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View Full Version : Chasing The Deflationary Dragon



Ares
17th June 2010, 10:20 AM
From Nic Lenoir of ICAP

For a while now I have been making for the great deflationary wave that is upon us. We have argued that for demographic reasons, because of the unprecedented productivity gains of the last 30 years, and last but not least due to the bursting of the credit bubble, deflation is inevitable. This is compounded by the fact that the phenomenon is generalized in the western world, China with excess capacity both in terms of production and workers, and with its huge credit bubble in the bursting, will absolutely not be our savior.

This is why despite government officials forecasting 3/3.5% growth over the next 5 years (which is both wishful thinking, an attempt to get the consumer to spend more money he doesn't have, and a way not to have to remark all the unfunded liabilities out there) Federal Reserve officials are worried that we are caught in a liquidity trap. Central banks are in a race to try to reinflate the system using monetary largesse and currency debasement, but that only works when everybody is not in the same boat... For now their liquidity has made its way straight to the stock market and increasingly to hard assets and precious metals. That just means whatever central banks are doing is relatively useless. The core fabric of our economy remains feeble and it's bubble or bust. The more that notion grows in the public's mind, as it is growing fast, the harder it will be to justify creating bubbles with much more cons that pros as the wreckage left after the bursting is usually worst than the state the world was in before it happened. Europe is already trying to implement some fiscal austerity (we remain skeptical on their chances of success).

Under a deflationary scenario and with short end rates already at zero the yield curve is likely to flatten quite a bit. For those who are not keen on holding long dated Treasuries outright or buying calls on 10Y future: meet the bull flattener. We first take a look at the 2Y/10Y treasury yield spread or the 5Y/30Y treasury yield spread. There is a negative carry associated with playing this flattener due the cost of being a payer of 2Y rates but the carry is a lot lower than it was when 2Y was yielding 1% not so long ago. The twist we add to the trade is to consider 2Y swaps against 10Y treasuries, or 1Y1Y fwd swaps against 10Y treasuries. The reason behind this is that if the economy does weaken debt refinancing and banks assets' financing is not going to get any easier which should push out swap spreads much wider. Being a payer of 2Y swap rates under these circumstances would make the cost of the payer position less and add to the performance of the trade. In the case of the 1Y1Y fwd the spread widening would contribute though less than on spot 2Y swaps, but by the same token should fixed income sell off 1Y1Y fwd payer would perform better than 2Y swaps. Note also that should the hyperinflation bugs be proven right and my deflationary theory is bogus, then the US fixed income curve should trade more like a credit curve and 2y/1y1y fwd rates will outperform 10Y treasury yields and swap spreads should widen out aggressively under such scenario as well.

<img src="http://www.zerohedge.com/sites/default/files/images/user5/imageroot/trichet/us%20govt%202%20vs.%2010.gif"/>

<img src="http://www.zerohedge.com/sites/default/files/images/user5/imageroot/trichet/us%20swap%202y%20vs.%20govt%2010%20daily.gif"/>

<img src="http://www.zerohedge.com/sites/default/files/images/user5/imageroot/trichet/us%20swap%202y%20vs.%20govt%2010.gif"/>

<img src="http://www.zerohedge.com/sites/default/files/images/user5/imageroot/trichet/us%20swap%201y1y%20%20vs%20gt10%20daily.gif"/>

<img src="http://www.zerohedge.com/sites/default/files/images/user5/imageroot/trichet/us%20govt%205%20vs.%2030.gif"/>

I am looking at ways to express this via options to see if there would be a way to reduce a little bit the negative carry on the position. The only adverse scenario to the trade is the economy does not roll over, short end yields remain low and the curve remain steep. With leading indicators rolling over and unemployment not really improving, it seems that betting on a growth slow down in the second half is far from a long shot. However there is always a cost betting on something that is not priced in, what we argue here is that in this case the cost is worth it.

http://www.zerohedge.com/article/chasing-deflationary-dragon