Unravelling the complexity of Deflation

Ever since recession hit economies, the word deflation has come to the forefront, and off late discussion on the subject has gathered steam because Japan’s official measure of price patterns recorded a sharpest rate of decline in half a century. Speculation is rife on whether Japan will enter yet another deflationary spiral.

Coincidently, in history, the word deflation is often linked to Japan; the country that witnessed a painful decade in the 1990’s, popularly known as the 'lost decade' on account of a deflationary spiral. Economic expansion came to a complete halt.

What is so damaging about deflation? According to most of the learned, deflation means fall in prices and that’s what I too learned when I was in college. Fall in prices- Isn’t it good? It should spur consumption and that’s what is required to pep up an economy. Then why is it feared? Out of curiosity, I happened to look up for some write ups and I came across something that caught my attention and took me by surprise. It said, the definition of deflation that I have known, ever since I was introduced to the word, is incorrect. Fall in prices is the impact of deflation and not deflation per se.

So here is an attempt to unravel this deceptively simple word.

Since most of us understand inflation, let me start from there. Inflation, as we all know, is too much money chasing too few goods. The cause is an increase in money supply. The effect of inflation is general rise in prices of goods. Deflation on the other hand, as is understood, has the opposite impact of inflation– fall in prices is the effect caused by a contraction in money supply. Simply put, deflation is fall in money supply.

Fall in money supply normally occurs is an economic downturn because of caution exercised by consumers fearing loss of job in the light of deteriorating economic conditions. The preference to save and hoard cash, results in fall in demand for goods, forcing corporates to reduce prices. Reduction in prices means coporates will rationalise resources to remain profitable which will lead to loss of jobs. The fear of losing jobs and the fact that prices could fall further, results in consumers holding back spending creating a vicious circle- a deflationary spiral. Thus, deflation is feared not because prices are constantly falling but because of a reduction in money supply which negatively impacts economic activity.

Governments world over dread a deflationary like situation because it is tough to uplift an economy from this downward spiral. Japan took a decade to get rid of this phenomenon and pep up economic activity. The only way to fight off deflation is, by recapitalising financial institutions, injecting liquidity in the economy and increasing public spending till the time negative sentiment turns around.

If deflation is dreadful, it seems inflation is the lesser of the evil and more preferred. The question then is, how much is acceptable? Spare a thought!

Carry Trade - Path to another financial turmoil?

For financial sector enthusiasts, the word ‘carry trade’ is not new. It has been in existence for over two decades and has been popularly known as “yen carry trade”. This investment strategy has come to the limelight in the last fortnight, as noted economist, Mr. Nouriel Roubini know as Dr Doom, spoke about the US dollar milking the mother of all carry trades. Nouriel Roubini’s claim to fame has been his prediction of the current economic recession and hence his view invites scores of thinkers and market analysts to analyse the subject.

Carry Trade- How does this investment strategy work?
Simply put, investors which include financial institutions and hedge funds, borrow money in a currency that is cheaply available ( in this case the US dollar) i.e. at phenomenally low rates of interest and invest in off-shore asset classes that provide higher rates of interest. The asset classes could include stock, bonds and commodities among others.

The risks involved include exchange rate risk (movement of the funding currency) and risk of the asset class in which the investment has been made. Likewise, the return from this strategy includes gains/losses from movement in currency and gain/losses from the investment in the asset class.

The premise on which carry trade functions is

• The funding currency (in this case the US dollar) will weaken or at best remain stable and

• The Central Bank of the funding country intends keep the borrowing costs low

Currently the US dollar is available at near zero rates and the US Fed has indicated that rates will remain low for an extended period. This has encouraged traders to resort to the “US dollar carry trade” investment strategy (US dollar is used as the funding currency) for quick bucks. After all, who doesn’t want to make hay when the sun shines?

What has been past experience on Yen carry trade?

The past two decades had seen the yen carry trade grow to several billions of dollars, the quantum of which is debatable, on account of easy availability of funds at low interest rates in Japan- the loose monetary policy stance adopted to awaken the sleeping giant. The most popular trade then was the dollar yen trade. The gain was twosome- return on the asset class and profit on exchange rate on account of a deprecating Yen.

