Keystone's Inflation-Deflation Indicator Signals DEFLATION

In January and February, the U.S. slipped into disinflation and in March the U.S. slipped into deflation. The equity markets manage to pump out new highs on the Fed's QE 4 Infinity and Beyond, money that had been fleeing Europe and moving into U.S. blue chips, and the BOJ's easy money as they began their intervention to weaken the yen.  Despite all the central banker pumping, the U.S. is firmly in deflation, what Chairman Bernanke fears most. The 10-year yield (now 1.65%) moves in the same direction as the equity markets since money moves from stocks into bonds and from bonds to stocks depending on risk-off, or risk-on, respectively. Lately, however, bonds and stocks both are moving higher but typically; higher yields = higher stocks = a move towards inflation. Lower yields = lower stocks = a move towards deflation.

The note price is used for the denominator of Keystone's equation. The 10-year Treasury price is 103.125. The CRB (Commodities Index) is under 290 at 289.44. Taking a look at the numbers;

CRB/10-Year Price = 289.44/103.125 = 2.81

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, QE2 and Operation Twist to stop the free-fall into deflation.  Last year, however, the Fed threw the kitchen sink at the markets with the promise of QE3 Infinity, timed with the ECB's OMT Bond-Buying program, and also QE4 Infinity and Beyond, which replaced Operation Twist with outright purchases, when the markets were already somewhat elevated. This orgy of Fed quantitative easing, along with the BOJ, creates the bullish equity markets.  The rotation from bonds to stocks is not occurring as would be expected for any other economic recovery.  The bond market is usually correct.  The Fed changed the game last year since they goosed the equity markets without waiting for deflation to occur.  They tried to get the maximum bang for the buck pumping markets without waiting for a pull back.

The plot thickens, however, since the weak commodities, as well as weak Baltic Dry Index (BDI) and shippers, indicate a global slowdown in play, and clearly Keystone's indicator signals deflation.  So the Fed is throwing the kitchen sink at the markets and it appears that is not enough.  What happens next?  The Fed can admit that their programs are ineffective only resulting in a bloated equity market but not helping the overall economy, but, this will not happen. The idea behind QE is to create a wealth effect. If people see their investments growing, they feel better about the economy, and they buy houses, cars and other goods to fuel the recovery. The bloated market part is working but the rest of the plan is missing in action. The Fed will likely keep pumping since they have no choice at this point.

The obscene 85 billion per month in purchases will have to increase, as insane as it sounds, since the economy has slipped into deflation.  This hints at the end game nearing since an increase of the current obscene QE borders on recklessness.  The BOJ easing supplied the fuel for the SPX to print new highs.  The ECB rate decision is key this week. European indexes have rallied already anticipating a rate cut. If the euro weakens on the rate cut, the dollar should rise, and commodities and the U.S. equities should weaken, however, using the BOJ as a guide, any easy money policy by the ECB may actually create some further equity buoyancy. No one knows how this is going to resolve this week. The ECB rate decision is 7:45 AM EST Thursday morning, less than 48 hours away.

Keystone's indicator is now signaling Deflation. The pundits and analysts that say Inflation and even Hyperinflation are at the doorstep are likely premature.  Inflation will likely not appear until two, three, or even more years down the road to line up with the 18-year stock cycle of 1964 (bear), 1982 (bull), 2000 (bear), and 2018 (bull). That will be a new and intense problem, especially hyperinflation, but for now, the disinflationary and deflationary scenario's remain more important despite the new daily highs in equities. Look at Japan's funk for the last twenty years; deflation can be nasty and will surely affect everyone's lives.  Layoffs continue in the U.S. and globally with tens of thousands of financial and insurance sector jobs cut over the last couple months.  The current stagnant wage growth (wage deflation) screams of deflation.  Technology, computers and the Internet are huge deflationary machines.  Robots continue to replace human's on the job. More tech and less human's continues to challenge the unemployment picture and will foster the structural employment problem for many years. Companies are meeting EPS by laying off workers and squeezing more production out of existing workers (as evidenced by flat to lower top line revenue).

Watch Keystone's formula above, you can crunch the numbers to check on the indicator every few days. Markets are in trouble when the indicator drops under 3.00 into Disinflation.  Equity markets should be going over the falls if 2.90 fails since it indicates a deflationary spiral is occurring and the U.S. is headed straight for a Japan scenario. The equity markets, however, are at all-time highs, due to the central banker intervention, that is affecting inter-market asset relationships, and negating the expected market relationship of lower commodities = lower yields = lower equities, at least for now.  As long as the indicator stays above 3.0, in the Neutral territory and higher, the equity market bulls are happy. The ECB decision is the last piece of the puzzle needed this week. Within 48 hours, we will know where the Fed, BOJ and ECB all stand. Deflation says lower equity markets ahead but obviously, this is not the current case as yet. Perhaps epic economic history may occur over the coming days and week or two.