Keystone's Inflation-Deflation Indicator Signals Neutral Territory

In January and February, the U.S. slipped into disinflation and in March the U.S. slipped into deflation. The equity markets printed new all-time highs due to the Fed's QE 4 Infinity and Beyond, money fleeing Europe moving into U.S. blue chips, and the BOJ's easy money as they weaken the yen. In May, things began to change. The Fed talk on tapering is creating upside in the dollar and in Treasury yields (prices down). Keystone's Inflation-Deflation Gauge moves into Neutral territory recovering from deflation and disinflation in a only a short few weeks time.  Chairman Bernanke may be content since he fears deflation the most and is trying to create inflation but he must be concerned about the rate of change now occurring. The 10-year Treasury note yield was 1.65% only eight weeks ago and now is at 2.74%, 110 basis points higher!  The treasury yields move in the same direction as the equity markets since money usually moves from stocks into bonds and from bonds to stocks depending on risk-off, or risk-on, respectively. Higher yields = higher stocks = a move towards inflation. Lower yields = lower stocks = a move towards deflation. The asset relationships are skewed, however, since in a robust economy, commodities should be flying higher with equities but this is not the case. Copper, commodities, gold and silver continue to create a disinflationary and deflationary vibe, but the central banker money printing is instrumental in pumping equity markets higher. If commodities recover, the indicator will move upwards faster.

The note price is used for the denominator of Keystone's equation. The 10-year Treasury price is 91.50 with a yield about 2.74%. The CRB (Commodities Index) is a sick 280.72. Taking a look at the numbers;

CRB/10-Year Price = 280.72/91.50 = 3.07

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-falls into deflation.  Last year, however, 2012, 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.  In addition, China, the BOE and ECB are all pumping the markets as well. The rotation from bonds to stocks has not been taken seriously as yet but with the 10-year yield at 2.74%, levels not seen for two years, traders are now paying attention.  Traders are tripping over each other to buy banks since the 2-10 spread is widening.

The plot thickens, however, since the weak commodities, and wek demand for raw materials, as well as weak Baltic Dry Index (BDI) and shippers, indicate a global slowdown is ongoing.  It is interesting to watch the power of the central bankers as they pump equity markets but without the global economy kicking into gear it will be all for naught. Keystone is surprised at the fast up in the 10-year yield; it was not expected. A reversal from 2.4%-2.6% would have been expected but it appears that the genie is out of the bottle. The indicator flies from deflation in April to disinflation in May and now neutral territory towards inflation as mid-summer approaches.

Keystone's indicator is now signaling Neutral territory where the inflationists and deflationists fight it out. The winner is not determined until the indicator either drops back under 3 into disinflation, or, catapults to 4 and higher to verify that the country has leaped into inflation. The pundits and analysts that say Inflation and even hyperinflation are at the doorstep are likely premature but Keystone may have to rethink this idea moving forward considering the wild up in yields.  Inflation is expected in the years ahead but it is surprising to see it start to surface so quickly.  Keystone has been thinking that inflation will occur in sync with the 18-year stock cycle of 1964 (bear), 1982 (bull), 2000 (bear), and 2018 (bull). So the thought was that inflation and hyperinflation are a few years away yet but the big up in yields throws a temporary wrench in the works. The expectation remains that Treasury yields should leak lower again, and move sideways for the next two to four years.

The deflationary fears are abating with the up in yields. Look at Japan's funk for the last twenty years; deflation can be nasty and will surely affect everyone's lives. A structural unemployment problem remains and the 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). However, the up in yields moves counter to a weakening global economy.

Watch Keystone's formula above, you can crunch the numbers to check on the indicator every few days. Equity markets are in trouble when the indicator drops under 3.00 into Disinflation.  Equity markets should be going over the falls if 2.70-2.80 fails since it indicates a deflationary spiral is occurring and the U.S. is headed straight for a Japan scenario but the up in yields is negating the affects.  As long as the indicator stays above 3.00, in the Neutral territory and higher, the equity market bulls are happy.