Debunking Deflation

The Producer Price Index also isn't showing inflation. The most recent (May 15) headline figure looks deflationary -- initially. The PPI fell 1.9% in April. But strip out volatile energy and auto prices, and producer prices have fluctuated along with spending and industrial production levels for the past year, movement that is not representative of deflation. Also, core prices for intermediate goods, a separate component of PPI and a leading indicator for consumer inflation, were zero in April, and thereby maintained a 3.85% annualized rate of inflation.

The falling dollar, along with Americans' taste for foreign goods, also is inflationary. The U.S. economy still hasn't felt the full impact of the past year's 25% decline in the price of the dollar against the euro nor the 11% decline in value against the yen. The price of imports is still going up, another inflationary factor.

Markets' Reaction

Rationally, December gold is reflecting inflationary expectations. At $375 an ounce, it is one of the strongest momentum markets among the most widely followed futures contracts. Look to enter on pullbacks from the three-month high.

Debt futures are not reflecting inflationary expectations. Their rally into record territory is going the other way, reflecting deflationary expectations. The perception that the Fed will become a buyer of the long end of the yield curve (of three-, five- and 10-year notes) to combat deflation or economic stimulus provides major upside pressure. So, too, does the Japanese "arbitrage trade" I wrote about on May 20. Indeed, the Bank of Japan recently said it offered 600 billion yen to buy Treasury bills on May 27.

Still, debt futures will need a steady stream of good news to keep their rally on the northbound track. Be on the lookout for traders front-running upcoming CPI and PPI reports. A whiff of inflation could send debt futures prices tumbling.