SIGN OF THE TIMES AS INFLATION - DEFLATION RIDDLE FAZES INVESTORS / THE FINANCIAL TIMES

Sign of the times as inflation-deflation riddle fazes investors

By David Oakley

Published: September 9 2009 03:00


The question increasingly being asked by investors is how quickly and how powerfully inflation will return.

Market action this week, which has seen commodities, gold, equities and long-term bond yields move higher, suggests many investors fear inflation will rear up sooner rather than later.
Yet the immediate concerns centre around deflation, with central bankers still cautious about the outlook, consumer prices falling in the US and eurozone, and short-term bond yields diving to record lows.

G20 finance ministers made clear their worries about the threat of deflation at the weekend, when they promised to keep fiscal and monetary stimulus in place for as long as necessary to ensure a sustained revival in the global economy.

It is this very determination to tackle deflation, meaning interest rates are likely to stay lower for longer, that is leading investors to fear that inflation will eventually return with a vengeance.

John Reade, strategist at UBS, says: "There is certainly a difference between policymakers, who are focused on dealing with deflation, and investors, who are worried about inflation.

"This fear of inflation is because the longer there is disinflation, the greater amount of liquidity the central banks inject into the system to tackle deflation.

"This then leads to a greater chance of inflation in the future. The central bank actions to tackle deflation are pre-inflationary."

The promise by the G20 to keep rates low has led to hopes that the economic recovery will be V-shaped, which is only encouraging the bulls to buy equities, commodities and other riskier assets.

David Karsboel, chief economist at Saxo Bank, says: "The irrational exuberance continues, and we have to respect it.

"There is a complete disconnect between what ordinary persons see and experience and the perceptions of investors at this point.

"But as the recently concluded G20 meeting virtually promised to continue the lax monetary policy, lax regulatory standards and lax accounting standards, this is being taken as a positive."

The rally in equities, which has been helped by this week's return of merger activity, saw a fourth straight winning day yesterday.

Most bourses have risen at least 40 per cent from their March lows, and many emerging markets have climbed even higher.

The FTSE All-World Emerging Market index is up 60 per cent since the start of March.

Gold, the traditional inflation hedge, yesterday surged above $1,000 a troy ounce - up 15 per cent since April 17 - while oil, which is linked with recovery hopes, jumped above $70 a barrel for its biggest one-day gain since July.

In the currency markets, the commodity currencies of the Australian dollar and the South African rand raced to one-year highs against the US dollar.

The US dollar, a traditional haven, also yesterday fell to lows last seen in September 2008.

The dollar index, which tracks the dollar against a basket of currencies, fell to its lowest level since September 30 last year.

The yield curve between two-year and 30-year bonds has widened sharply in the past month.

Since August 7, the spread between two-year yields and 30-yields of German bunds has steepened by 50 basis points to 300bp.

This has primarily been driven by the fall in yields at the short end.

Two-year German bund yields fell on Monday to their lowest levels since the data was first tracked in 1991. These rates are sensitive to short-term bank interest rates.

In many respects, however, investors have been positioned for extremes through much of this year, with many funds overweight in inflation linked bonds, cyclical stocks and gold.

But defensive stocks and conventional bonds have also been in demand, suggesting that not all investors think the global economy is out of the woods.

With central banks still notably cautious about the strength of the revival, this is not surprising.

The Bank of England, for example, only last month extended its quantitative easing programme.

Are policymakers right to stress the need to tackle deflation, in spite of investors fretting about inflation?

John Wraith, head of sterling rates product development at RBC Capital Markets, says: "Clearly, deflation is the immediate concern and will be for the next year or so at least. There is a lack of demand and a lot of spare capacity in the economies.

"Central banks have poured such a lot of petrol on the fire, particularly in the UK through quantitative easing, that there is a danger it might get out of control and lead to inflation. So inflation is a concern down the road.

"But the central banks are right to concentrate on dealing with deflation. As we have seen with Japan, it is very difficult to get out of deflation.

"You can print money, you can give it all to the banks, but even then you are not guaranteed that people will want to borrow or spend, if they are worried about that money being cheaper tomorrow.
"Inflation is easier to tackle as you can raise interest rates."

Don Smith, economist at interdealer broker Icap, agrees. "I regard deflation as the bigger risk. It's difficult to imagine moving further into deflation while economies are gathering strength.

"But if core inflation remains very low through the recovery, there is a heightened risk that the next recession may tip us over the edge into a sustained period of deflation."

An environment in which consumer prices are falling while asset prices are rising is an unusual one. Investors have a far from easy task in trying to respond to both.

Copyright The Financial Times Limited 2009