Deflation, reflation, inflation

May 24, 2016 01:00 PM

Economic trends, which are caused by deflation, reflation and inflation, create sequences of price actions in markets than can be exploited by traders closely monitoring technical indicators. Often a one-time bearish (deflationary) event causes all markets to react collectively. These are often referred to as “Black Swan” events. Following the initial reaction, after markets have subsequently recovered, future price action often fragments as new economic issues become dominant. For the long-term trader, the fragmentation creates important, long-term trading opportunities. Nonetheless, macro trends will always change course, creating new and different trading opportunities as the economic process works itself through deflation, reflation and toward inflation (see “How it all began,” below). 

Beginning of the cycle

The decline in equity prices from October 2007 to March 2009 was the result of a Black Swan event: The Lehman Brothers bankruptcy—or more precisely, the underlying bank solvency issue and the decision by the U.S. Treasury Department to hold the line with Lehman instead of engineering a bailout like with Bear Stearns months earlier. The low in March 2009 stopped the decline in the major stock indexes, like the Dow Jones after prices traded below the November 2008 low and shortened the downward thrusts. In 18 months, the decline had retraced 50% of the advance from the 1984 low to the 2007 high. After 2009, because of the reflation effort, the macro trade became bullish stocks. 

Having rallied from the low in 2009, to recover the greater part of the decline from the high in 2007, price action in 2012 experienced two intra-year corrections as prices “absorbed” selling in preparation to extend the macro rally. It was clear in December 2012 that prices were on the springboard ready to rise in a sign of strength. Because of this, as well as the multi-year preparation, the rally should have lasted multiple years within the macro uptrend channel. The macro trade remained very bullish stocks. 

After a two-year rally, price action in equities began to flatten with lateral price action in 2015. Prices peaked in May 2015. Subsequently, two corrections carried prices laterally and out of the uptrend channel, a warning that the long-term bull market in equity prices was approaching its end. Nonetheless, recent short-term price action may have remaining potential because monthly price action, since the January 2016 low, has been able to climb a wall of fear. 

What about bonds?

In June 2007, the fixed income markets anticipated the forthcoming October 2007 top in the stock market. The intra-month reversal in bond price action (i.e., from bearish to bullish) in June and the subsequent rally preceded the resulting October 2007 top in equity prices. Sequentially, and in macro terms, the trade became: Long bonds after June 2007, short stocks after October 2007 until the March 2009 low. Thereafter, in macro terms, remain bullish on bonds and buy stocks. Fundamentally, low yields were a tool of reflation. Technically, the long-term indications remained bullish for both markets because both markets were establishing macro uptrends. 

Today, fixed income and the equity market’s price actions pose new questions about the current position of prices (i.e., the sustainability of longer-term trends). Does the bond market’s price actions since its low in December 2013, plus its most recent macro highs in April 2015 and February 2016, indicate that the end to its long-term uptrend is imminent? Yes, it does!

Fixed income price action implies a developing long-term top, however, the fixed income top may have a near-term lag time, which may allow equities to sustain prices within their trading range, or instead top with a flurry—the famed blow-off top (see “Are you afraid of heights?” below). The trade has become: Cautiously hold equities, but look for additional indications that it is time to exit and short bonds. 

From January 2014 to April 2015, the bond market had exploded upward in price appreciation with a 45-point rally. The rally represented a flight to quality as investors bought bonds to lock in total returns in a low inflation environment because stocks had a limited upside and a potential downside. 

The recent bond rally is developing what could be a trend ending long-term blow-off top in bond prices. Bonds could soon become bearish after additional information from price action indicates that the transition, from a long-term bull market to a long-term bear market, is progressing as expected. 

A crude development 

The catalyst for this last leg of appreciation in the long-term bull market for bond prices has been failed inflation. Commodity prices peaked in 2011. Afterward, crude oil prices lapsed into a multi-year trading range in response to increased U.S. production from fracking. In 2014 and afterward, falling oil prices started to create the fear that global influences, led by falling oil prices and concerns about China, would cause the return of deflation. As oil fell, because the Saudis maintained production levels to protect their market share, bond prices rallied causing bond yields to fall. This new sequence of events—cratering oil prices along with China’s stock market—changed the dynamics of the macro trade. The trade had become: Bullish on bonds, bearish oil and hold reduced equity exposure. 

Because oil prices still remain in what appears to be their last leg within the long-term downtrend channel, it is not clear whether oil has its final low in place. Nonetheless, in macro terms, there should not be a sustainable decline remaining in the price of oil. Therefore, oil’s intrusion as a deflationary factor has started to diminish (see “Crude’s worst is over,” below).

Golden moment

Along with the bottoming process in oil, the new and important sequence in price actions is the rally in gold. The rally from the December low broke out of the downtrend channel and recovered 95% of the decline in prices from the January 2015 high. The gold market’s ability to rally is a positive leading indicator for the reflation effort. 

Technically, the rally developed because December’s narrow price bar indicated that the bearish price bar for November was not a sign of weakness, which would have indicated markdown, liquidation and lower prices. Instead, December’s narrow monthly price bar, intra-month price action and decreased volume all indicated that the downward thrust had shortened (see “Golden rule,” below). As a result, prices were expected to turn up, which they did. 

Fundamentally, the gold rally is in recognition that weak oil prices plus fear of global influences have caused a readjustment in growth and the reflation process. Rate expectations have been lowered by the Fed, therefore, short-term rates [real rates] are expected to rise more slowly. The adjustment in rate expectations is beneficial for gold prices because it offsets the deflationary impact of oil prices while keeping the reflation process working. 

In December gold turned bullish. Gold rallied more than $200 and broke a long downtrend channel. Technically, because of this positive change in price behavior and its contribution to long-term analysis, traders should expect prices to be supported within a bullish trading range. The trading range should represent higher support to the December 2015 low and eventually, the last phase of accumulation. Afterward, the longer-term trend should turn up. The macro trade has become: Bullish on gold. 

Where are we now?

After October 2007, deflationary price actions created a macro sequence of trades. The trades evolved as markets either perceived or anticipated responses within the transition from deflation to reflation. Importantly, the decline in the price of oil extended the deflationary effect within the macro reflation response. Nonetheless, fast-forwarding to current longer-term price action, the position of prices in markets and importantly, the recent rally in gold is suggesting the development of a new sequence of macro trades due to reflation. 

Recent price action in oil, bonds and gold implies that markets are in the early process of changing direction in trends. Therefore, their price actions are creating a new sequence of macro trades. Nonetheless, macro price actions may need additional time to develop. Importantly, gold’s price action, because of its recent rally, which broke the downtrend channel and recovered almost 95% of the decline from January 2015, is a positive leading indicator for the continuing transition from deflation to reflation.

The macro reflation trade has become: Selectively hold stocks, look to exit and short bonds and buy gold. Reflation is replacing deflation. Markets will be returning to more normal trading patterns as reflation progresses.

Throughout the period following the Great Recession, there has been a great deal of talk regarding “the new normal” and questions of when a more normal market environment will return. While there are cycles of all kinds, the deflation, reflation, inflation cycle sits on top as a sort of market overlay. And while there have been many failed attempts to define the period we have been in during the last decade and when things will return to normal—however you define it—all cycles end. The trick is knowing when and what to do about it.

About the Author

Robert Burgess has been a broker and trader, and published the Burgess Technical View, a newsletter featuring his technical views on stocks, bonds and commodities, which developed an extensive subscribership, which included large financial institutions, pension funds, and Fortune 500 companies.  He continues to keep a watchful eye on markets.