Deflationary, Reflationary Bet

Posted By Darren Winters on Nov 26, 2020

Deflationary, Reflationary Bet

The deflationary, reflationary bet is currently playing out as speculative capital flows seek to capitalize on either falling or rising prices. 

The deflationary, reflationary bet, or trade, could both end-up being winning trades at different investment time intervals

In the short term, the likely winner of the deflationary, reflationary bet is likely to be those trades geared towards falling prices, known as the deflationary trade.

Stocks have rallied despite US President Trump contesting the presidential election, the worst-case scenario, according to BoA Global Fund Manager Survey.  

Nevertheless, Washington managed to pass a $2.2 trillion coronavirus stimulus plan in late September, a few months before the presidential election. So, with the stimulus approved, that is likely to be reflationary in the second and third quarter of 2021.

The deflationary, reflationary bet is likely to benefit trades geared towards falling prices in the short term

Deflationary, Reflationary Bet

Deflation leads to monetary policy becoming ineffective due to already very low-interest rates and very high saving rates, which is known as the liquidity trap. During times of deflation, goods and assets decrease in value, meaning that cash and other liquid assets become more valuable. 

If deflationary, reflationary bet favors falling prices, albeit in the short term, how is that likely to impact bond yields?

Bond yields in a deflationary environment tend to fall. Capital flows from stocks into bonds during deflationary periods. 

Falling prices for goods and services in an economy equates to declining revenues, tighter profit margins, which also leads to lower stock dividends.

So, in a deflationary economy, the risk of holding higher-risk assets, such as stocks, outweighs the benefit. In other words, there is a pivot to less risky fixed-income investment bonds. Moreover, increased investors’ demand for bonds results in higher bond prices during times of deflation, thereby resulting in corresponding lower bond yields.

Monetary easing also continues in a deflationary environment. But with a near-zero interest rate policy, the Fed already has its pedal to the metal.

More asset purchases, quantitative easing QE puts a floor under asset prices, but it still will not raise inflation. 

The Fed could also target yields to the downside, which would facilitate expansionary fiscal policy, additional government spending, to trigger economic growth. 

So, $2.2 trillion coronavirus stimulus plan is an example of expansionary fiscal policy. 

With that in mind, I do not believe that the Fed will idly watch the treasury bubble pop. Rates are already near zero, which leaves the Fed targeting yields to the downside as the next available tool to make servicing the public debt more manageable. 

Put simply, the Fed is likely to buy treasuries to suppress yields and make government spending more affordable, particularly in a deflationary depression.

Here is why the deflationary, reflationary bet is likely to favor rising prices over the long term

When monetary and fiscal policy time lag eventually lapses, the economy will see reflationary pressures build. 

Political divisions, a stalemate in Washington over fiscal stimulus could also dampen the reflationary trade bets. 

Perhaps the best case for the reflationary bet would be rolling back the pandemic hysteria with vaccinations, herd immunity. The case for more lockdowns, movement restrictions, curfews disruptions to business is over. A legitimization crisis would soon follow if governments were to continue with draconian lockdowns. Already mass protests in Europe and around the world underscore the above point. 

The deflationary, reflationary bet would favor rising prices when economies get back to normality

So, the post covid feel-good factor, burning the mask, is likely to spur on consumption. Light at the end of the pandemic tunnel could look like a renaissance of innovation as the human ability to adapt is put to the test. We could also see pent-up demand, particularly in travel. Technology facilitates human digital interaction, but it will not replace real-life human interaction. The invention of the telephone and email has not ended business travel or made family gatherings obsolete, and Zoom is not going to make the body warmth of lovers entwined in each other’s arms old-fashioned.

So, the alphabet shape guide to economic recoveries could be applied to different sectors of the economy with those sectors satisfying human needs, wants most likely to experience pent-up demand, and a V-shaped recovery. 

I continue to believe that air travel and related stocks were oversold during the pandemic, and most likely to experience a V-shaped recovery

The tourism sector, hotels, car hire, restaurants, night clubs will probably experience a U shaped recovery, “Nike Swoosh” recovery where the economy stagnates for a few quarters and up to two years, before experiencing a relatively healthy rise back to its previous peak.

The deflationary, reflationary bet depends on the velocity of money and not the money supply

The 2020 pandemic occurred during the fourth industrial revolution with both events being deflationary because both events are detrimental to employment and consumption. 

The existing framework of monetary policy, near-zero interest policy, QE, suppressing the yield curve has failed to raise consumption.

I liken existing forms of monetary easing to a four-wheel-drive transmission with a broken driveshaft to the rear axle. Powers is going to the front wheels, which is driving asset inflation, but the rear driveshaft connects to the rear differentials, which spin the rear wheels is disconnected. So, the rear driveshaft is spinning aimlessly, but it is not driving the rear wheels, household consumption. QE and near-zero interest rate policy are not inflationary. 

But some forms of Universal Basic Income, a digital central bank app, central bank digital money with an expiry date would be inflationary.

If the Fed starts implementing UBI, then all bets would be on the reflationary trade

In the short term, the deflationary, reflationary bet is pointing to a deflationary depression

You do not need to be a noble prize economist or a market wizard to figure that out. Just put on your walking shoes, and you will see signs of a deflationary, great depression two. No UBI and the deflationary depression continues. 

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