Is Deflation Scare Over?

　

The unexpected Tory victory in the UK general election catapulted the GBP to the top of the currency heap last week. The AUD was the second best performer helped by a shift in interest rate expectations to later in the year. The NZD was the only currency that shielded the USD by sliding into last place ahead of it. The latest employment and wage date; and the continued slump in dairy auction prices weighed heavily on the currency. Meanwhile, the closely watched U.S. employment and wage data did not offer a strong sign of a pick-up in the U.S. economy; helping extended the USD’s correction for a third week. The end result is that market watchers have pushed expectations of the Fed’s rate lift off from June to September.

The stunning victory by Prime Minister Cameron was shocking but it would have to take a back seat to the flash crash in the German bund market. Having fallen to just 0.05 % in mid-April, the benchmark 10-year German Bund yields shot as high as 0.78% intraday on Thursday, before easing again. This set off similar moves in the global bond market. Moves of this magnitude are extremely rare in government bond markets – rising yields can be a healthy development if the global economy is picking up speed, but it spells trouble ahead if they suddenly jump at a time of sluggish growth. Thus, the Deutsch Bund Kernschmelze (German bund meltdown) either signals that the threat of deflation has eased or that inflation is about to rise on top of a sluggish economy, which is characterised as stagflation.

Is the deflation scare over and are we now headed toward inflation? This may be the case, especially if we see what has transpired in the oil and copper market as of late. Since falling 60% between June and January to a six-year low of $45 a barrel, crude oil has posted a strong recovery gaining more than 30%. Copper is up close to 20% off its January lows which according to an old investor’s mantra means that the global economy is coming back to life – copper has a Ph.D. in economics because of its ability to predict turning points in the global economy. Because of copper's widespread use in most sectors of the economy, demand for copper is often viewed as a reliable leading indicator of economic health. If we are moving away from deflation and into inflation then we should expect central banks to rein in stimulus and start to raise interest rates.

The only problem is that the current macro-economic back-drop doesn’t support this scenario. Media reports of market participants within the fixed income arena are blaming the meltdown on the lack of liquidity. This topic is more complex than we care to explain here but in a nutshell the lack of liquidity at times reflects changes in structure of the fixed income market due to the involvement of central bank buying for their QE programs. This may explain the violence of the move but perhaps the change in sentiment may actually reflect a realization of a bonafide Eurozone recovery. Having said this, the bond meltdown may also be reflecting the tenuous situation in the Greek default negotiations. The pressure is mounting and even though Greece was able to scrape together enough funds to make Monday’s 767 Million euro payment to the IMF it does not have enough funds to get through to the end of the month.