Keystone's Inflation-Deflation Indicator Moves into the Neutral Zone

In May, Keystone's indicator dropped into Deflation. The recent stock market rally has moved money from Treasury's back into higher-risk stocks.  This results in higher yields and lower note and bond prices.  The 10-year yield is 1.64% with a price at 99.891 as this missive is typed. The 10-year yield peaked at 1.73% yesterday before pulling back thus far today. The happy talk from central bankers caused the equity market rally and up in yields.  Keystone's indicator has now moved back up thru disinflation and is now back into the Neutral zone.The CRB (Commodities Index) languished at 270 on the cliff edge during June but recovered, now well above 300 again. Taking a look at the numbers;

CRB/10-Year Price = 304.81/99.981 = 3.05

Over 4 = Inflation
Between 3 and 4 = Neutral; inflationists and deflationists fight it out
Between 2.9 and 3.0 = Disinflation
Under 2.9 = Deflation

Chairman Bernanke announced QE1 and QE2 as the country became mired in deflation with Keystone's indicator in the 2.5-2.6 range. The indicator dipped into this area in May but then recovered. Therefore, the QE3 watch continues but for Bernanke to act, the 10-year yield will need to drop lower (price higher) as well as the CRB dropping back down thru 270 and heading lower again.  The markets are hugely optimistic that Chairman Bernanke will announce future easing plans at Jackson Hole on Friday, 8/31/12.  With the CRB over 300, traders will be extremely disappointed. Bernanke fears deflation, a la the Great Depression and Japan's continued two-decade funk. With the CRB over 300, Bernanke likely has no plans for QE3.  The next FOMC rate decision and meeting is 9/11/12 and 9/12/12.

Do not worry too much about the timing of QE3 since the announcement will be dictated by the deflationary pressures. QE3 is coming but not until the deflationary forces reemerge.  In general, focus on the CRB; once it loses 270 the Fed will stand ready with QE3. At CRB 250-270, the Fed will act with QE3. This may happen in a few days, or it may take a few weeks, or a few months, or even not until 2013. Bernanke will avoid deflation at all costs which will cause him to act with QE3 but with the CRB higher and yields higher, QE3 will be on a milk carton for the next couple months, in contrast to what equity traders now expect. Ironically, a disappointment by the Fed will result in a market sell off, which will send the CRB lower and yields lower, thus, creating the environment for when Bernanke will act.