Market Meltdown – Deflation Trade is Back

posted by Nima

May 6, 2010 · Posted in Investing 

Many things are being said about today’s market plunge by over 1000 points at some point. I won’t delve into that, just how today’s action beautifully shows the general idea behind my long term view.

Dollar

I have been writing for a while now about my expectation of mid to long term strength in the Dollar:

August 2nd 2009 – US Dollar Looks Bullish Fundamentally & Technically

August 13th 2009 – 3% Bullish Sentiment on Dollar – Indication of a Coming Dollar Rally

December 9th 2009 – Has The Dollar Rally Started?

Here is the Dollar over the past months through today:

dollar-2010

This Dollar rally is best explicable as a symptom of global de-leveraging alongside deflation in the US. As investments the world over are being unwound, a flight into the world’s reserve currency is inevitable.

Today’s gains in the Dollar index were around 1% overall. In particular the Euro took a significant beating over the ongoing monetary insanities perpetrated by the ECB. A Dollar rally is at the same time usually a very bearish sign for stocks. Today’s moves beautifully accentuated this correlation, in particular during the intraday spikes and corrections. The fact that the Dollar has been moving up together with stocks over the past months is to me just a sign of how severe a correction stocks are going to be in for sooner or later.

Gold

Global delevaraging is also bullish for gold. As I have said many times: During deflation cash is king. And gold is the king of all cash. This is counter-intuitive to many people because they throw gold in one bucket with all other soft commodities. But gold is a categorically different commodity. It serves virtually no industrial production, except for some negligible applications. It is a money commodity. Silver has some money characters, but also has quite a lot of industrial uses.

Thus I explained in August of last year when commenting on an article by James Kostohryz at Minianville:

I agree with his bullishness on the dollar. I don’t necessarily agree with his conclusions on gold. I think gold may actually do OK during a dollar rally. Maybe it will drop a little, maybe rise a little, but it will most definitely outstrip other commodities. In fact, I think a smarter play when betting on a dollar rally would be to short any other commodity BUT gold.

And how has gold done throughout the dollar rally? Here it is:

gold

You see? The Dollar has risen to a new 12 months high over the past 6 months, during that time gold dropped for a little while, but has gained back all those losses and is now actually up on the net as flight to safety continues. Meanwhile most other commodities are actually down on the net over that time. That’s what I meant when I said what I said above in my comment.

Today in particular gold was up around 2% while all other commodities got clobbered.

Treasurys

As a corollary of Dollar strength one can expect the prices of Treasury notes, pretty safe claims to Dollars at interest, and bonds to rise and thus their rates to fall. I have been arguing for a while that over time treasury rates will fall, but with quite some noise inbetween, sparked by false inflation fears:

I think Treasurys will continue to act well. There maybe some upward pushes here and there so long as inflation expectations pop up once in a while, but the mid-term trend remains unchanged: It is likely that yields are headed for new lows.

Treasury rates have been moving pretty much up and down and are actually still a bit up from when the rally started, but one thing I just wanted to point out is the strong move today in long term treasury instruments, alongside a strengthening Dollar and strong gold, see Mish:

Yield Curve as of 2010-05-06 3:15PM EST

Bullish Flattening of Yield Curve

That chart shows a bullish flattening of the yield curve as I expected. Those expecting a bearish flattening (yields rising) got their clocks cleaned today as treasury bears were slaughtered.

What’s next?

… we shall see. I certainly expect this global sovereign debt contagion to spread rapidly and exert its effects, among other things. I would be rather surprised if US equities could somehow decouple from this avalanche. Personally I still think that a healthy mix of gold, Dollars, and Treasurys is the right recipe to protect one’s wealth in these turbulent times.

One should not think that I am suggesting that the US is immune against sovereign debt problems. The public debt in this country is crushing as well, I just think that before the US defaults outright on its Treasury bonds many much more serious things would need to happen. One thing you can be sure of: The US government will continue to raise taxes should there ever be doubts about its ability in servicing the public debt, and it will probably do so quite a few more times before the people would be ready and willing to do more than hang a few teabags on their ears, grab signs, and protest before Congress to express their inconsequential anger.

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