This article is a guest contribution by Bill Hester, CFA, Hussman Funds.
August 2010
One group of investors was likely to give up its view. The divergence in the performance of stocks and bonds was clearly at odds during July and the beginning of August. In July, stocks had their best month in a year, while at the same time bond investors were piling into Treasuries sending their yields to near-historic lows. Last week, stock investors finally blinked and began to appreciate the concerns of bond investors, including weak trends in the leading indicators, in the jobs data, in components of the GDP data, and in the slowing rate of inflation among various price indexes.
Inflation, of the lack of it, is one of the trends market participants are focused on. On Friday the BLS reported that overall inflation rose last month, the first increase in four months. On a year-over-year basis, the rate of inflation slowed its decent. But from the end of last year, inflation has still cooled to 1.2 percent from 2.7 percent.
Another indicator of inflation is graphed below. It's the Federal Reserve Bank of Cleveland's tally of how quickly prices are rising. It improves on the BLS's Consumer Price Index – which can be noisy because of volatile components like food and energy – and the Core Consumer Price Index – which can be bullied around by a few of the components with large weightings, especially its imputed rent component. The researchers simply take the median price change of the components within the CPI Index. Not only is it less susceptible to outlier price changes, it's also done a better job at forecasting future inflation than have the two CPI indexes, according to the Fed's research. As the chart shows, the trend has been mostly down, and it's moved in that direction with a surprising amount of speed and consistency. This measure stabilized slightly in July, rising .1 percent.
With fears of deflation spreading among market participants, it was an auspicious time for a member of the FOMC committee to deliver a paper arguing that the Federal Reserve's current policy was likely to increase the probability of deflation. This was the paper put out earlier this month by James Bullard, the President of the Federal Reserve Bank of St Louis. Much of the focus has been Bullard's comment that the US is closer to a Japanese-style outcome today than at any time in recent history. It's also been highlighted that his preference is for the Fed to buy longer-dated Treasury securities, restarting the type of quantitative easing that it pursued last year.
