The Devil too can cite Scripture

This morning I opened up my news pages to learn that inflation is dead! Given that all last week most of the commentaries I read warned of the inflation inherent in the massive deficits in Europe- and, I thought in the United States- I was somewhat surprised to find that that dragon had once again been slain.

If I scroll back to the beginning of the year it seemed that most market commentators at the major banks were predicting a recovering economy and therefore were advising against Treasuries and promoting stocks.

Now, not even 6 months later, we are being bombarded by warnings of deflation and fears that the austerity measures being introduced to rollback deficits will cripple growth thus taking pressure off inflation. There are articles heralding that perhaps the US is entering into the limbo of Japan's "Lost Decade", and suddenly not only Treasuries, but a quasi-derivative thereof, STRIPS is suddenly all the rage.

Now it is true that STRIPS have had a great performance since the beginning of the year, and the stock markets have not, so relatively speaking there is merit ex post facto that once should have bought STRIPS. But the question is not what one should have done, but rather what one should do.

STRIPS are zero's so they can only go to 100. The 30 year UST yields around 4%. The 10 year around 3.25%, and the 5 year around 2%. There is a bond market adage that says 10 year yields of today are inflationary expectations of tomorrow. The 10 year yield today is suggesting that there isn't that much fear of inflation although if we are entering a lost decade I should add that in Japan the 10 year yield level sunk to around .75% so there is a lot of room to fall if you think we are going that way.

But just 2 months ago there were headlines screaming that US 10 year yields were the highest they had been since June 2009. The small print asked if this reflected optimism about the US recovery, or because of concern about the rising level of US debt.

So which is it? What is the significance of the large budget deficits? Are they harbingers of inflation, or foreshadowing deflation? Well do you believe that the public sector has the ability to manage the economy at times of crisis to stimulate growth, or do you think that the only solution is through the private sector, and more importantly can either of them decrease the deficit without causing recession(deflation) or create non-inflationary growth?

Maybe it is a theological question after all-it's just a matter as to how you interpret the scriptures!