My Deflation View

Many Accrued Interest readers will gafaw at the memory of John Ryding, economist at Bear Stearns from 1991 until the bitter end in 2008. Intelligent man, I’m sure, but also something of the Nouriel Roubini of the bond market. I think he was bearish on interest rates basically my entire career, which is ironic, since for most of my career, interest rates have been falling.

Anyway, the one really good piece of advice I heard from Ryding over the years was if you have a view on inflation, don’t change your inflation outlook, change your Fed outlook. In other words, if you think forces are aligning toward higher inflation, bet on Fed hikes, not on inflation itself. I think this is a smart way to approach the bond market, because the Fed may actually short-circuit inflation itself (making a bet on, say, TIPs a loser).

Today St. Louis Fed President James Bullard declared that the Fed had averted a deflationary outcome, and is now considering an exit strategy. As readers know, I’ve been touting deflation as the Fed’s primary concern for some time now. But in talking about deflation as the primary risk, I’m still thinking of Ryding’s advice. I’m not necessarily betting on deflation per se, but on a Fed ready and very willing to fight it. That’s why I’ve been willing to bet on massive rate cuts, unorthodox liquidity programs, etc.

But will we see CPI print below zero? Only if the Fed fails. In other words, sustained deflation remains a remote possibility. But sustained Fed interference in the markets in attempt to avert deflation is a strong probability.

So the bet should be not on deflation outright, but on the fallout from attempts to fight it. Weaker dollar. Higher commodities. Low short-term rates (including buying 2-year bonds as opposed to holding cash). Flat yield curve. Lower mortgage rates (at least from here).

That’s is how I’m playing my deflation view.