Currently, there is a lot of talk about deflation. It hasn’t really happened yet… but there are a lot of signs pointing in that direction. We all know what inflation is, but what is deflation?
There are two types of deflation: the good kind and the bad kind. The good kind happens when prices decrease due to improvements in productivity, either though technology and/or lower cost of production. The bad kind of deflation is when the lack of demand forces margin squeeze. The lower demand eventually means lay-offs and demand decreases even more. And it spirals down from there. To pull out of an era of deflation is much harder and takes longer than handling an inflationary period.
We could say that the growth of globalization and technology has been the main reason that prices look like they are very contained if not decreasing in real terms. The catchword is “low-flation”. However, there is another factor that can exacerbate deflation. It’s called a “liquidity trap.”
A liquidity trap is when interest rates are so low that there is little motivation for people to invest in certain instruments such as bonds. Indeed, investors feel that interest rates will soon rise and they hold-off buying and providing capital to the financial system. Of course, Central Bank monetary largesse has pumped trillions into bond buying and that has driven interest rates even lower. What investors would buy negative yielding bonds?
The liquidity trap doesn’t apply to Central Banks… or does it? Most doomsday Monetarists felt that Quantitative Easing would bring about high rates of inflation but that hasn’t happened. Inflation is generally too much money chasing too few goods. The reason there hasn’t been inflation is that the trillions of dollars from Quantitative Easing have just been recirculating in the regulated financial system and not chasing goods but pumping up stock prices. Also, banks aren’t lending to anyone but the most credit worthy.
OK that’s the simplistic look at the current situation. No inflation to speak of and stagnating unemployment. So, we could say that we are experiencing mostly productivity based price containment, not deflation in the bad sense. All that said, what if the right decisions coming out of the Fed or the ECB can’t stimulate economies? How does a Forex trader trade in a deflationary environment?
Here’s my take based on thirty-five years of trading. By recirculating excess money supply and not letting it loose in the consumption sector, there will probably be more downward pressure on margins. However, there is high demand in emerging world markets. In an effort to boost domestic jobs and production, there may be a race to devalue the currencies for the purpose of pumping up exports. It’s already happening in Japan. However, if every exporting nation does that all at once, there is the danger of a slack tide grounding all boats. But that would take a while and then we would come face-to-face with worldwide “bad” deflation; that would be bad news and a probable inflection point in history.
Investors are constantly reminded that trying to time the market is a losing proposition. However, traders are all about timing and what is happening to prices at the moment and not in the future. Although curious, traders are not trying to read the future in the mathematical-statistical entrails of technical indicators.
In summary, successful Forex traders will do what they always do: trade price movement, be it up or down. That said, about ten years ago, the World-famous Blue Angels flying team lost all four formation airplanes and their pilots when all four flew into the ground at over 600 mph. The reason for the accident was that three of the planes follow the lead plane without fail. The lead plane had lost control and the others followed their training mandate into the ground. So, if deflation does happen, try not to listen to the popular strategies and end up flying into the ground.