central banks' ability to keep boosting commodities, which are barometers of the real economy. And the rocky performance of stocks doesn't inspire confidence that they can keep the bull market running indefinitely.

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