"I explained that the deflation hype was rather exaggerated"

Emre Deliveli also sees Inflation ahead:

"At my inaugural column last week, I explained that the deflation hype was rather exaggerated, as the two commonly-quoted signs of deflation, U.S. October inflation and yields on American inflation-protected securities, were not accurate indicators at all. However, other market prices such as weakening oil and dividend yields on stocks surpassing yields on 10-year Treasuries have been pointing to deflation as well.

It seems that the market is definitely pricing for Deflationary Inferno even if deflation itself is not very likely. However, the alternative, Inflationary Purgatorio, is still far off the the markets’ radar. While many have learned to trust markets painfully, my overconfidence stems from the ongoing and prospective firefighting. After all, as a reader rightly noted, “numbers are important, but it is government policy that will shape the future”. And both fiscal and monetary policy are pointing towards eventual inflation.

The direction of monetary and fiscal policy

Even though he has been quick to announce his Economics team, you should not expect anything on the fiscal front until Obama settles in. This means that we are not likely to see the effects of fiscal policy on the economy until the second half of 2009 at the earliest. But once the stimulus comes, it is likely to be on the larger side because as this year’s Nobel Prize winner Paul Krugman notes, unlike monetary policy, fiscal policy is inherently asymmetric: It is easier to fix too much of it with contractionary monetary policy than too little of it with another stimulus package. Therefore, when it comes, the fiscal boost is likely to have an inflationary bias.

While fiscal policy is still far away, the Fed has had its hands full for some time now. While traditional monetary easing has not been effective, it has been complemented with more unorthodox tools such as intervening directly in credit markets. As the so-called quantitative easing is now semi-official, we can expect more of such creative policy from the Fed, whose balance sheet is starting to look increasingly like a hedge fund’s. In a similar vein, last week’s announcement that it would purchase USD 100bn in debt obligations from GSEs –government sponsored enterprises- is a first step in the monetization of public debt. With the low money multipliers, Fed’s actions are having a very limited impact on money supply for now. But the mere fact that the Fed is willing to shift to the extreme of policy means that it is not worried about inflation at this point."

This is what I believe is happening as well. Purgatorio is the Mezzanine Tranche of the Afterlife.

"Market implications, risks, and short-run outlook

Crises are always marked by the breakdown of time-tested relationships, but two interesting anomalies have emerged lately: Stocks have rallied while yields on the long end of the curve have fallen and the well-known positive correlation between dollar and long-dated Treasuries has broken. The scenarios I have explained above might shed some light on what is going on.

The recent flattening of the yield curve hints that quantitative easing is well-understood by markets, but its implications are not: All that liquidity and fiscal stimulus could find its way to inflation, which would in turn raise interest rates. With a huge US and global bond supply, we could even end up with a considerable bond market crash and another recession before the recovery from the current one is completed. While this dreaded W-shaped outlook is unlikely to pose a threat before the second half of 2009, it is in line with the anomalies above and paints a rather confusing outlook for the dollar (to be continued)."

I have already posted that we might have a bond market crash, and you know my theory of why these rates are so low. I believe it has to do with an overreaction based on the fear and aversion to risk, and an accompanying flight to safety.