Deflation and the Treasury bubble

One more reason why it's probably still too early to short U.S. Treasuries, what many now refer to as "the biggest bubble of them all", becomes quite clear after realizing that the talk of "deflation" has just begun.

Unfortunately, we are likely to hear people screaming about "deflation" for about the next six months - at least until last year's high energy prices work their way through the year-over-year figures in the CPI (Consumer Price Index).

Last week's +0.1 percent annual reading in the CPI produced quite a stir and that was when $40 a barrel crude oil was being compared to $90 crude oil.

Unless energy prices rebound sharply in the next few months, the statisticians at the Labor Department will soon be starting out with $140 oil and, when the final inflation numbers are calculated, you're going hear more and more people say stupid things like, "deflation is definitely here now" and "deflation is really taking hold".

As if falling prices have any real impact on how consumers think about their future spending plans when the whole world is in the process of falling down all around them. Haven't we already been conditioned to buy despite prices going down? Computers, TVs, iPods, iPhones? Hasn't this been Wal-Mart's main advertising campaign for the last ten years?

Puuuhlease...

Naturally, the fixed income crowd will hear this talk and they'll only want to buy more government debt, pushing prices ever higher and pushing yields down. They are already expecting little or no return on their money, figuring that they'll still come out ahead, apparently fearing that the government can't print up enough money fast enough - that our fate of a "deflationary abyss" is already sealed.

You wait and see - by the time the flowers are blooming this spring, it'll be all-deflation, all the time in the financial media.

Tony D’Altorio, an analyst at Bourbon & Bayonets (not to be confused with Whisky and Gunpowder) had some similar thoughts about the bond market and deflation the other day.

Investors' gullibility is really showing with the way they have swallowed the entire deflation myth hook, line and sinker. It's hard to believe that people can't see that Treasuries yielding zero per cent means that Treasuries are trading at BUBBLE valuations. How can an investor spot a bubble?

One major attribute of every bubble in history is that it is “sold” with a great story. We have that today – a great “story” is being told - the fairy tale known as deflation. Deflation has been made out to be this horrible monster of mythical proportions by the government and by the mainstream financial media.

The “story” is being spread by mainstream financial media outlets such as CNBC, where if they are not talking about Apple Computer, they're talking about deflation. By the way, I have always amused by the name of CNBC's chief economic correspondent, Steve LIESman. What an appropriate name!

Scary tales of a global recession and collapsing financial markets are spiced up with dark remembrances of the Great Depression of the1930s and Japan in the 1990s. These fairy tales have driven investors to protect themselves against the deflation “monster” by blindly purchasing “risk-free” Treasuries at any price.

Another attribute of every bubble in history is that they are believed to enjoy the support of the governing authorities. The governing authority in this case is the Federal Reserve. I'm sure we all recall how the “Greenspan put” of the 1990s emboldened stock speculators, leading to the dot-com bubble.

Today, we have the recent announcement by the Fed that they would be purchasing government bonds. This announcement has led Wall Street to believe that there is now a “Bernanke put”, placing a floor under the Treasuries market. This has led directly to the bubble-like valuations in Treasuries.

There is no doubt that Treasuries are in a bubble.

There is also no doubt that, regardless of where consumer prices head in late-2009, 2010, and beyond, we're going to be hearing a lot more talk about deflation in the next few months with the clear implication that the bubble in Treasuries could get even bigger.