The Crunch Time Has Arrived

Yesterday’s sharp rally in the stock market takes the edge off of deflation concerns…for the moment. But let’s not forget that the Treasury market’s implied 10-year inflation forecast is still bouncing around at the lowest levels since last October. In other words, yesterday’s revival of bullish spirits in equities didn’t pare deflationary anxiety, at least not yet.

The inflation forecast is a thin 1.70%, based on yesterday’s yield spread for the nominal 10-year Treasury Note less its inflation-indexed equivalent. The jury’s still out on whether this dip has legs, although the downside momentum seems to be picking up strength. As for what comes next, much depends on whether the risk-aversion trade still has a head of steam. Yesterday’s action in stocks offers some evidence for thinking the tide has turned and that the renewed rush into Treasuries in recent months run its course. Maybe, but one day a trend does not make.

This much is clear: the days and weeks ahead are likely to be a crucial turning point, for good or ill, in the renewed battle against the forces of deflation. The crunch time has arrived. It’s just not obvious which side will get crunched.

Yesterday’s skirmish seemed to favor the cause of reflation. The S&P 500 soared over 3%. But while the daily change is impressive, the broader trend of selling risk has yet to break. The S&P is still well below its 200-day moving average. As market technicians have been pointing out, the 50-day moving average recently fell below the 200-day counterpart—the so-called death cross, which is considered by some to be bearish signal of some import. But nothing’s foolproof in forecasting the future, and so the crowd watches and waits for the next data point.

On that note, the Treasury is scheduled to sell a whopping $12 billion of inflation-protected bonds today. As a measure of how the crowd’s thinking about pricing trends, we’ll get a pretty good sentiment reading with this auction.

Meantime, the IMF raised its outlook for global economic growth:

Balancing the strong growth numbers for the first half of 2010 and the adverse impact of increased financial turbulence, the IMF forecasts world growth to rise to 4 ½ percent this year, before falling somewhat to 4 ¼ percent in 2011—with the world average masking large differences around the globe.

But despite the stronger than expected first half recovery, the IMF warned that uncertainties surrounding sovereign and financial sector risks in parts of the euro area could spread more widely, posing difficulties for both financial stability and the economic outlook.

The disinflation/deflation minions are still pressing hard, but the cause for growth isn’t yet lost, as the IMF forecast reminds. But it’s still too soon to say which side will win. The case against outright deflation still looks stronger, but the defences are slowly giving way. The battle rages on.

About James Picerno 894 Articles

James Picerno is a financial journalist who has been writing about finance and investment theory for more than twenty years. He writes for trade magazines read by financial professionals and financial advisers.

Over the years, he’s written for the Wall Street Journal, Barron’s, Bloomberg, Dow Jones, Reuters.

Visit: The Capital Spectator

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