As recently as 9 months ago, it was easy to find a quote by anyone (your author included) that inflation seemed to be running rampant. Crude oil was pushing new highs, grain prices were exploding, meats and soft markets were running up as well. The prevailing fear was, as the US entered what we thought to be a simply downturn, cuts by the Fed would lead to extreme levels of inflation. Gold would go to $5,000 an ounce, crude would trade over $200, the cash strapped, debt-laden consumer would be in greater trouble.
Flash forward to November. Crude has fallen over 60% from its’ peak prices. Grains have given back 30% or more of their gains. We are now in a new paradigm, deflation. On the surface, lower prices are good for a consumer that is more focused on making their mortgage payments than buying a new plasma TV. Lower gas prices and lower food prices would seem to benefit individuals, and it will over the short term. Typically, reductions in inflation that are lead by commodities markets are beneficial because it increases consumer’s real income. The problems pop up as you look towards the future, when prices fall too fast in too short of a period.
As futures traders, we are always watching the horizon for things to come. We trade markets for delivery months in advance, so our prices are not a representation of a discounted net present value. We are looking at what might be. The unfortunate offshoot of deflation is that debt becomes more costly to those who hold it. Following economic dictum, households that are debt laden will be more worried about paying off loans more rapidly. One only needs to look at the first and largest level of personal debt, mortgage debt, to see just how much the US consumer owes. It is not a pretty picture. It seems we are headed to an economically disastrous condition known as debt deflation. Debt deflation will have consumers and companies rushing to pay off debt as credit further dries up. This will lead to further price cuts at the retail level and more demand destruction on the product level. Deflation will in fact increase the real cost of debt, which is already historically high. Consumers recent reluctance to spend and borrow coupled with the banks ever tightening credit requirements are exacerbating the problem.
So now that I’ve told you where I believe we are, as a futures trader it is my duty to tell you where I think we will go and how I believe you can follow the trends that debt deflation will lay out. First, I’d like to make the case that commodity trend following (which has done very well during this economic downturn) will continue to do well in this climate. In a debt deflation cycle, real interest rates tend to fall. In the case of the US, I believe the Fed Funds target rate will be cut to .50 in December and further cut to 0 during the first quarter of 2009. I believe the way to play this is to be long Fed Funds futures contracts. Many of the trend followers that we employ are currently positioned this way. In the same way, I expect bond prices to continue to trend upwards across the yield curve. Again, many trend followers use global interest rate markets to trade. Most mangers are positioned long bond prices in the US as well as around the world as this debt deflationary cycle spins from the US across the globe.
The second trade, or method to trade, is one that is long volatility. In this climate, the options markets continue to price in an extremely volatile climate in the global equities markets. Typically, in a high volatility market, S&P 500 swing traders and index speculators tend to outperform. The markets, with their daily swings of hundreds of points, are not expected to slow down any time soon.
So, instead of fearing debt deflation, make it work for you. Your trading theme in 2009 should not be to hide. The money being lost in the market is not vanishing into thin air, especially in futures. Our markets are a zero sum game. The goal is to find yourself on the right side of the trade. If this debt deflation cycle persists, I believe that trend following and long volatility S&P speculators will outperform other methods.
