One last hurrah for inflation?

Inflation expectations on the rise in the US. Higher producer and consumer inflation in China. What then of the deflation  that many were fearful of just a couple years ago? Well, I believe the key risk factors that could presage a return to deflation are demographics, a higher US dollar and the deflationary impact from a collapse in industrial metal prices.


Perhaps the biggest deflationary force on the horizon is entirely predictable. And its pretty intuitive why slower population growth, or even outright falls should be deflationary. Although demand growth would typically slow, supply particularly through the housing is very slow to respond helping to push down price inflation elsewhere in the economy. Look at the Japanese economy (perhaps the poster child for deflation) over the past few decades and you will see a strong correlation between population growth and inflation.

Meanwhile, over the next 5 years the ‘Baby Boomers’, those born in the early 1950’s will hit retirement. And while you can argue the notion of retirement has changed for many over the past couple decades there is still likely to be an impact on investing and spending patterns. Retirees will be looking to gradually cash in their chips to fund their retirement. Their spending patterns will also be different. More money focused on experiences than actual physical consumption of material goods. Even the goods that they spend their money on will be different.

One final leg up for the US dollar?

A rebound in the US dollar could also cause a deflationary shock. There have been three broad dollar cycles since the 1970’s. The first reaching a trough in the late 1970’s, the second in the mid-1990’s and the third around 2010. Each of the first two cycles has featured a bounce off the lows of around 20%, a pause followed by a third final leg higher. Over the past couple years there has been a clear pause in the dollar bull market that started around 2010. If the cycle repeats then the next movement in the dollar should be a sharp final movement up over the next few years.

False signals

All of these risk factors is being obscured by the rise in commodity prices and thus inflation expectations. I believe that many commodity prices have been giving a false signal of strong demand growth since the start of 2016 with steel and other industrial metal prices soaring. It just does not make any sense in terms of either cyclical demand growth or ‘typical’ super-cycle timescales (10-15 year down-cycle). Rather it is (mostly) a function of the state mandated infrastructure spending and the threat of capacity cuts by the Chinese and actual cutbacks elsewhere from major commodity producers like Glencore.

Although this policy may have succeeded in bolstering the margins of state producers, it is not a function of the invisible hand of the market, rather the iron-fist of Chinese officialdom. And as priorities change, so could how policy is directed or implemented. We are already seeing Chinese PPI and CPI increase sharply as commodity prices feed through into the real economy. In a country so sensitive to inflation it may not be long before officials start to relax their capacity curtailment policy, resulting in a sharp drop in metal and other commodity prices.

The risk of a sharp slowdown (if not outright recession) in China and elsewhere is also under appreciated. Saxo Bank’s global credit impulse monitor measures the “rate of change of change” of credit in the market. According to the bank the “there is a high probability of a big slowdown in the global economy 9-12 months later – so from October 2017 to March 2018”. Industrial metal prices are particularly sensitive to credit conditions, especially if you consider that past credit growth may have encouraged speculators in China to load up on commodity financing to expand their positions.

What could cause the US dollar to appreciate sharply?

As we are starting to see, inflation expectations in the US are beginning to shift this fall as commodities continue to rally on broad dollar weakness and cuts to capacity in China. The Fed and the market will be forced to rethink the trajectory of the Fed’s rate path, biasing front end yields higher. Positioning on the US dollar will be reaching historically extreme levels by the end of the year increasing the potential for a sharp rebound.

The US Treasury had run down its cash balance sheet to almost zero this year as it neared the federal debt ceiling fixed by law. The Treasury has stated that it wishes to maintain a cash buffer of $US500 billion ($628.6 billion) in normal times, but as it builds the cash balance – by making a permanent -deposit at the Fed – it automatically tightens monetary policy.

What makes the US Treasury actions doubly potent this time is that the Fed is about to pull the trigger on “quantitative tightening” (QT) at exactly the same time, taking the first steps to wind down its $US4.4 trillion balance sheet. The Fed will start by selling $US10 billion of bond holdings each month, rising in stages to $US50 billion a month after a year. This will lead to a corresponding fall in US liquidity and may create the type of dollar shortage that has led to all manner sell offs in commodities and emerging market in the past.

All of which means that if the Fed acts as it has stated it will, then deflation expectations could start to rise much sooner than many expect. Combined with the long term, predictable structural effects in the real economy (ie, the slowdown in population growth and retirement for the ‘Baby Boomers’) then deflationary forces could prove much stronger.

It may just be the case that the recent rise in inflation expectations is what sets it off. A lot depends on central bank policy makers not making mistakes.

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