Sometimes you need to do the trade that scares you the most

2015-01-22 8am EDT  |  #bunds #deflation #Draghi #ECB #Germany #QE

There can be no denying that the worries about deflation have hit a feverish pitch over the past couple of weeks. Have a look at this article from CNN Money, reporting from Davos:

Prices are falling, that’s a good thing right? Wrong. Deflation is as scary as Darth Vader, at least according to SkyBridge Capital’s Anthony Scaramucci. The hedge fund manager used the Star Wars metaphor at the World Economic Forum to ram home his point about the hidden dangers of a deflationary spiral. Scaramucci, affectionately called The Mooch, said the average person does not understand the terrible consequences falling prices can have. Over time, they can encourage people to postpone purchases in the hope of buying cheaper in the future, sapping demand from the economy. That can turn into a vicious circle. “It’s an annihilation. It’s Darth Vader, [the] Death Star outside of the atmosphere of the Earth, shooting lasers to blow up the world’s economy,” he said. “Erm, that’s kind of dramatic,” responded Harvard economic professor Ken Rogoff, trying to calm things down.But his words were hard to hear over the delighted laughter of the Davos audience. Japan spent the best part of 20 years trying to shake off deflation and economic stagnation. Inflation has turned negative in Europe, and most experts believe the European Central Bank will unveil a program of quantitative easing Thursday to try to turn the tide.

“The Mooch” sounds a little scared about the prospects of falling prices. And when it comes to the hedge fund community, this fellow is about as plugged in as it gets.

My guess is that he represents the consensus thinking within this group. And if they are worried about it, they have already hedged for it. But before you run out and emulate their hedge, don’t forget that this was the same group that in 2009–11 were warning about the coming hyper inflation brought on by the Fed’s QE programs.

Don’t get me wrong. I understand that deflation is a very real threat that is knocking on every Central Banker’s door. But these Central Bankers are probably even more scared of deflation than “The Mooch.”

Over the past couple of weeks we have seen an alarming number of these Central Bankers turn tail and run in the face of these mounting deflationary pressures. Yesterday the Bank of Canada surprised the market with a 25 basis point rate cut. Last week it was the Bank of Switzerland who pushed overnight rates down to negative 75 basis points. This morning we will see how much the ECB is going to panic.

We are riding a deflationary wave lower, but the Central Bankers are furiously paddling trying to get out before it crests over.

If you think that the Central Bankers are going to be impotent, then by all means, hunker down with your 10 year Switzerland bond with a negative yield.

But I think that this deflationary scare is a necessary precondition for the really big policy mistakes that will over shoot in the opposite direction. The fact that the Central Bankers (and the hedge funds for that matter) are so scared about deflation means that they will do too much to fix it.

Although I am sympathetic to the argument that much of QE sits on banks balance sheet and does not get lent out thus meaning that we might never get inflation, I also believe that if a Central Bank does enough balance sheet expansion, eventually the spark will ignite and the inflationary bonfire will explode.

Maybe inflation is like when you are trying to get ketchup out of the end of the bottle.

As it fails to come out, we hammer harder and harder on the ketchup bottle. We get more and more scared that there won’t be any ketchup for our burger. And then when we are convinced that it isn’t coming, it will pour all over our meal in a massive spurt.

I am going to make today’s post short as the excitement from Daghi’s ECB announcement is going to quickly dominate the morning’s action. But I wanted to let you know that yesterday I finally strapped on my full Bund short position.

I believe that QE programs are inflationary, or at the very least, they cause the yield curve to steepen. This is contrary to much of the rhetoric that you hear, but when you look at the data, the conclusion is clear.

There is no doubt that shorting bunds into the deflationary armageddon warnings from the likes of the “The Mooch” and the start of the ECB’s big QE program is scary, but I think that is why it might work. No one said this game is easy. Sometimes you need to do the trade that scares you the most. I think this is one of those times…