Tuesday, 5 September 2017

Big Picture of Inflation, Reflation and Deflation, So Far

This is something of a follow-up of Resumption of the Reflation Trade ? article.


TIP to TLT Ratio chart showing market expectation of inflation
TIP to TLT Ratio chart showing market expectation of inflation
(Click chart to enlarge)

The TIP to TLT ratio provides a nice picture of how the the bulls and bears of inflationary forces are being played out since Trump won the election. If the ratio is trending up, the market is expecting rising inflation; if it's trending down, deflation (or disinflation).

I remember the market euphoria after Trump election when the noted hedge fund manager and billionaire Stanley Druckenmiller excitedly told CNBC (inter)viewers to short bonds because it's going to burst by Trump's fiscal policies. When inflation picks up, bond prices will drop. Many other well known investors also chimed in and called the Bond Bubble Burst.

This Trump fiscal euphoria sent bond yields soaring (bond prices plunging) within a month in a stunning fashion (indicated by the oval in the chart). As the markets started to digest the news coming out of new administration from Washington in the following 3 months, the inflation expectation was in a trading range (indicated by the rectangle in the chart).

By mid-March, the markets have digested the news (that are mostly D.C. dramas) and decided that either the Trump Team isn't going to deliver the fiscal policy soon, or that the confidence in Trump Team to carry out these policies successfully is slowly being eroded. This leads to Trump Dump (indicated by the downtrend line in the chart).

By mid-June, the inflation expectation - as described by this chart - is completely rewound, or that Trump Dump is complete. That is, the TIP/TLT ratio is back to same level as the Election Day (indicated by the horizontal green line). It's as if Trump has never being elected, as far as inflationary expectation is concerned.

When i wrote the article about the resumption of reflation in July, the inflation was trended up into August. But it has since dripping down. Interestingly, 4 trading days ago (29 Aug), this ratio bounces off strongly, forming a double bottoms. If you look closely at this chart, it's no coincidence that this come at a juncture with 2 supports (the Election Day level + Uptrend line from July low of 2016).

This strong bounce could just be a technical bounce, but if i'm pressed for explanation in terms of fundamentals, i'll say it's either due to the recent strong Chinese data (accompanied by rising industrial metal prices: Dr. copper, zinc, and aluminium). But it could also due to the Trump Team's talk of tax reform and other fiscal policies that re-ignite the rally.


We're approaching the apex of the triangle - another critical juncture. Whatever the fundamental reason, it's important that the ratio would hold this Election Day level. A breakout of the descending triangle is a sign of positive inflation expectation and is bullish for equity market. A break below this Election Day level would be messy.

My feeling is that it would break out of the triangle because despite the rewinding of inflation expectation since mid-March, the ratio is trending up since Mid-July last year. With synchronized global economic growth, while i don't expect rampant inflation, it's pretty hard to sell deflation expectation.

But then, who cares about my feeling? It's not made of pure crystal. We just have to wait and see...

Keep a close eye on this chart in the next few weeks for clues in the direction of inflation expectation.

The Fed could put a spanner in the works. But that would also reflect in this chart.