Treasury bond yields are falling, the breakeven inflation rate is nearing zero (based on 10-year TIPS) and inflation swaps are anticipating deflation next year followed by price stability through 2014. The good news is that the deflationary path suggested by inflation swaps for the next couple of years is nowhere near as bad as that experienced during the great depression – the level of the CPI was down roughly 13% by 1933. The bad news is that the swap market anticipates deflation to set in much faster than it did in Japan following the start of its credit crisis in 1989. Deflation in Japan only set in after the Asian crisis in 1998 – the CPI had remained on a small uptrend until then. Why should we worry more about deflation in the U.S. over the next three years than in Japan in the early 1990s?

The answer lies with the state of the economy at the start of the crisis. As shown, Japan entered its recession in a position of excess demand. In the U.S., the economy was actually in a position of excess supply when the credit crisis began to unfold, a situation that is likely to worsen in 2009. This explains why markets are quicker in anticipating deflation in the U.S. and why authorities are contemplating a massive stimulus package to limit the build-up in spare capacity.

Mounir R. El-Ayari, CIM, FCSI, C.h. P. Strategic Wealth
Investment Advisor
Associate Portfolio Manager
e-mail: mounir.el-ayari@nbf.ca