Tables were bound to turn at some point in time. In 2007, Yen took an about turn and started appreciating. The appreciation was significant enough forcing traders to unwind the Yen carry trades. This had an impact on markets as positions were getting liquidated. The unwinding of carry trade coincided with the downward spiral that the Dow witnessed from around 14,000 to 7,000 levels.

Will dollar carry trade lead to carnage in the financial markets?

For traders, carry trade with US Dollar as the funding currency is an excellent money making opportunity as the Fed has indicated that rates will not head upwards anytime soon. Also the latest reading of the unemployment numbers which has now crossed the 10 per cent mark in the US will make it difficult for the Fed to think of interest rate hardening in the immediate future. Besides, the depreciating US dollar adds to the gains of the traders.

The dollar carry trade is currently on full-fledged. This means that money is flowing out of the US and moving into countries that provide attractive returns on various asset classes. Is this the reason why all asset classes are moving in one direction only i.e. upward? Equity and commodities have been rallying for several months now. Surely fundamentals have improved with pressures on the global economy easing but aren’t valuations looking stretched? Is this a situation of too much liquidity chasing these asset classes? One needs to answer the critical question of whether the economic recovery warrants such a quick run up in prices of the various asset classes. If not, it’s time to exercise caution as an asset bubble is being formed.

When the interest rate cycle in the US turns, it will be accompanied by an appreciation in the currency. That will create havoc in the financial system as traders will rush to unwind their carry trade positions. A downward spiral in the asset classes funded by traders will be witnessed and it will cause pain to the financial markets.

Also, we cannot deny the fact that the dollar as a currency commands immense investor faith and we all fend for it a situation of crisis. If any such situation were to arise, you will find traders of carry trade running for shelter bringing about carnage in several asset classes.

Market movements- Too much hype?

Set aside the last couple of weeks, the run up in the Indian equity market has been impressive. One would say that it has been in line with an emerging economic recovery - GDP numbers bettering, companies beating analyst expectation and the global economy giving indications of stability and gradual growth. India being the second fastest growing economy after China, has but naturally attracted FII flows which have been to the tune of Rs 181 bn so far this year, domestic institutions which stayed away from the previous rally have started participating and retail investors are gradually gaining confidence. The negative news of deficit rainfall has been practically brushed aside by markets because of the now not so significant contribution of agriculture to GDP of  less than 20 per cent. Markets have appreciated by over 80 per cent in 10 months.

In the last couple of weeks though, the situation seems to have changed - correction to the tune of ~12% since Muhurat trading. Sentiment has turned cautious. Don’t forget that this is happening in the midst of an earnings season which in my assessment has been relatively good barring a few exceptions. Yesterday’s live mint said, “Nifty companies have posted best results in seven quarters.” Then why is it that markets are reacting the way they are? Correction in a market that was running up fast was warranted, but 12 per cent in two weeks? It does seem like something is amiss. That leads me to the question; do equity markets give you an indication of where the economy is headed?

In an ideal scenario, equity markets should reflect the economy’s performance and they do over long stretches of period as is evidenced by history. In the short term, anomalies tend to have a grip on the market- factors such as excess liquidity, FII participation among many others. What else can explain a dramatic fall in 2008 in a market that had nothing fundamentally wrong with it apart from the fact that growth would slow on account of recession globally?

A classic case in point is the current corrective phase. No significant negative news has emerged w.r.t to the Indian economy. The only visible parameter impacting markets is the fact that FII’s have turned net sellers. Whether we are decoupled or not, as a nation we can’t deny the fact that FII’s still have a strong hold on our markets. This clearly brings to us the fact that growth is not the only parameter that impacts markets in the short term. Several compulsions and aberrations can overpower rationale and logic.

Interestingly, after cricket scores, the most favoured discussion in the last few days has been the shape of recovery because of the sudden change in direction of markets. Is it U, V, W or some other mathematical sign? It’s amusing that one can base an argument of the shape of economic recovery on market movement over a few days. Take short term market movements with a pinch of salt, they make portray a picture which may be different from reality. It is also easy to get carried away with the hype created- you may make an investment decision which may look foolish in hindsight. Look beyond the surface.